Chapter 13, Problem 13.8P

Expected cash flow approach; product recall

• LO13–6

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 contingent liability?

2. 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. 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.

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 2017, Company H records loss and contingent liability amounting to $30 million based on probability of 50%.

To determine

To calculate: The amount H’s liability at end of the year 2018 fiscal year by applying the expected cash flow approach.

Explanation of Solution

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

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

H’s liability (and loss) at the end of 2018 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).

To determine

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

Explanation of Solution

Date		Accounts and Explanation			Post Ref	Debit ($)	Credit ($)
2018		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.

To determine

To Prepare: Journal entry to accrue interest on the liability at the end of 2019.

Explanation of Solution

Date		Accounts and Explanation			Post Ref	Debit ($)	Credit ($)
2019		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:

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

To determine

To prepare: Journal entry to pay the liability at the end of 2019.

Explanation of Solution

Date		Accounts and Explanation			Post Ref	Debit ($)	Credit ($)
2019		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, debit liability account by $29,000,000. Loss decreases the value of equity and thus, debit 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:

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