In: Accounting
AICPA Adapted
Part a. |
The two basic requirements for the accrual of a loss contingency are supported by several basic concepts of accounting. Three of these concepts are the period of time assumption, the recognition principle, and the qualitative characteristic of verifiability. Required: Discuss how the two basic requirements for the accrual of a loss contingency relate to the three concepts mentioned above.
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Situation I
A company offers a 1-year assurance-type warranty for the product that it manufactures. A history of warranty claims has been compiled and the probable amount of claims related to sales for a given period can be determined.
Explain the accrual and/or type of disclosure necessary (if any) and the reason(s) why such disclosure is appropriate for each of the three independent situations described.
Part a. The two basic requirements which has to be fulfilled for accuring a loss contingency are the chances of suffering a loss and making a reasonable estimate.
Time - The first requirement that must be fulfilled for accuring a loss contingency is that time prior to the issuance of the financial statements there is an indication that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements. The company need to account for or disclose the accural in the period it relates to. If the company reasonably estimate the amount of loss, adjusting entries is required to be made at the end of the year in order to be reflected in the balance sheet and income statement.
Measurement - The second requirement for the accrual of a loss continegency states that the amount of the loss must be reasonably estimable. The Measurement concept works accurately record an item with the most relevant valuation tool, which for current liabilities is the present value of the required future payments. Measurement of the possiblility of loss that could be probable, reasonably possible to occur and remote. Reasonable effort should be made to measure the probable loss.
Objectivity - Objectivity with which loss such as making acquisition decision are made. Financial data must be neutral, credible and honest so that stakeholders can access and make decisions. The concept of objectivity is supportive of the contention that future events will confirm the occurrence of a loss at the date of the financial statements and the loss must be probable and estimable.
Part b.
Situation I - It is a contingent liability - which is also known as loss contingency, which may arise depending on the future events.
Loss contingency is recognized only if it indicates that:
Contingent liability that do not fulfill the both criteria for recognition still may need to be disclosed in the financial statement and put disclosure about the liability in the footnotes (i.e. notes to the financial statements).