Question

The following three independent sets of facts relate to (1) the possible accrual or (2) the possible disclosure by other means of a loss contingency.

Situation I

A company offers a 1-year assurance-type warranty for the product that it manufactures. A history of warranty claims has been compiled and the probable amount of claims related to sales for a given period can be determined.

Situation II

Subsequent to the date of a set of financial statements, but prior to the issuance of the financial statements, a company enters into a contract that will probably result in a significant loss to the company. The amount of the loss can be reasonably estimated.

Situation III

A company has adopted a policy of recording self-insurance for any possible losses resulting from injury to others by the company's vehicles. The premium for an insurance policy for the same risk from an independent insurance company would have an annual cost of $2,000. During the period covered by the financial statements, there were no accidents involving the company's vehicles that resulted in injury to others.

Required: Choose a Situation and explain the accrual and/or type of disclosure necessary (if any) and the reason(s) why such disclosure is appropriate.

Answer 1

Situation I.
In this situation company should use the expense warranty accrual method. In this case, it is assume that the company is giving warranty to increase the sales and therfore matches the estimated warranty expenses against these sales. The warranty expenses can be calculated on the experience of previous warranty claims settled by the company. Once the warranty expenses is estimated, the amount will be accrued. When the warranty is claimed by the customer, a decrease to both current liability and the assets occurred.
Situation II.
Since the agreement is entered after the date of financial statements and before the issue of financial statements, it prevents the accrual of loss evntuality in financial statements for period prior to the loss. The disclosure should me in the form of note in the finacial statement containing the nature of contingency and the amount of probable loss.
Situation III.
Since the company chooses to self-insure the injury to others caused by its vehicles is not enough of a basis to accrue a loss that has not occurred at the date of the financial statements. An accrual cannot be made for the amount of insurance premium that would have been paid had a policy been obtained to insure the company against a particular risk. The fact that the company is self-insuring this risk should be disclosed by means of a note to the financial statement.