Question

The following two independent situations involve loss contingencies.

Part 1: Benson Company sells two products, Grey and Yellow. Each carries a 1-year warranty.

1. Product Grey—Product warranty costs, based on past experience, will normally be 1% of sales.

2. Product Yellow—Product warranty costs cannot be reasonably estimated because this is a new product line. However, the chief engineer believes that product warranty costs are likely to be incurred.

Instructions

How should Benson report the estimated product warranty costs for each of the two types of merchandise above? Discuss the rationale for your answer. Do not discuss disclosures that should be made in Benson’s financial statements or notes.

Part 2: Constantine Company is being sued for \(4,000,000 for an injury caused to a child as a result of alleged negligence while the child was visiting the Constantine Company plant in March 2017. The suit was filed in July 2017. Constantine’s lawyer states that it is probable that Constantine will lose the suit and be found liable for a judgment costing anywhere from \)400,000 to \(2,000,000. However, the lawyer states that the most probable judgment is \)1,000,000.

Instructions

How should Constantine report the suit in its 2017 financial statements? Discuss the rationale for your answer. Include in your answer disclosures, if any, that should be made in Constantine’s financial statements or notes.

Short answer

a. Estimated product warranty cost should not be accrued by charges

income because the amount of loss cannot be estimated reliably.

Acharge must earn potential judgment ($1,000,000) for the expenseand a credit for a liability.

Step-by-step solution

Meaning of Financial Statement

Financial explanations provide a genuine picture of an organization's financial performance after a financial year. It isan archived record of all money-related exchanges made inside a company.

(Part 1) Explain the reporting of estimated product warranty costs for each type of merchandise.

Since the taking after criteria were fulfilled for Item Grey, the anticipated item warranty costs ought to be recorded as an expense and credited to a liability:

1. As a result of a past incident, a corporation has a present duty (legal or constructive);
2. It is likely that an outflow of resources, including economic advantages, would be necessary to pay the obligation; and
3. The obligation size (1% of sales) may be accurately estimated.

As the loss cannot be accurately predicted, the expected product warranty expenses for Product Yellow should not be charged to revenue. Only two of the prerequisites are met; hence it is necessary to disclose using a note.

(Part 2) Explaining the reporting of the suit in the 2017 financial statements.

The following requirements were satisfied. Thus, the anticipated judgment ($1,000,000) should be accumulated by a charge to the expense and a credit to a liability:

1. As a result of a previous occurrence, a business has a present responsibility (legal or constructive).

2. Because Constantine's lawyer predicts that the company will lose the lawsuit, an outflow of resources encapsulating economic benefits will likely be necessary to pay the debt.

3. A realistic estimate of the debt amount can be formed because Constantine’s lawyer believes that the most probable verdict is $1,000,000.

Constantine should include the following information in its financial statements or notes:

• The lawsuit's total cost is $4,000,000.
• The accrual's nature.
• Exactly what the provision is.
• The potential loss range ($400,000 to $2,000,000).