4.1 Contingencies and Warranties Flashcards
Future events are likely to occur
Probable
The chance of occurrence is more than remote but less than probable
Reasonably possible
The chance of occurrence is slight
Remote
If at least one condition is not met but the probability of loss is at least reasonably possible, the nature of the contingency must be
disclosed in the notes to the financial statements but is not recorded in the accounts.
Loss contingencies with a remote probability are
not disclosed
Gain contingencies are recognized…
only when realized
A company is the plaintiff in two lawsuits. The first suit involves a competitor who has made an exact copy of one of the company’s products, and the company is suing for patent infringement. The attorney’s estimate a $5,000,000 award for the company; however, it is anticipated that the case will be in litigation for 2 to 3 years before final resolution. The second case also involves patent infringement; however, in this instance, the attorneys do not believe the company has a strong case. It is estimated that the company has 50% chance of winning and the award, if any, would be in the $250,000 to $1,000,000 range. The most appropriate amount to be recorded as a gain contingency is
A. $0
B. $5,000,000
C. $5,125,000
D. $5,250,000
A. $0
Gain contingencies are not recorded; they are recognized only when realized. A gain contingency must be adequately disclosed.
A liability arising from a loss contingency should be recorded if the
A. Contingent future events have a reasonably possible chance of occurring.
B. Amount of the loss can be reasonably estimated.
C. Contingent future events have a reasonably possible chance of occurring and the amount of the loss can be reasonably estimated.
D. Contingent future vents will probably occur and the amount of the loss can be reasonably estimated.
D. Contingent future vents will probably occur and the amount of the loss can be reasonably estimated.
A material contingent loss must be accrued when the two conditions are met. Those are:
- It is probable that, at the balance sheet date, an asset has been impaired or a liability has been incurred.
- The amount of the loss can be reasonably estimated.
Which one of the following loss contingencies would be accrued as a liability rather than disclosed in the notes to the financial statements?
A. A guarantee of the indebtedness of another.
B. A pending lawsuit with an uncertain outcome.
C. A dispute over additional income taxes assessed for prior years (now in litigation)
D. Liabilities for service or product warranties made as a regular part of business.
D. Liabilities for service or product warranties made as a regular part of business.
Similarly to the guidelines for loss contingencies, a liability for future warranty costs should be accrued if (1) the incurrence of the expense is probable and (2) the amount can be reasonably estimated. Warranty liabilities are usually probable and can be reasonably estimated.
A company manufactures stereo systems that carry a 2-year assurance type warranty against defects. Based on the past experience, warranty costs are estimated at 4% of sales for the warranty period. During the year, stereo system sales totaled $3 million, and warranty costs of $67,500 were incurred. In its income statement for the year ended December 31, the company should report warranty expense of
A. $52,500
B. $60,000
C. $67,500
D. $120,000
D. $120,000
An assurance type warranty creates a loss contingency. The accrual method therefore should be used if (1) incurrence of warranty expense is probable, (2) the amount can be reasonably estimated, and (3) the amount is material. Thus, a provision for costs incurred under an assurance type warranty is made when the related revenue is recognized.
The 67,500 of actual costs incurred would reduce the warranty liability but does not impact the warranty expense.
On April 1, a corporation began offering a new product for sale under a standard 1-year assurance type warranty. Of the 5,000 units in inventory at April 1, 3,000 had been sold by June 30. Based on its experience with similar products, the corporation estimated that the average warranty cost per unit sold would be $8. Actual warranty costs incurred from April 1 through June 30 were $7,000. At June 30, what amount should the corporation report as estimated warranty liability?
A. $9,000
B. $16,000
C. $17,000
D. $33,000
C. $17,000
An assurance type warranty creates a loss contingency. Because the product is new, the balance of the estimated warranty liability at the beginning of the year is $0. If 3,000 units were sold at an estimated $8 per unit warranty cost, the total credits to the liability account equaled $24,000. Given that accrual warranty costs of $7,000 were debited to the account, the ending balance must have been $17,000.
