Click the “Check Your Answer” box below each problem to reveal the correct answer and explanation.
1. The company had the following situations occur during the current year:
A. A company’s workers went on strike during the current year. The strike resulted in lost production resulting in $1,000,000 in lost sales. The company did not pay $200,000 in wages while the employees were not working.
B. The company was sued for $11,000,000 when a product injured a customer. The company’s legal council expects to settle the lawsuit for between $100,000 and $200,000. The customer is currently stating that they will not settle.
C. The company discovered that several of its facilities have environmental issues that must be cleaned up. It is expected to cost between $1,000,000 and $3,000,000 depending on the extent of the cleanup which will be determined by OSHA next year. Other companies that have had the same issues have had to clean up the facilities.
D. The company has been notified that they have won a lawsuit and have been awarded $122,000. The award will be paid in 6 months.
Determine what must be recorded and or reported for each contingent situation.
A. Nothing is recorded. This is not a contingency. A contingency is a potential cash payment or cash receipt that is dependent on a future event occurring. The lost business and saved wages will be reflected in the actual transactions of the company during this period.
B. The company determined that payment of $100,000 to $200,000 is probable when they expect to settle for this amount. An expense and a liability are recorded for the low estimate. The situation and the range of payment and the amount of the suit must be disclosed in the footnotes.
|Legal Expense $100,000
Legal Liability $100,000
C. This situation is probable due to the fact that other companies in the same situation have had to clean up and pay the cost. An expense and a liability should be recorded for the low estimate and the situation and range of potential payment should be disclosed in the footnotes.
|Environmental Expense $1,000,000
Environmental Liability $1,000,000
D. This is a gain contingency. No gain is recorded until the cash is received and the gain is realized. In most cases, no footnote disclosure is made until the cash is received. If the gain is absolutely certain it may be disclosed in the footnotes.
2. The company had sales of products in the amount of $40,000 and $60,000 for the first month and the second month respectively. The products carry a 45-day warranty included in the sales price. In addition, customers paid $4,000 and $5,500 for a one- year warranty with additional coverage related to sales in the first and second month, respectively. Over the last two prior years, customers have claimed 3% of the sales price within the first 45 days and 5% of the sales price within the year following the purchase. Warranty claims under the 45-day warranty related to the first month sales were $800 (claimed in the first month) and $300 (claimed in the second month). There were no claims under the extended warranty during the first two months.
Record all entries related to the sales and warranties for the first and the second month.
1st Estimate the warranty liability for the first 45 days included in the sales price.
|Sales||% claims||Estimated Liability|
2nd Estimate the warranty liability for the one year warranty
|Sales||% claims||Estimated Liability|
|Month 1||$40,000||5%||$2,000 / 12 = $167 month|
|Month 2||$60,000||5%||$3,000 / 12 = $250 month|
3rd Record the estimated warrant expense and the sale of the extended warranty
|Warranty Expense 1,367
Warranty Liability (45 day) 1,200
Warranty Liability (1 year) 167
|Warranty Liability (45 day) 800
Cash (or inventory) 800
Unearned Warranty Revenue 3,667
Warranty Revenue 333
|Warranty Expense 2,217
Warranty Liability (45 day) 1,800
Warranty Liability (1 year) 417
The one-year warranty is expensed 1/12th each month.
Unearned Warranty Revenue 4,709
Warranty Revenue – month 2 458
Warranty Revenue – month 1 333
|Warranty Liability – 45 days 300
Cash or inventory 300
The liability that is left on the books after the 1st month sales 45-day warranty expires is removed from the books. (800 – 400 – 300)
|Warranty Liability 100
Warranty Expense 100
3. The company has 196 employees that worked during the past 2 weeks. Salary expense was $220,000 for the two weeks. Employees earn 4 hours of sick time and 6 hours of vacation time for every two weeks worked. The average hourly pay rate is $14 per hour. Employees were paid $8,000 for vacation days and $2,200 for sick days during the two weeks.
Record the entries for all transactions related to vacation and sick time during the two weeks.
|Compensation Expense $27,440
Accrued Vacation $16,464
Accrued Sick Time $10,976
Vacation = 6 hours x 196 employees x $14 per hour = $16,464
Sick Time = 4 hours x 196 employees x $14 per hour = $10,976
|Accrued Vacation $8,000
Accrued Sick Time $2,200
Salaries Payable or cash $10,200
Expense in the time period the employee works to earn the time off and do not expense again when the time is taken.
4. Sub Sandwiches, Inc. offers a coupon card to customers that gives them 1 free sandwich for every 5 sandwiches purchased. Sales for the first 3 months of the year were as follows:
Customers redeem free sandwiches valued at approximately 10% of current month sales during February and March.
Record the entries associated with the free sandwich card for the 1st quarter.
1st Determine the liability associated with the free sandwich:
|Sandwich Sales||1/6 Free**||= Cost of Free|
** 1/6 is free because the customer paid for 5 out of 6.
2nd Determine the value of free sandwiches redeemed:
|February||$6,200 x 10% = $ 620|
|March||$7,700 x 10% = $ 770|
3rd Record the liability and the redemption:
|Marketing Expense 3,273
Deferred Revenue 3,273
Deferred Revenues 1,390
5. The company has been notified by the IRS that an audit of the last 5 years will occur beginning next year. The company has been aggressive with deductions and believes they could owe between $150,000 and $300,000 depending on what the IRS discovers. However, the estimated range is very uncertain. The IRS has stated that they will audit all areas that carry risk of over deductions. The company is planning to cooperate only as much as required during the audit. The company’s current year sales are $1,000,000.
Record any entry or write any footnote disclosure that must be reported in the financial statements.
The contingent payment is reasonably possible at this time. No liability is recorded until the audit is underway and it becomes probable that a payment will be made based on audit findings. The company must disclose that will be undergoing an audit and the company may be required to pay an amount they cannot currently reliably estimate. A payment of $100,000 may be material to the company’s financial position because the amount is 10% of sales and a high percent of profits.
Required Footnote Disclosure:
The company expects to be audited by the Internal Revenue Service during the next year. Any potential liability cannot be reasonably estimated at this time. The amount may be material to the company’s financial position.