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. Classical’s products carry a one-year warranty against manufacturer’s defects. Based on previous experience, warranty costs are expected to approximate 2% of sales. Sales were $3.3 million (all credit) for 2021. Actual warranty expenditures were $22,800 and were recorded as warranty expense when incurred. Although no customer accounts have been shown to be uncollectible, Classical estimates that 2% of credit sales will eventually prove uncollectible. 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 $2.8 million in penalties. Classical is the plaintiff in a $5.3 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 $3.8 million. 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 $630,000. Classical offered $20 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 65% of the rebates will be claimed. Eleven thousand and three hundred of the jigsaws were sold in 2021. Total rebates to customers in 2021 were $118,000 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

Firstly, we need to understand the Law - IAS 37:
"A provision shall be recognized if the following criteria are fulfilled:

• an entity has a present obligation as a result of a past event;
• it is probable that an outflow embodying economic benefits will be required to settle the obligation;
• a reliable estimate can be made of the amount of the obligation.
• a specific current statement, the entity will accept certain responsibilities and other parties have valid expectations that the entity will discharge its responsibilities.

No provision, however, is recognized for costs that need to be incurred to operate in the future. Also, an obligation always involves another party to whom the obligation is owed (even if this party is unknown)."

Let us now break down the multiple events mentioned in the question:
(i) Warranty Costs
(ii) Bad Debts (Un-collectible credit sales)
(iii) Case with State of Tennessee for violation of clean air laws
(iv) Case where "Classical" is the plaintiff
(v) Product recall
(vi) Rebate on new model of jigsaw

Now, let us examine each of the above mentioned situations individually and decide on the entry to be recorded, or the disclosure to be made, or both:

Case (i) - Warranty costs:
Total sales for the year = $3,300,000
Expected warranty cost % = 2%
Therefore, expected warranty cost in $ = 3,3000*2% = $66,000
Actual warranty expenditure already recorded in the books = $22,800
Therefore, balance warranty expenses to be recorded in the books = $43,200
(Note: Warranty costs satisfies all the conditions covered under IAS 37, therefore the same should be recognized as provision as on year end date.)

The journal entry for the same is as follows:
Warranty expenses a/c ..................... Dr 43,200
To Provision for Expenses 43,200
(Being balance warranty expenses recorded based on past estimates)
No Disclosure note is required for this transaction

Case (ii) - Bad Debts:
Total sales for the year = $3,300,000
Expected Bad debt cost % = 2%
Therefore, expected Bad debt cost in $ = 3,3000*2% = $66,000
(Note: Bad Debts costs satisfies all the conditions covered under IAS 37, therefore the same should be recognized as provision as on year end date)

The journal entry for the same is as follows:
Bad Debts a/c ..................... Dr 66,000
To Provision for Bad Debts 66,000
(Being Bad debt expenses @2% of sales recorded based on past estimates)
No Disclosure note is required for this transaction

Case (iii) - Case with State of Tennessee for violation of clean air laws
Case filed date - December 2021
Fiscal closing for "Classical" - December 2021
Settlement reached on - January 2022
Financials if "Classical prepared and issued on - April 2022

From the above, it is clear that all the conditions of IAS 37 are being satisfied. The actual amount of settlement, which has been agreed upon for in Jan 2022, has to be recorded as a provision for the fiscal ending 2021.
The journal entry for the same is as follows:
Legal Expenses a/c ..................... Dr 2,800,000
To Provision for Expenses 2,800,000
(Being provision created for settlement of case with the State of Tennessee for violation of Clean Air)

Further, the Disclosure note to be given for the same is as under:
"The Sate of Tennessee has filed a suit of law against the company in the month of December 2021, for the violation of clean air laws. The company has begun negotiations with the State immediately and arrived at a settlement amount of $2.8 million as on 23rd January 2022. This agreed upon sum has been recorded as a provision for this fiscal as the case was filed in this year."

Case (iv) - Case where "Classical" is the plaintiff:
Alternative 1: As the question clearly states, that the suit is still in the final appeal stage, and no verdict has yet been reached by the court of law, no treatment for the same is to be made in the books of the company on account of prudent accounting principles.
In this approach, the following Disclosure note shall be given -
"The company had filed a suit against one of its suppliers for $5.3 million. The suit is in the final appeal stage and a final verdict of the Court of law is yet to be made. However, our attorneys are virtually certain that the case will be won by the company and are expecting a payout of $3.8 million."

Alternative 2: The virtual certainty provided by the attorneys may be construed as provided by an expert, and therefore can be used as a basis for recording the sum as a receipt for the current fiscal itself.
In this approach, the following journal entry is to be recorded:
Supplier a/c .................. Dr 3,800,000
To Other Income a/c 3,800,000
(Being income accrued to the company on the basis of virtual certainty provided by attorneys, in the suit filed against the supplier)

Further, the Disclosure note to be given for the same is as under:
"The company had filed a suit against one of its suppliers for $5.3 million. The suit is in the final appeal stage and a final verdict of the Court of law is yet to be made. However, our attorneys are virtually certain that the case will be won by the company and are expecting a payout of $3.8 million, hence the same is recorded as 'Other Income' in the current fiscal itself. The balance $1.5 million is the contingent income of the company which shall be recognized when the final verdict of the same is received."

Case (v) - Product recall:
It has clearly been provided that, the product recall is un-avoidable, and the company is aware of the same in the month of Nov 2021 itself, therefore all the conditions of IAS 37 are satisfied.
Therefore, the journal entry for the same is as follows:
Product recall expenses a/c ..................... Dr 630,000
To Provision for Expenses 630,000
(Being provision made for recall of product due to flaw in design of product.)

Case (vi) Rebate on new model of jigsaw
Total Jigsaws sold = 11,300
Total % of customers who would claim rebate = 65%
Therefore, total jigsaws for which rebate will be payable = 7,345 (11300*65%)​​​
Rebate to be provided on each jigsaw = $20
Therefore, estimated rebate amount = $146,900 (20*7345)
Amount already accounted for = $118,000
Therefore, balance amount to be recorded = $28,900
The journal entry for the same is as follows:
Promotional expenses a/c ..................... Dr 28,900
To Provision for Expenses    28,900
(Being provision made for the balance amount of rebate to be provided on the basis of past experience)