Question

Question #2:

(PART 1) Johnson Corp. sells two products with a 1-year warranty. It estimates that the first product’s warranty cost will be 1% of sales. It is unable to estimate the cost of the second product’s warranty cost but it assumes that it will exist.

Present your answer as to how the warranty costs should be recorded for each of the two products for the current year 2018. What is your rationale.

(PART 2) Johnson Corp is also involved in a litigation matter. The plaintiff claims that she was injured using the product and is suing for $10,000,000. Johnsons attorney believes that the company will lose the suit with a judgment between $1,000,000 and $10,000,000 with a most probable judgment of $ 5,000,000.

How should the company report the suit, if at all, in the current year’s financial statements?What disclosure should be made?

Answer 1

The above questions are replied assuming that the company follows accounting standards issued by FASB in this behalf.

PART 1. To answer this part of question, we need to first understand the disclosure of Warranty Costs as per FASB ASC.

As per ASC (FASB Accounting Standards Codification) 460-10-25 Guarantees, which provides guidance on warranty obligations incurred in relation to sales of goods, explains that due to the uncertainty related with such warrantly claims, they will fall under the definition of a contingency.

Accounting for Contingencies in ASC 450-20-25-2 Loss Contingencies provides guidance on when it is appropriate to record an accrual for contingent losses. The criteria for recognizing an accrual is:

a. Information should be available before the financial statements are issued, which indicates that there is a probable that a liability had been incurred at the date of financial statement

b. the amount of loss can be reasonably estimated.

Hence, in this case only for Product A (where both above conditions are satisified) warranty cost @ 1% of sales should be treated as probable contingent loss and shall be accrued by a charge to income in the financial statements.

For Product B (only one condition is satisified), hence only discosure is required indicating the nature of contingency and reasons for not estimating the amount.

PART-2: In accordance with ASC 450-20-25-2 Loss Contingencies, in relation to Litigation or Claim following factors must be considered in determining, whether accrual or disclosure is required

a. the period in which the underlying cause of the pending or threatened litiagtion or of the actual or possible claim ocurred

b. the degree of probability of an unfavourable outcome

c. the ability to make a reasonable estimate

Since all above conditions are met, therefore, disclosing the contingent liability as a probable liability, accural of $ 5,000,000 should be made by charge to income account.