Question

You are the independent auditor engaged to audit Millay Corporation’s December 31, 2017, financial statements. Millay manufactures household appliances. During the course of your audit, you discovered the following contingent liabilities.

1. Millay began production of a new dishwasher in June 2017 and, by December 31, 2017, sold 120,000 to various retailers for \(500 each. Each dishwasher is under a 1-year warranty. The company estimates that its warranty expense per dishwasher will amount to \)25. At year-end, the company had already paid out \(1,000,000 in warranty expenses. Millay’s income statement shows warranty expenses of \)1,000,000 for 2017. Millay accounts for warranty costs on the accrual basis.
2. In response to your attorney’s letter, Morgan Sondgeroth, Esq., has informed you that Millay has been cited for dumping toxic waste into the Kishwaukee River. Clean-up costs and fines amount to \(2,750,000. Although the case is still being contested, Sondgeroth is certain that Millay will most probably have to pay the fine and clean-up costs. No disclosure of this situation was found in the financial statements.
3. Millay is the defendant in a patent infringement lawsuit by Megan Drabek over Millay’s use of a hydraulic compressor in several of its products. Sondgeroth claims that, if the suit goes against Millay, the loss may be as much as \)5,000,000. However, Sondgeroth believes the loss of this suit to be only reasonably possible. Again, no mention of this suit is made in the financial statements.

As presented, these contingencies are not reported in accordance with GAAP, which may create problems in issuing a favorable audit report. You feel the need to note these problems in the work papers.

Instructions

Heading each page with the name of the company, balance sheet date, and a brief description of the problem, write a brief narrative for each of the above issues in the form of a memorandum to be incorporated in the audit work papers. Explain what led to the discovery of each problem, what the problem really is, and what you advised your client to do (along with any appropriate journal entries) in order to bring these contingencies in accordance with GAAP.

Short answer

1. The business entity must report the warranty expenses andadjust this balance against the estimated liability.
2. The business entity willrecord the accrual of lawsuit liability.
3. The business entity willdisclose the amount in the notes to the financial statement.

Step-by-step solution

Definition of Audit Report

An audit report is a letter representing the auditor’s opinion about the financial statement. The auditor provides information on whether the financial statement is free from misstatement or not. Auditor also reports whether the financial statements are prepared using GAAP or not.

Memo 1

Date: 31 December 2017

Millay Corporation

Recognition of warranty expenses

The business entity has entered a new product line and started its manufacturing in June. The sales of the business entity are 120,000 units @ $500 per unit. Journal entry for sales will be as follows:

Date	Accounts and Explanation	Debit ($)	Credit ($)
	Cash$\left(120,000\times \$500\right)$	60,000,000
	Sales		60,000,000

The business entity has paid warranty expenses of $1,000,000. The journal entry made will be:

Date	Accounts and Explanation	Debit ($)	Credit ($)
	Warranty expenses	1,000,000
	Inventory		1,000,000

Now entry made for accrual of future warranty cost:

Date	Accounts and Explanation	Debit ($)	Credit ($)
	Warranty expenses $\left(\left(120,000\times \$25\right)-\$1,000,000\right)$	2,000,000
	Warranty liability		2,000,000

Memo 2

Date: 31 December 2017

Millay Corporation

Loss contingency arising from degradation of the environment

The business entity has dumped toxic waste into the river and was cited for the same. The business entity estimated that liability that will arise in the future would total $2,750,000. It includes the clean-up cost and fines. Even if the suit is pending, the business entity must report liability because the liability can be estimated, and the event is probable. The business entity will make journal entry as follow:

Date	Accounts and Explanation	Debit ($)	Credit ($)
	Lawsuit loss	2,750,000
	Lawsuit liability		2,750,000

Memo 3

Date: 31 December 2017

Millay Corporation

Loss contingency on patent infringement

It is mentioned that the possible loss from the lawsuit is reasonably possible, and therefore, it must not be disclosed in the financial statement of the business entity. The estimated amount of loss is $5,000,000; the business entity must reflect this amount in notes to the financial statement.