Question

Sound Audio manufactures and sells audio equipment for automobiles. Engineers notified management in December 2021 of a circuit flaw in an amplifier that poses a potential fire hazard. An intense investigation indicated that a product recall is virtually certain, estimated to cost the company $5.0 million. The fiscal year ends on December 31.
a. should this loss contingency be accrued, disclosed only, or neither?
b. what loss, if any, should sound audio report in its 2013 income statement?
c. what liability, if any, should sound audio report in its 2013 balance sheet?
d. prepare any journal entry needed.

Answer 1

Answer:

Contingent Liability:

A contingent liability is a liability of a company that depends on a future event on the basis of a past transaction. It may be called as probable liability or an eventual liability. It may or may not become a liability of a company is entirely depends on future events.

Contingency involves the following:

• Lawsuits
• Income tax disputes
• Discounted notes receivable
• Guarantees of debt
• Failure to follow government regulations

 

Part (1)

Reporting of contingent loss (liability):

As per situation, the contingent liability is probable and reasonably estimated: so, the warranty costs (loss contingency) should be accrued and should be reported and recorded based on the estimated amounts.

Part (2)

Reporting of loss in income statement:

Income statement refers to financial statement that helps evaluate the financial performance of the company over particular period of time. The evaluation pertaining to financial performance is undertaken with reference to the expenses and revenue incurred by the business through both non-operating activities and operating activities.

S Audio should report a loss of $5 million in its 2021 income statement as shown below:

S Audio Income Statement (Partial) For the Year Ended December 31, 2021  

Warranty expense = 5.000.000

Part (3)

Reporting of liability in balance sheet

Balance sheet refers to the type of statement which represents the financial position of the company for a given period of time. A Balance sheet of the company is divided into three segments that are Liabilities, Assets and shareholder's Equity.

S Audio should report a liability of S5 million in its 2021 balance sheet as shown below:

S Audio Balance Sheet (Partial) As on December 31, 2021:  

Current liabilities:  

Warranty liability = 5,000,000

Part (4)

Prepare journal entry to record the loss and liability: The following is the accounting equation for the entry:

Assets = Liabilities + Stockholders' Equity + 5,000,000(Estimated Liability ) -  S5,000,000(Loss )

Journal entry:

Record the following journal entry in general journal:

Debt: Loss = 5,000,000  

Credit: Estimated liability = 5,000,000

[To record the contingent liabilities.]  

Explanation:

• Loss decreases the value of equity. Therefore, debit loss account by $5,000,000.
• Estimated liability is increased. Therefore, credit estimated liability account by $5,000,000.

Answer 2

Answer:

1. The loss contingency should be accrued

2.$5,000,000

3. $5,000,000

4. loss- product recall $5,000,000

liability- product recall $5,000,000

Explanation:

Sound Audio manufactures and sells audio equipment for automobiles. Engineers notified management in December 2021 of a circuit flaw in an amplifier that poses a potential fire hazard. An intense investigation indicated that a product recall is virtually certain, estimated to cost the company $5.0 million. The fiscal year ends on December 31.

from the question we can deduce that:

1. This is a loss contingency and should be accrued because of the liability. The if the event will occur and the estimate is certain

2) loss: $5,000,000

3) liability: $5,000,000

4) loss- product recall $5,000,000

liability- product recall $5,000,000

a disclosure note is needed