Question

Required information (The following information applies to the questions displayed below.) A company designs and sells high-end stereo equipment for auto and home use. Engineers notified management in December Year 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 $2.2 million. The fiscal year ends on December 31 Required: 1. Should this contingent liability be reported, disclosed in a note only, or neither? This contingent liability should be

Answer 1

1. In this case provisions need to be created instead of recording it as contingent liability. Provision created if there any chances of arise of any obligation and the obligation can be settled by outflow of resources.

In this case products can be recalled and a reliable estimate of the outflow of resources can be made. Provision should be created of $2.2 million (estimated product recall cost to the company amounts to $2.2 million).

2. Company should report a loss of $2,200,000 in its income statement for Year 1 as a result of provision created on account of product recall.
3. Company should report a liability for $2,200,000 in its Year 1 balance sheet on account of provision created for expenses to be incurred on product recall.

4. Journal Entry –

Loss on account of product recall - Debit - $2,200,000 (effect in income statement)

Provision for warranties and liabilities - Credit - $2,200,000 (effect in balance sheet)

Answer 2

1	Loss	2,200,000
	Contingent Loss		2,200,000

The book talks about this under "Contingent Liabilities"

    - it also shows a journal entry example

Book: Financial Accounting by David Spiceland 5th edition

good luck guys, you can do it :)