Question

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.

Answer 1

Solution :

Provisions : A provision is a liability with uncertain timing or amount but it satisfies the definition of a liability (A present obligation as a result of a past event, the settlement of which would result in an outflow of economic benefits) and most importantly, it satisfies the recognition criteria. (A probable flow of economic benefits that can be reliably measured). Once all the above criteria are met , a provision should be recorded in the books of accounts

Contingent Liability : A contingent liability is either a ‘possible’ obligation (which means it fails the definition of liability) or a contingent liability could a present obligation (i.e. it satisfies the definition of liability) but this present obligation can either be not be reliably measured or it can be reliably measured but the outflow of economic benefits may not be probable. Hence it satisfies the definition of liability but fails the recognition criteria.This event would be disclosed in the notes to the financial statements.

Situation I : A provision must be booked(accrual entry for warranty) for the amount ascertained for warranty claims since both the conditions are satisfied i.e. obligation and ascertainment.

Situation II : This is a contingent asset since it is not an obligation of a past event. The event occured after the financial period end but before the issuance. Since the amount of liability can be ascertianed , this should be disclosed in the financial statement as a contingent liability.

Situation III : Th ecompnay should record the premium paid for $2000 in the books as an insurance cost. Also not other accidents were recorded.