The Heinrich Tire Company recalled a tire in its subcompact line in December 2018. Costs associated with therecall were originally thought to approximate $50 million. Now, though, while management feels it is probable thecompany will incur substantial costs, all discussions indicate that $50 million is an excessive amount. Based onprior recalls in the industry, management has provided the following probability distribution for the potential loss:Loss Amount Probability$40 million 20%$30 million 50%$20 million 30%An arrangement with a consortium of distributors requires that all recall costs be settled at the end of 2019. Therisk-free rate of interest is 5%.Required:1. By the traditional approach to measuring loss contingencies, what amount would Heinrich record at the endof 2018 for the loss and contingent liability?2. For the remainder of this problem, apply the expected cash flow approach of SFAC No. 7. Estimate Heinrich’sliability at the end of the 2018 fiscal year.3. Prepare the journal entry to record the contingent liability (and loss).4. Prepare the journal entry to accrue interest on the liability at the end of 2019.5. Prepare the journal entry to pay the liability at the end of 2019, assuming the actual cost is $31 million. Heinrich records an additional loss if the actual costs are higher or a gain if the costs are lower.
The Heinrich Tire Company recalled a tire in its subcompact line in December 2018. Costs associated with the
recall were originally thought to approximate $50 million. Now, though, while management feels it is probable the
company will incur substantial costs, all discussions indicate that $50 million is an excessive amount. Based on
prior recalls in the industry, management has provided the following probability distribution for the potential loss:
Loss Amount Probability
$40 million 20%
$30 million 50%
$20 million 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. By the traditional approach to measuring loss contingencies, what amount would Heinrich record at the end
of 2018 for the loss and
2. For the remainder of this problem, apply the expected
liability at the end of the 2018 fiscal year.
3. Prepare the
4. Prepare the journal entry to accrue interest on the liability at the end of 2019.
5. Prepare the journal entry to pay the liability at the end of 2019, assuming the actual cost is $31 million. Heinrich records an additional loss if the actual costs are higher or a gain if the costs are lower.
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