Question

Western Manufacturing is involved with several potential contingent liabilities. Your assignment is to draft the appropriate accounting treatment for each situation described below. Western’s fiscal year-end is December 31, 2021, and the financial statements will be issued in early February 2022.

a. During 2021, Western experienced labor disputes at three of its plants. Management hopes an agreement will soon be reached. However, negotiations between the company and the unions have not produced an acceptable settlement, and employee strikes are currently under way. It is virtually certain that material costs will be incurred, but the amount of possible costs cannot be reasonably estimated.

b. Western warrants most products it sells against defects in materials and workmanship for a period of a year. Based on its experience with previous product introductions, warranty costs are expected to approximate 2% of sales. A new product introduced in 2021 had sales of $2 million, and actual warranty expenditures incurred so far on the product are $25,000. The only entry made so far relating to warranties on this new product was to debit Warranty Expense $25,000 and credit Cash $25,000.

c. Western is involved in a suit filed in January 2022 by Crump Holdings seeking $88 million, as an adjustment to the purchase price in connection with the company’s sale of its textile business in 2021. The suit alleges that Western misstated the assets and liabilities used to calculate the purchase price for the textile division. Legal counsel advises that it is reasonably possible that Western could lose up to $88 million.

 

Required:

In a memo, describe the appropriate means of reporting each situation and explain your reasoning.

Answer 1

Contingent Liabilities:

A contingent liability is a liability of a company that depends on a future event on the basis of a past transaction. It may be called probable liability or an eventual liability. It may or may not become a liability of a company is entirely depends on the future events.

 

Journal entries:

Journal entry records the accounting transactions of a business in a journal book. All the business transactions are recorded in the chronological order using the double entry system of accounting.

 

Memo describing the appropriate means of reporting each situation:

MEMO

To : Manager of W.M.

From : XXX Accountant

Date : XX/XX/20XX

 

Subject: Accounting Treatment of the Situations Presented This memo is prepared with the aim to clear your doubts about the accounting treatment of the situations presented.

 

The situations somehow represent Accounting for Contingent Liabilities. Contingent liabilities are a liability that may be incurred by a company if a future uncertain event occurs. In other words, the creation of contingent liability is dependent on the occurrence and non-occurrence of a future event.

 

(a)

The first situation is about labor disputes in company's three plants. The company has estimated that as there has not been acceptable settlement between the company and the union, the material costs are virtually certain to be incurred. However, the estimate of the cost is not reasonably known. The possible treatment for this is-Contingent liabilities are reported only when the event has high probability to be occurred and the amount related is reasonably known.

 

This means that no loss will be recorded because the management has no knowledge of the amount of loss that may be incurred in the event. However, the management is recommended to disclose the matter in its notes to financial statements.

 

(b)

The company issues warrant when it sells its products and it is approximately 2% of its sales. For the sales reported in the year 2021 which was $2 million, the warranty expenses that were incurred by the company were only $25,000. So, the company passed a journal entry only for the amount actually incurred. The possible treatment for this is:

The company must have reported $40,000 (2% of S2 million) as warranty expense rather than just $25,000 as it has incurred so far. There is a possibility that the warranties will be incurred and will be equal to the estimates of the company based on previous product launches. Hence, the following journal entry must be passed:

Date	Account title & Explanation	Debit ($)	Credit ($)
	Warranty expense	15,000
	Warranty liability		15,000
	[To record the loss contingency for warranties.]

 

Warranty expense is an expense account and carries debit balance. It decreases the value of equity. Therefore, debit warranty expense account by $15,000. Warranty liability is a liability account and carries credit balance. It is increased by $15,000. Therefore, credit estimated warranty payable account by $15,000.

 

(c)

The company is involved in a lawsuit. The possible treatment for this is-Contingent liabilities are reported only when the event has high probability to be occurred and the amount related is reasonably known. This means that no loss will be recorded because the management has no knowledge if the loss may incur or not in the event. However, the management is recommended to disclose the matter in its notes to financial statements.

Account Title	Debit	Credit
Legal Expenses	88000000
Lawsuit liability payable		88000000

 

It is expected that the above explanation clears all your doubts relating to contingent liabilities. Feel free to reach out to me for more doubts, if any.

 

Regards,

XXX

(a)

However, the management is recommended to disclose the matter in its notes to financial statements.

(b)

It is increased by $15,000. Therefore, credit estimated warranty payable account by $15,000.