The following three independent sets of facts relate to contingent liabilities:

Question

The following three independent sets of facts relate to contingent liabilities:

In November of the current year an automobile manufacturing company recalled all pickup trucks manufactured during the past two years. A flaw in the battery cable was discovered and the recall provides for replacement of the defective cables. The estimated cost of this recall is $2.3 million.

The EPA has notified a company of violations of environmental laws relating to hazardous waste. These actions seek cleanup costs, penalties, and damages to property. The company is reasonably certain there will be cost associated with the cleanup, but cannot estimate the amount. The cleanup cost could be as high as $4,030,000 or as little as $530,000 and insurance could reimburse all or part of the cost. There is no way to more accurately estimate the cost to the company at this time.

Holland Company does not carry property damage insurance because of the cost. The company has suffered substantial losses each of the past three years. However, it has had no losses for the current year. Management thinks this is too good to be true and is sure there will be significant losses in the coming year. However, the exact amount cannot be determined.

a.What are three categories of contingent liabilities

b. For each item above, determine the correct accounting treatment. Prepare any required journal entries. (If no entry is required for a transaction/event, select "No journal entry required" in the first account field.)

- Record the warranty expense for event 1.

- Record the fines associated with the violations of environmental laws for event 2.

- Record the current year losses for property damage in event 3.

The following three independent sets of facts relate to contingent liabilities:

Explanation / Answer

There are three scenarios for Contingent Liabilities and all involving different accounting treatment.

1- High Probablity -When it is probable that the loss will occur, and you can reasonably estimate the amount of the loss then record a contingent liability. If you can only estimate a range of possible amounts, then record that amount in the range that appears to be a better estimate than any other amount. if no amount is better, then record the lowest amount in the range. “Probable” means that the future event is likely to occur. You should also describe the liability in the footnotes that accompany the financial statements.

2- Medium Probability-Disclose the existence of the contingent liability in the notes to the financial statements if the liability is reasonably possible but not probable, or if the liability is probable, but you cannot estimate the amount. “Reasonably possible” means that the chance of the event occurring is more than remote but less than likely.

3- Low Probability- Do not record or disclose the contingent liability if the probability of its occurrence is remote.

1- Automobile manufacturing company recalled all pickup trucks manufactured during the past two years. A flaw in the battery cable was discovered and the recall provides for replacement of the defective cables. The estimated cost of this recall is $2.3 million. If the company has not made any provision regarding Warranty expenses in earlier years then it has to be recognized as provision and liability for expected amount $2.30 million because probability is high.

Debit- Provision for Warranty Expense $2.30

Credit- Accrued Warranty liability $2.30

2- The company is reasonably certain there will be cost associated with the cleanup, but cannot estimate the amount. In such case only disclosure in notes to account is required about contingent liabilities where amount of loss can not be estimated. Hence no journal entry required in this case anly disclosure required in notes to financial statement.

3-Management thinks this is too good to be true and is sure there will be significant losses in the coming year. However, the exact amount cannot be determined.

When amount of expected loss can not be determined then only disclosure in notes to financial statement is required and no journal entry needed in such case.

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