Question

(Warranties and Loss Contingencies)

The following two independent situations involve loss contingencies.

Part 1: Benson Company sells two products, Grey and Yellow. Each carries a 1-year warranty.

1.Product Grey—Product warranty costs, based on past experience, will normally be 1% of sales.

2.Product Yellow—Product warranty costs cannot be reasonably estimated because this is a new product line. However, the chief engineer believes that product warranty costs are likely to be incurred

How should Benson report the estimated product warranty costs for each of the two types of merchandise above? Discuss the rationale for your answer. Do not discuss disclosures that should be made in Benson's financial statements or notes.

Part 2: Constantine Company is being sued for $4,000,000 for an injury caused to a child as a result of alleged negligence while the child was visiting the Constantine Company plant in March 2017. The suit was filed in July 2017. Constantine's lawyer states that it is probable that Constantine will lose the suit and be found liable for a judgment costing anywhere from $400,000 to $2,000,000. However, the lawyer states that the most probable judgment is $1,000,000.

How should Constantine report the suit in its 2017 financial statements? Discuss the rationale for your answer. Include in your answer disclosures, if any, that should be made in Constantine's financial statements or notes.

please cited

thank you

Answer 1

Part 1

Product warranty is an obligation incurred in connection with the sale of good therefore it involves the uncertainty for settlement of such claim so it falls under the purview of contingency which are treated as per Accounting Stand. 5.

Condition to be satisfied for accrual of loss contingency as a charge against the income are specified by paragraph 8-

               a) It must be probable that one or more future events will occur confirming the fact of loss.

               b) The amount of loss can be reasonably estimated.

Note - Probable mean future event likely to occur.

In the light of above discussion, Product gray satisfy both the condition however in case of product Yellow amount can not be reasonably estimated.Following reporting can be made -

1 Product Gray - Warranty expense at the rate of 1 % of sales should be recognized.

2. Product Yellow- As warranty expense can not be reasonably estimated therefore should not be recognized.

Note - Disclosure has not been discussed.

Part 2

The following factors must be considered in determining whether Suit/litigation will be recognized or disclosed in the Financial statements-

1. The period in which the underlying event that causes the litigation or of the actual or possible claim took place.
2. Probability of unfavourable outcome.
3. Reasonable estimate of the loss amount.

The condition to Paragraph 8 (a) requires that information available prior to the issuance of financial statements indicate that it is probable that a liability had been incurred at the date of the financial statements.

In Constantine Company' s case the event that causes the litigation occurred in March 2017 which is at the date of financial statements however the suit was filled in July 2017. Therefore the condition of paragraph 8 (a) satisfied and the accrual would clearly became appropriate. The amount of loss that is most probable as stated by lawyer can be considered as reasonably estimated as per Paragraph 8 (b). So the accrual of $ 1,00,000 should be made in the financial statement of 2017. Moreover disclosure (paragraph 9) of the nature of an accrual made pursuant to the provisions of paragraph 8, and in some circumstances the amount accrued, may be necessary for the financial statements not to be misleading.

Assumption - Financial Year means 1 April to 31 March.

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