Question

Top Sound International designs and sells high-end stereo equipment for auto and home use. Engineers notified management in December 2018 of a circuit flaw in an amplifier that poses a potential fire hazard. Further investigation indicates that a product recall is probable, estimated to cost the company $2.3 million. The fiscal year ends on December 31.

Q6:

1. Should this contingent liability be reported, disclosed in a note only, or neither?

	Reported
	Disclosed in a note only
	Neither 2. What loss, if any, should Top Sound report in its 2018 income statement? (Enter your answer in dollars, not in millions (i.e. 5.5 should be entered as 5,500,000).) Loss to be reported......................................

3. What liability, if any, should Top Sound report in its 2018 balance sheet? (Enter your answer in dollars, not in millions (i.e. 5.5 should be entered as 5,500,000).)

Liability to be reported..............................

4. What entry, if any, should be recorded? (If no entry is required for a transaction/event, select "No journal entry required" in the first account field. Enter your answers in dollars, not in millions (i.e. 5.5 should be entered as 5,500,000).)

Answer 1

1. In the present case, a provision needs to be created and the scenario will not result in a contingent liability. Provision is created for a present obligation (legal obligation towards its customers) arising as a result of a past event (sale of stereo equipment) and it is probable that a outfow of resources would be required to settle the obligation (product recall will need to be made and cost will be incurred) and a reliable estimate of the outflow of resources can be made (estimated product recall cost to the company amounts to $2.3 million)

2. Top Sound should report a loss of $2,300,000 in its income statement for 2018 as a result of provision created on account of product recall.

3. Top Sound should report a liability for $2,300,000 in its 2018 balance sheet on account of provision created for expenses to be incurred on product recall.

4. Journal entry to be passed in the books of accounts of 2018

Loss on account of product recall - Debit - $2,300,000 (effect in income statement)

Provision for warranties and liabilities - Credit - $2,300,000 (effect in balance sheet)