Current Liabilities and Contingencies CONTINGENCIES FASB Statement of Financial Accounting Standards No. 5 defines a contingency “as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.” Gain Contingencies Gain contingencies are never recognized until they actually occur. Typically there is no mention of a gain contingency in the financial statements. The only place any mention might be made would be in the notes to the financial statements. Loss Contingencies There is a range of probabilities within which a contingent liability might occur. The FASB has defined the following terms in an attempt to define this range. • Probable-the future event or events are likely to occur • Reasonably possible-the chance of the future event or events occurring is more than remote but less than likely • Remote-the chance of the future event or events occurring is slight A contingent liability should be booked if the following two conditions are met. 1. As of the date of the financial statement it was probable that a liability has been incurred, and 2. The amount of the loss can be reasonably estimated Common loss contingencies are: A. Litigation, Claims, and Assessments Three factors must be considered in evaluating whether a contingent liability should be reported on the balance sheet (1) The underlying cause of the action must have occurred before the balance sheet date (2) An unfavorable outcome of the action must be probable (3) The entity must be able to make a reasonable estimate of the amount of the loss B. Guarantee and Warranty Costs A product guarantee or warranty is an obligation on the part of the seller to make good regarding any deficiency of quantity, quality or performance of the product. There are two methods of accounting for warranty costs. (1) Cash Basis If the warrant liability is not accrued in the year of sale the cash basis must be used. This method requires a charge to warranty expense when the event occurs that requires the company to incur costs to make good on the warranty. The entity may use the cash basis method only if a) It is not probable that a liability has been incurred on or before the balance sheet date, or b) The amount of the contingent liability cannot be reasonably estimated F:\course\ACCT3322\200720\module1\c13\tnotes\c13b.doc 11/9/2006 1Current Liabilities and Contingencies (2) Accrual Basis The accrual basis method is GAAP. This method requires that the warranty costs be charged to operating expense in the year of sale. The textbook identifies this at the expense warranty approach. Example: Spencer Company sells 100 dog runs for $500 each during 2004. The dog runs have two-year warrants covering parts and labor. Based on past experience, management estimates that the average warranty costs per dog run will be $25. The company incurs $1,000 in warrant costs in 2004 and $1,200 in 2005. The following journal entries reflect the sale of the dog runs and accrual of the warrant liability during 2004. Account Debit CreditAccounts receivable $50,000 Sales $50,000To record sales of dog runs for 2004 Analysis of sales:Selling price per unit $500Number of units sold 100 Sales $50,000 Account Debit CreditWarranty expense $2,500 Estimated liability under warranties $2,500To accrue warranty expense associated with 2004 salesAnalysis of warranty expense:Estimated warranty cost per unit $25Units sold 100 Estimated warranty expense $2,500 The actual costs incurred and paid during 2004 were $1,000. The following journal records warranty costs incurred during the year. Account Debit CreditEstimated liability under warranties $1,000 Cash, inventory or accrued payroll $1,000To recognize warranty costs incurred during 2004 F:\course\ACCT3322\200720\module1\c13\tnotes\c13b.doc 11/9/2006 2Current Liabilities and Contingencies The following T-Account analysis shows the estimated liability that would be presented in the balance sheet at December 31, 2004. Description Debit CreditAccrual of estimate during for 2004 $2,500Actual warranty costs incurred in 2004 $1,000 Ending balance, 12/31/04 $1,500T-Account: Estimated Liability Under Warranties The actual costs incurred and paid during 2005 were $1,200. The following journal records warranty costs incurred during the year. Account Debit CreditEstimated liability under warranties $1,200 Cash, inventory or accrued payroll $1,200To recognize warranty costs incurred during 2005 The following T-Account analysis shows the estimated liability that would be presented in the balance sheet at December 31, 2005. Description Debit CreditAccrual of estimate during for 2004 $1,500Actual warranty costs incurred in 2004 $1,200 Ending balance, 12/31/05 $300T-Account: Estimated Liability Under Warranties If warranties are sold separately from the product then the entity will use the sales warranty approach. The revenue on the sale of product warranties sold separately is deferred and amortized over the life of the warranty on a straight-line basis. C. Premiums and Coupons Premiums and coupons are considered a contingent liability. This contingent liability must be estimated and reflected in the balance sheet. The entity normally purchases the premiums, which are used over subsequent accounting periods. Example: Spencer Company includes a coupon in each 10-pound bag of dog food giving the purchaser the opportunity to receive a free custom dog tag. The custom dog tags cost Spencer Company $1. The Company will incur an additional $0.50 of cost for engraving and shipping when the customer redeems the coupon. During 2004 Spencer Company purchased 20,000 dog tags. The Company sold 100,000 bags of dog food for $10 each. The company expects 10% of the coupons to be redeemed. During 2004, customers redeemed 2,500 of the coupons. The following journal entries reflect the purchase of the dog tags, sales made F:\course\ACCT3322\200720\module1\c13\tnotes\c13b.doc 11/9/2006 3Current Liabilities and Contingencies during 2002, premium expense associated with the sales and the cost of the premiums redeemed. Account Debit CreditInventory, premiums (dog tags) $20,000 Cash $20,000To record the purchase of dog tags as a premiums Analysis of inventory, premiums:Price per dog tax $1Number of dog tags purchased 20,000 Inventory,