Question

Western Manufacturing is involved with several potential contingent liabilities. Your assignment is to draft the appropriate accounting treatment for each situation described below. Western's fiscal year-end is December 31, 2018, and the financial statements will be issued in early February 2019.

a. During 2018, Western experienced labor disputes at three of its plants. Management hopes an agreement will soon be reached. However, negotiations between the company and the unions have not produced an acceptable settlement, and employee strikes are currently under way. It is virtually certain that material costs will be incurred, but the amount of possible costs cannot be reasonably estimated.

b. Western warrants most products it sells against defects in materials and workmanship for a period of a year. Based on its experience with previous product introductions, warranty costs are expected to approximate 2% of sales. A new product introduced in 2018 had sales of $2 million, and actual warranty expenditures incurred so far on the product are $25,000. The only entry made so far relating to warranties on this new product was to debit Warranty Expense $25,000 and credit Cash $25,000.

c. Western is involved in a suit filed in January 2019 by Crump Holdings seeking $88 million, as an adjustment to the purchase price in connection with the company's sale of its textile business in 2018. The suit alleges that Western misstated the assets and liabilities used to calculate the purchase price for the textile division. Legal counsel advises that it is reasonably possible that Western could lose up to $88 million. Required: In a memo, describe the appropriate means of reporting each situation and explain your reasoning

Answer 1

a. In order to record a contingent liability, the loss must be probable and the amount must be reasonably estimable. A loss and liability will not be recorded for the employee strikes, even though the likelihood of loss is probable (virtually certain), because the loss cannot be reasonably estimated. However, careful disclosure of the situation should be provided in the notes to the financial statements.

b. Western should record warranty expense of $40,000(2% x $2 million in sales) rather than just the $25,000 in warranty expense recorded for expenditures incurred so far. It is that costs for warranties will be incurred and, based on their experience with previous product introductions, the company can reasonably estimate the amount. Therefore the following additional amount should be recorded:

Warranty Expense	15,000
Warranty Liability		15,000
(Loss contingency for warranties)

c. The likelihood of loss is reasonably possible rather than probable, so a contingent liability is not recorded. However, full disclosure of the contingent liability is made in a footnote to the financial statements