Question

The Heinrich Tire Company recalled a tire in its subcompact line in December 2021. Costs associated with the recall were originally thought to approximate $54 million. Now, though, while management feels it is probable the company will incur substantial costs, all discussions indicate that $54 million is an excessive amount. Based on prior recalls in the industry, management has provided the following probability distribution for the potential loss: (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.) Loss Amount $44 million $34 million $ 24 million Probability 20% 50% 30% An arrangement with a consortium of distributors requires that all recall costs be settled at the end of 2022. The risk-free rate of interest is 5%. Required: 1. & 2. By the traditional approach to measuring loss contingencies, what amount would Heinrich record at the end of 2021 for the loss and contingent liability? For the remainder of this problem, apply the expected cash flow approach of SFAC No. 7. Estimate Heinrich's liability at the end of the 2021 fiscal year. 3. to 5. Prepare the necessary journal entries.

Answer 1

A contingent liability is a potential liability that may arise depending on the outcome of a specific event, such as pending lawsuits or honoring product warranties. If the liability is likely to occur and the amount can be reasonably estimated, the liability should be recorded in the accounting records of a firm. It may or may not become an actual liability.

1. By the traditional approach to measuring loss contingencies, Heinrich would record $34 million (probability of 50%) at the end of 2021 for the loss and contingent liability.

2. Applying the expected cash flow approach of SFAC No. 7, we can estimate Heinrich's contingent liability and loss at the end of the 2021 fiscal year.

$ 44 million x 20% =   8,800,000

$34 million   x 50% = 17,000,000

$24 million   x 30% =   7,200,000

Total Liability = $33,000,000

Heinrich's contingent liability and loss = $33,000,000 x .95238 (Present value of $1, where n = 1 and i = 5%(risk-free rate of interest))

= $ 31,428,540

3.

Sl.No	General Journal	Debit	Credit
1	Loss-product recall Dr.	$ 31,428,540
	To Liability-product recall		$ 31,428,540
2	Interest expense                                                       Dr.	$ 1,571,460
	To Liability-product recall		$ 1,571,460
3	Liability-product recall Dr.	$33,000,000
	Loss-product recall Dr.	$2,000,000
	To Cash		$35,000,000

4. The difference between $ 33,000,000 and the initial value of the liability $ 31,428,540 represent the interest expense of $ 1,571,460, which Heinrich will accrue during 2022.

5. Interest increases the liability to $ 33,000,000 at the end of 2022. Since there is a difference between the actual costs and liability, Heinrich will record an additional loss.