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 events 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.
True Co. did not record an accrual for a probable loss from a lawsuit in its financial statements. Which of the following explanations for True’s not accruing the probable loss is in accordance with generally accepted accounting principles?
A. An estimate range for the loss can be made but no amount in the range is more accurate than any other amount
B. No reasonable estimate of the loss can be made
C. Recognizing an amount in its financial statements would weaken the company’s defense of the lawsuit
D. Accrual was not required because an estimated amount of the loss was disclosed in the notes to the financial statements
B. No reasonable estimate of the loss can be made
A material contingent loss must be accrued when (1) it is probable that, at a balance sheet date, an asset has been impaired or a liability has been incurred, and (2) the amount of the loss can be reasonably estimated. If one or both conditions are not met, no loss is accrued.
In May Year 1, Caso Co. filed suit against Wayne, Inc., seeking $1.9 million in damages for patent infringement. A court verdict in November Year 4 awarded Caso $1.5 million in damages, but Wayne’s appeal is not expected to be decided before Year 6. Caso’s counsel believes it is probable that Caso will be successful against Wayne for an estimated amount in the range between $800,000 and $1.1 million, with $1 million considered the most likely amount. What amount should Caso record as income from the lawsuit in the year ended December 31, Year 4?
A. $1,000,000
B. $0
C. $1,400,000
D. $800,000
B. $0
Gain contingencies are not recognized until they are realized. Because the appeal is not expected to be decided before Year 6, Caso should not record any revenue from the lawsuit in the Year 4 income statement. This gain contingency should be disclosed; however, care should be taken to avoid misleading implications as to the likelihood of realization.
Hill Corp. began production of a new product. During the first calendar year, 1,000 units of the product were sold for $1,200 per unit. Each unit had a two-year warranty. Based on warranty costs for similar products, Hill estimates that warranty costs will average $100 per unit. Hill incurred $12,000 in warranty costs during the first year and $22,000 in warranty costs during the second year. The company uses the expense warranty accrual method. What should be the balance in the estimated liability under warranties account at the end of the first calendar year?
A. $66,000
B. $112,000
C. $100,000
D. $88,000
D. $88,000
A liability for warranty costs is recognized when the related revenue is recognized (i.e., on the day the product is sold). Even if the warranty covers a period longer than the period in which the product is sold, the entire liability for the expected warranty costs must be recognized on the day the product is sold. Thus, in the first calendar year a warranty liability of $100,000 (1,000 units x 100 estimated warranty cost per unit) was recognized. Actual payments for warranty costs reduce the amount of warranty liability recognized. Thus, at the end of the first calendar year, the balance of the warranty liability is $88,000 ($100,000 warranty liability initially recognized - $12,000 actual warranty costs incurred during the first year).
