Question

7

The Heinrich Tire Company recalled a tire in its subcompact line in December 2018. 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 2019. 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 2018 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 2018 fiscal year. 3. to 5. Prepare the necessary journal entries.

Answer 1

Henrich Tire Company

1. By traditional approach companies records the highest probability as the loss contingencies as contingent liability. In this case $34 million and probability 50% is the highest one.

It will record the liability: -

Liability                 34 million ($34 million 50%)

2. Under SFAC No. 7 companies record the only the contingent liabilities that are the most probable can be recognized as a liability on financial statements. Other contingencies are relegated to footnotes as long as uncertainty persists.

Liability                 44,000,000*20%=8,800,000

                             34,000,000*50%=17,000,000

                             24,000,000*30%=7,200,000

                             Total                     33,000,000

                                                                                      *0.95238 (n=1, i=5% from PV of $1)

                                                                                    31,428,540

3. Journal Entry

Loss-product recall                 dr.        31,428,540

Liability-product recall                       31,428,540

Interest expenses                    dr.        1,571,460 (33,000,000-31,428,540)

Liability-product recall                       1,571,460

(The diff. between 33 million and actual value of liability 31,428,540 represents interest expense, which companies will accure)