Chapter 13 Part 2 - Contingencies Intermediate Accounting II II Dr. Dr. Chula King Student Learning Outcomes Identify situations that constitute contingencies and the circumstances under which they should be accrued Demonstrate the appropriate accounting treatment for contingencies, including unasserted claims and assessments Definition of Liability Probable future sacrifice of economic benefit arising from a present obligation to transfer assets or provide services to other entities in the future as a result of past transactions or events. 1
Loss Contingency Existing uncertain situation involving potential loss depending on whether some future event occurs Factors affecting whether loss contingency is accrued and reported as a liability The likelihood that the confirming event will occur Whether the loss amounts can be reasonably estimated Likelihood of Occurrence Probable a confirming event is likely to occur Reasonably Possible the chance the confirming event will occur is more than remote, but less than likely Remote the chance the confirming event will occur is slight Loss Contingencies Likelihood Probable Reasonably possible Remote Known Liability accrued and disclosure note Dollar Amount of Potential Loss Subject to Reasonable Estimation Liability accrued and disclosure note Not subject to Reasonable Estimation A loss contingency is accrued if a loss is probable and the amount can be reasonably estimated 2
Product Warranties and Guarantees Product warranties inevitably entail costs, i.e., they are probable The amount of those costs can be reasonable estimated using comm available estimation techniques Therefore, a liability for the estimated cost should be accrued Warranty expense Estimated liability for warranty For Example Apex, Inc., sold a product that carried a one-year warranty against defects. Estimates based upon past experience and industry standards indicate that warranty costs approximate 3% of sales. During 2013, sales of the warranty based product were $2,000,000, and were all on account. In 2013, Apex paid $10,000 to service the warranties. For Example (continued) Accounts receivable 2,000,000 Sales revenue 2,000,000 Warranty expense (3%x2,000,000) 60,000 Estimated liability for warranty 60,000 (entry to estimate total warranty costs) Estimated liability for warranty 10,000 Cash, parts, etc. 10,000 (entry to record actual expenditures for warranty) 3
Extended Warranty Contracts Sold separately from the product The related revenue is not earned until Claims are made against the extended warranty; OR The extended warranty period expires Entry to record the sale of extended warranty Cash Unearned warranty revenue Premiums Included with the product Expensed in the period of the sale of the product Contingent on action by the customer, and require accounting similar to warranties Subsequent Events Events occurring between the fiscal yearend date and the date financial statements are issued can affect the appearance of disclosures on financial statements Events occurring after the year-end date but before the financial statements are issued can also affect the appearance of disclosures on the financial statements 4
Unasserted Claims and Assessments Unasserted claim No disclosure needed No Is a claim or assessment probable? Yes Evaluate (a) the likelihood of an unfavorable outcome and (b) whether the dollar amount can be estimated. An estimated loss and contingent liability would be accrued if an unfavorable outcome is probable and the amount can be reasonably estimated. The Next Step Exercises 2, 3, 5, 6, 7,15, 24 Problems 2, 4, 5, 6 5