Written Communication AP8-7 Western Manufacturing is involved with several poten
ID: 2517577 • Letter: W
Question
Written Communication AP8-7 Western Manufacturing is involved with several potential contingent liabilities. Your assignment is to draft the appropriate accounting treatment for each situation described below. Western's fiscal year-end is December 31, 2018, and the financial statements will be issued in early February 2019. During 2018, Western experienced labor disputes at three of its plants. Management hopes an agreement will soon be reached. However negotiations between the company and the unions have not produced an acceptable settlement, and employee strikes are currently under way. It is virtually certain that material costs will be incurred, but the amount of possible costs cannot be reasonably estimated. a. b. Western warrants most products it sells against defects in materials and workmanship for a period of a year. Based on its experience with previous product introductions, warranty costs are expected to approximate 2% of sales. A new product introduced in 2018 had sales of $2 million, and actual warranty expenditures incurred so far on the product are $25,000. The only entry made so far relating to warranties on this new product was to debit Warranty Expense $25,000 and credit Cash $25,000. Western is involved in a suit filed in January 2019 by Crump Holdings seeking $88 million, as an adjustment to the purchase price in connection with the company's sale of its textile business in 2018. The suit alleges that Western misstated the assets and liabilities used to calculate the purchase price for the textile division. Legal counsel advises that it is reasonably possible that Western could lose up to $88 million c. Required In a memo, describe the appropriate means of reporting each situation and explain your reasoningExplanation / Answer
a. A contingent liability has to be disclosed in the notes to the financial statements if the liability is probable but cannot be reasonably estimated.
With reference to the labour disputes which Western is experiencing, it is given that it is virtually certain that material costs will be incurred but the possible costs cannot be reasonably estimated. Hence the labour disputes should be disclosed in the notes to the financial statements.
b. A contingent liability that is both probable and whose costs can be estimated should be recorded as an expense or loss in the income statement and should be shown as a liability in the Balance Sheet.
Since the warranties provided by Western satisfy both the required conditions the following entry has to be recorded in the financial statements
Debit Warranty Expense 15,000 ( 2% x 2,000,000 -25000)
Credit Provision for Warranty expense 15,000
Warranty expense will be included in the income statement and provision for warranties will shown as liability in the Balance sheet.
c. A contingent liability has to be recorded if an event that triggers a lawsuit has taken place before the Balance sheet date though the lawsuit may have been filed after the Balance Sheet date but before the financial statements are issued.
Since the lawsuit filed against Western,though filed in Jan 2019, relates to the misstatement of its assets and liabilities with reference to sale of its textile division in 2018 and the amount of damages of $ 88 million claimed in the lawsuit is a potential loss for Western and as per the legal counsel's advise that it is reasonable possible that Western could lose up to 88 million, the same has to be recorded as a loss in the financial statements.
Debit Loss against lawsuit damages $88 million
Credit Provision for loss against lawsuit damages $ 88 million
The loss has to be shown in the income statement and the provision has to be shown as a liability in the Balance Sheet as on Dec 31 2018.
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