Question

The following selected transactions relate to contingencies of Classical Tool Makers, Inc., which began operations in July 2021. Classical's fiscal year ends on December 31. Financial statements are issued in April 2022. 1. Classical's products carry a one-year warranty against manufacturer's defects. Based on previous experience, warranty costs are expected to approximate 3% of sales. Sales were $2.3 million (all credit) for 2021. Actual warranty expenditures were $20,100 and were recorded as warranty expense when incurred. 2. Although no customer accounts have been shown to be uncollectible, Classical estimates that 2% of credit sales will eventually prove uncollectible. 3. In December 2021, the state of Tennessee filed suit against Classical, seeking penalties for violations of clean air laws. On January 23, 2022, Classical reached a settlement with state authorities to pay $1.8 million in penalties. 4. Classical is the plaintiff in a $4.3 million lawsuit filed against a supplier. The suit is in final appeal and attorneys advise that it is virtually certain that Classical will win the case and be awarded $2.8 million. 5. In November 2021, Classical became aware of a design flaw in an industrial saw that poses a potential electrical hazard. A product recall appears unavoidable. Such an action would likely cost the company $530,000. 6. Classical offered $25 cash rebates on a new model of jigsaw. Customers must mail in a proof-of-purchase seal from the package plus the cash register receipt to receive the rebate. Experience suggests that 60% of the rebates will be claimed. Ten thousand and three hundred of the jigsaws were sold in 2021. Total rebates to customers in 2021 were $108,000 and were recorded as promotional expense when paid. Required: 1-a Prepare the year-end entries for any amounts that should be recorded as a result of each of the above contingencies. 1-b Indicate whether a disclosure note is needed for the above transactions.

Answer 1

Classical Tool Makers Requirement 1 Journal Enteries Trans. Particulars Debit in $ Credit in $ Warranty expense a/c Dr. 48900 To Estimated warranty liability 48900 Warranty expense: ([3% $2,300,000] - $20,100) = $48,900. 2 46000 Bad debt expense a/c Dr. To Allowance for uncollectible accounts 2300000 x 2% = 46000 46000 Loss-litigation a/c 1800000 To Liability-litigation 1800000 This is a loss contingency. Classical can use the information occurring after the end of the year and before the financial statements are issued to determine appropriate disclosure. 4 No journal entry required This is a gain contingency. Gain contingencies are not accrued even if the gain is probable and reasonably estimable. The gain should be recognized only when realized. A disclosure note is appropriate. 5 530000 Loss-product recall a/c Dr. To Liability-product recall 530000 6 Promotional expense a/c Dr. 46500 To Estimated premium liability 46500 Promotional expense: ([60% $25 x 10,300] - $108,000) = $46,500. Because the rebate is offered as a promotion rather than provided as part of a sales transaction, it really is a "coupon" as discussed in the Additional Consideration Box in the text section for product warranties and guarantees. An expense and liability is recorded for the estimated amount that will be paid in the future. If the rebate instead was offered as part of a sale transaction, it would be accounted for as variable consideration. In that case, rather than debiting an expense, revenue associated with the sale would be reduced, and a liability recorded for the estimated amount that will be paid in the future. Requirement 2 Event 1 Event 2 Event 3 Event 4 Event 5 Event 6