Chapter 13, Problem 13.20E

Various transactions involving contingencies

• LO13–5, LO13–6

The following selected transactions relate to contingencies of Classical Tool Makers, Inc., which began operations in July 2018. Classical’s fiscal year ends on December 31. Financial statements are issued in April 2019.

Required:

Prepare the year-end entries for any amounts that should be recorded as a result of each of these contingencies and indicate whether a disclosure note is indicated.

1. Classical’s products carry a one-year warranty against manufacturer’s defects. Based on previous experience, warranty costs are expected to approximate 4% of sales. Sales were $2 million (all credit) for 2018. Actual warranty expenditures were $30,800 and were recorded as warranty expense when incurred.

2. Although no customer accounts have been shown to be uncollectible, Classical estimates that 2% of credit sales will eventually prove uncollectible.

3. In December 2018, the state of Tennessee filed suit against Classical, seeking penalties for violations of clean air laws. On January 23, 2019, Classical reached a settlement with state authorities to pay $1.5 million in penalties.

4. Classical is the plaintiff in a $4 million lawsuit filed against a supplier. The suit is in final appeal and attorneys advise that it is virtually certain that Classical will win the case and be awarded $2.5 million.

5. In November 2018, Classical became aware of a design flaw in an industrial saw that poses a potential electrical hazard. A product recall appears unavoidable. Such an action would likely cost the company $500,000.

6. Classical offered $25 cash rebates on a new model of jigsaw. Customers must mail in a proof-of-purchase seal from the package plus the cash register receipt to receive the rebate. Experience suggests that 60% of the rebates will be claimed. Ten thousand of the jigsaws were sold in 2018. Total rebates to customers in 2018 were $105,000 and were recorded as promotional expense when paid.

To determine

Contingent Liability

Contingent liability is one form of liability that arises based on a particular outcome of a specific event. They are possible obligation that might arise or might not arise based on the future events. It is otherwise called as probable liability or eventual liability. Following are examples of contingencies:

• Income tax disputes
• Discounted notes receivable
• Lawsuits
• Debt guarantees
• Failure to follow government regulations

To prepare: Journal entry for warranty expense.

Explanation of Solution

Date		Accounts and Explanation			Post Ref	Debit ($)	Credit ($)
2018		Warranty Expense				49,200
			Estimated Warranty Payable				49,200
				(To record the accrual of warranty payable)

Explanation: Warranty expense is an expense and it decreases the equity value. Thus, debit warranty expense account by $49,200. Estimated warranty payable is a liability and is increased by $49,200. Thus, credit estimated warranty payable account with $49,200. Working note for calculation of warranty expense is as follows:

$\begin{array}{c}\text{Warranty expense}=\left(\text{Sales }\times \text{ Percent(\%)}\right)–\text{Actual}\text{warranty}\text{expenditure}\\ =\left(\text{\$2,000,000}\times 4\text{\%}\right)\text{– \$30,800}\\ =\text{\$80,000–\$30,800}\\ =\text{\$49,200}\end{array}$

To determine

To prepare: Journal entry for uncollectible account (bad debts expense).

Explanation of Solution

Date	Account Title and Explanation	Post Ref	Debit ($)	Credit ($)
	Bad Debts Expense		40,000
	Allowance for Uncollectible Accounts			40,000
	(To record the bad debts expense)

Bad debts expense is an expense and equity is decreased due to recording of bad debt expense. Thus, debit bad debt expense account with $40,000. Allowance for uncollectible accounts is a contra asset and decreases the asset account by $40,000. Thus, credit Allowance for uncollectible account with $40,000. Working note for determination of bad debt expense is as follows:

$\begin{array}{c}\text{Bad debts expense}=\text{Sales}\times \text{Percent(\%)}\\ =\text{\$2,000,000}\times \text{2\%}\\ =\text{\$40,000}\end{array}$

To determine

To report: Contingent loss (liability) and prepare journal entry for loss and liability.

Explanation of Solution

In the given situation, the loss contingency is probable and estimated reasonably. The loss amount and liability is estimated reasonably. Thus, loss contingency is accrued and disclosure note is required in the foot notes of the financial statement.

Record journal entry for loss and liability.

Date		Accounts and Explanation			Post Ref	Debit ($)	Credit ($)
		Loss				1,500,000
			Estimated liability				1,500,000
				(To record contingent liabilities.)

Loss decreases the value of equity and thus, debit loss account by $1,500,000. Estimated liability is increased as contingent liability is recorded. Thus, credit estimated liability account by $1,500,000.

To determine

To report: Contingent gain (asset)

Explanation of Solution

Given situation is a gain contingency. Contingent assets are not recorded as an asset on the balance sheet till gain is occurred. When there is uncertainty towards loss, then it must be recorded. But, when there is uncertain gain, then it is not recorded. Thus, an appropriate disclosure is to be provided in the footnote of financial statement.

To determine

To report: Contingent loss (liability)

Explanation of Solution

Given situation is a loss contingency. It is accrued, reported and recorded based on the estimated amounts. An appropriate disclosure note is also required in the footnote of financial statement.

Record journal entry for loss and liability.

Date		Accounts and Explanation			Post Ref	Debit ($)	Credit ($)
		Loss				500,000
			Estimated liability				500,000
				(To record contingent liabilities)

Loss decreases the value of equity and thus, it is debited by $500,000. Estimated liability is increased due to recording of ocntigent . Therefore, credit estimated liability account by $500,000.

To determine

To prepare: Journal entry for promotional expense.

Explanation of Solution

Date		Accounts and Explanation			Post Ref	Debit ($)	Credit ($)
2018		Promotional Expense				45,000
			Estimated Premium Liability				45,000
				(To record the accrual of premium liability)

Promotional expense is an expense and value of equity is decreased due to accrual of premium liability. Therefore, debit promotional expense account by $45,000.

Estimated premium liability is a liability and increases by $45,000 due to accrual of premium liability. Therefore, credit estimated premium liability account by $45,000.