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

In situation 1, when a product that is subject of warranty is sold by the company, it is quite possible that expenses are to be incurred in future accounting periods in relation to revenue that is recognized in the current period. Liability (in relation to warranty) is incurred on the same date as on the revenue is recognized. On the basis prior experience, it is easy for the company to estimate occurrence of warranty claims and dollar amount of liability. The contingent liability for warranties fulfils both the requirements that relates to accrual of a loss contingency. Therefore, it is essential to record the amount of loss in the financial statements. Moreover, factors that are used to derive estimates should be disclosed by means of a note. This practice most recommended when the possibilities of a greater loss than it was accrued.

In situation 2, the contract was entered into after the date of the financial statements but it has already included the accrual of the loss of contingency in financial statements for periods before the incurrence of the loss. This indicates that there is a probable loss on the contract and the amount of loss can be reasonably estimated and possibility of loss was discovered before the issuance of financial statements. Material loss that is incurred after the date of financial statements but before the issuance of financial statements should be disclosed by means of a note. The disclosure should specify the type of contingency as well as estimated amount of loss or probably the range of possible loss.

In situation 3, a company chooses to self-insure due to the contingency of injury to others that may cause to them due the use of company’s vehicles is not sufficient to accrue a contingency loss that has not actually not incurred at the date of financial statements. It is not advisable to make an accrual or reserve for the amount of insurance premium that would have been paid had a policy been obtained to insure the company against the particular risk. A contingency loss can only accrued if a specific event that impair an asset or create liability has occurred before the date of the financial statements as well as the amount of loss can be reasonable estimated. Thus, it is advisable for the company to disclose the fact that it is self-insuring by means of a note to inform the readers of financial statements.