The Heinrich Tire Company recalled a tire in its subcompact line in December 201

ID: 2523196 • Letter: T

Question

The Heinrich Tire Company recalled a tire in its subcompact line in December 2018. Costs associated with the recall were originally thought to approximate $38 million. Now, though, while management feels it is probable the company will incur substantial costs, all discussions indicate that $38 million is an excessive amount. Based on prior recalls in the industry, management has provided the following probability distribution for the potential loss: (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.) Loss Amount $ 28 million $18 million $8 million Probability 20% 50% 30% An arrangement with a consortium of distributors requires that all recall costs be settled at the end of 2019. The risk-free rate of interest is 5%. Required: 1. & 2. By the traditional approach to measuring loss contingencies, what amount would Heinrich record at the end of 2018 for the loss and contingent liability? For the remainder of this problem, apply the expected cash flow approach of SFAC No. 7 Estimate Heinrich's liability at the end of the 2018 fiscal year 3. to 5. Prepare the necessary iournal entries

Explanation / Answer

1. Traditional approach

According to traditional approach, Heinrich would record the loss and contingent liability which has probability of 50%.

Therefore, the amount he would record loss and contingent liability is $18 million which has probability of 50%.

2. Expected cash flow approach

Loan amt in

million ($) (A)

Probability (B)

Expected loss (A)*(B)

In million

20%

5.6

50%

30%

2.4

Total expected loss

Discount factor [1/(1+0.05^2)]

0.907029

PV of expected loss (17*0.95238)

$15,419,501

Therefore, the amount he would record loss and contingent liability is $15,419,501

3. Journal entries

Sr. No.

General Journal

Dr.

Cr.

Financial Loss

$15,419,501

To Estimated Liability

$15,419,501

An estimated loss from a loss contingency (as defined in paragraph 1) shall be accrued by a charge to income 3 if both of the following conditions are met

a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.

b. The amount of loss can be reasonably estimated.