In: Accounting
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.
Part B.
The following three independent sets of facts relate to (1) the possible accrual or (2) the possible disclosure by other means of a loss contingency.
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.
Situation II
Subsequent to the date of a set of financial statements, but prior to the issuance of the financial statements, a company enters into a contract that will probably result in a significant loss to the company. The amount of the loss can be reasonably estimated.
Situation III
A company has adopted a policy of recording self-insurance for any possible losses resulting from injury to others by the company's vehicles. The premium for an insurance policy for the same risk from an independent insurance company would have an annual cost of $2,000. During the period covered by the financial statements, there were no accidents involving the company's vehicles that resulted in injury to others.
Required: Choose a Situation and explain the accrual and/or type of disclosure necessary (if any) and the reason(s) why such disclosure is appropriate.
Situation 1:it would be sufficient to disclose contingent liabilities in the notes to accounts. If however, the management is of the opinion that it would be prudent to make a provision from profits, it may do so, but a deferred tax asset would be needed to be recognized since a timing difference would arise with the accounting income being lower than the taxable income. After the lapse of the warranty period, the provision may be written if there are no claims. Unless the chances of non-occurance of the event are remote, disclosure for each class of asset must be made in the financial statements.
Situation 2 The loss is likely to be suffered after the balance sheet date. For the sake of transparency, and in keeping with the principle of conservatism, a provision for the loss should be made, and necessary disclosures should be given in the notes to accounts.
Situation 3:
Company is self insuring itself needs to be disclosed in the notes, however no monetary value can be assigned to it until the next year when any amount is actually paid for the expenses occurring through vehicles