Chapter 13, Problem 13.8P

1

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 measure: Contingent liability through traditional approach.

Explanation of Solution

As per traditional approach, H accrues more likely amount and it does not exceed probability of 50%. Here, at the end of the year 2019, Company H records loss and contingent liability amounting to $30 million based on probability of 50%. 

2

To determine

To calculate: The amount H’s liability at end of the year 2016 fiscal year by applying the expected cash flow approach.

Answer to Problem 13.8P

$\begin{array}{c}\begin{array}{l}\text{ H’s liability(and loss)}\\ \text{at the end of the 2016}\end{array})\text{ = }\left[\begin{array}{l}\left(\text{Loss}\text{amount}\times \text{Probability}\right)\\ \times \text{Present}\text{Value}\text{Factor}\end{array}\right]\\ \text{= }\left(\begin{array}{l}\left(\text{\$40,000,000}\times 20\%\right)\\ +\left(\text{\$30,000,000}\times 50\%\right)\\ +\left(\text{\$20,000,000}\times 30\%\right)\end{array}\right)\times 0.95238\end{array}$

$\begin{array}{c}\begin{array}{l}\text{ H’s liability(and loss)}\\ \text{at the end of the 2016}\end{array})=\$29,000,000\times 0.95238\\ =\$27,619,020\end{array}$

Explanation of Solution

Explanation

H’s liability (and loss) at the end of 2016 is determined by multiplying loss amount and probability with present value factor. The Present value of an ordinary annuity of $1 for 1 period at 5% is 0.95238 and refer Table 4 in Appendix).

3

To determine

To prepare: Journal entry to record the contingent liability (and loss).

Explanation of Solution

Date		Accounts and Explanation			Post Ref	Debit ($)	Credit ($)
2016		Loss (E–)				27,619,020
December	31
			Estimated liability (L+)				27,619,020
				(To record contingent liabilities)

In order to record the contingent liabilities, Loss and estimated liability accounts are affected. Loss decreases the value of equity, and thus debit, loss account by $27,619,020. Estimated liability increases the liability account. Thus, credit estimated liability account by $27,619,020.

4

To determine

To Prepare: Journal entry to accrue interest on the liability at the end of 2017.

Explanation of Solution

Date		Accounts and Explanation			Post Ref	Debit ($)	Credit ($)
2017		Interest Expense (E–)				1,380,980
December	31
			Estimated liability (L+)				1,380,980
				(To record contingent liabilities)

In order to record the contingent liabilities, Interest expense and estimated liability accounts are affected. Interest expense decreases the value of equity and thus, debit Interest expense account by $1,380,980. Estimated liability increases the liability account. Thus, credit estimated liability account by $1,380,980. Working note for determining amount of interest expense is as follows:

$\begin{array}{c}\text{Interest expense = Total loss amount (Requirement 1) – Estimated liability }\\ \text{= \$29,000,000 –\$27,619,020}\\ \text{= \$1,380,980}\end{array}$

5

To determine

To prepare: Journal entry to pay the liability at the end of 2017.

Explanation of Solution

Date		Accounts and Explanation			Post Ref	Debit ($)	Credit ($)
2017		Liability (L–)				29,000,000
December	31
		Loss (E–)				2,000,000
			Cash (A–)				31,000,000
				(To record contingent liabilities)

When contingent liability is recorded, liability is decreased and thus, debits liability account by $29,000,000. Loss decreases the value of equity and thus, debits loss account by $2,000,000. Cash is an asset account and it decreases by $31,000,000. Thus, credit Cash account with $31,000,000.

Working notes below to determine the amount of loss is as below:

$\begin{array}{c}\text{Loss amount = Actual cost – Liability amount }\\ \text{= \$31,000,000 – \$29,000,000}\\ \text{=\$2,000,000}\end{array}$