Accounting for Contingencies?

Question

Dustin Clemens, the accounting and finance manager for a manufacturer. At year-end, he must determine how to account for the company's contingencies. His manager objects to Clemen's proposal to recognize an expense and a liability for a warranty service on units of a new product introduced in the fourth quarter. His manager says, "There's no way we can estimate this warranty cost. We don't owe anyone until a product fails and it is returned. Let's report an expense if and when we do any warranty work."

How would you defend Clemen's proposal?

Answer 1

Clemens should ask his manager to read IAS 37 PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS.
Under this standard a Liability, defined as a Present obligation as a result of past events in which Settlement is expected to result in an outflow of resources (payment) must be provided for. The amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date, that is, the amount that an enterprise would rationally pay to settle the obligation at the balance sheet date or to transfer it to a third party. [IAS 37.36] This means:

Provisions for one-off events (restructuring, environmental clean-up, settlement of a lawsuit) are measured at the most likely amount. [IAS 37.40]
Provisions for large populations of events (warranties, customer refunds) are measured at a probability-weighted expected value. [IAS 37.39]
Both measurements are at discounted present value using a pre-tax discount rate that reflects the current market assessments of the time value of money and the risks specific to the liability. [IAS 37.45 and 37.47]

A warranty must be provided for because there was a past event i.e., the sale of the defective goods. In practice, you'd make your best estimate based on history of the company itself or based on industry standards, e.g. it may be common for this industry to provide warranties at 2% of sales.

It's a fairly technical standard, but do be guided by this IAS

Answer 2

Contingency liabilities, assets will go under IAS 37 as you'd probably already know. -First, the company is being sued and a loss is reasonably possible and reasonably estimable. First of all, IAS 37 specifies three types of provisions: Probable, Reasonable Possible and Remote. For the account to show on the balance sheet, a loss has to be probable AND the amount to be estimable. First statement lacks of the loss being probable as it says reasonably possible. Also, even if it is probable that the plaintiff will win the case and receive a monetary award, it cannot recognize the contingent asset until such time as the lawsuit has been settled -The company deducts life insurance premiums from employees' paychecks. Estimates of probable claims are not specified. Remember, to be recognised as contigent asset/liabilities on balance sheet, it must meet both condition of the circumstance being probable to happen and reasonable estimates to be present. -The company offers a two-year warranty and the expenses can be reasonably estimated. IAS 37 specifies that 'warranty liability' its amount needs to be recorded at the time of sale and when the expenses are reported. Warranty payable and warraty liability are contingency liabilities that are both probable and capable of being estimated. So on double entry, £ £ DR Warranty Payable xxxx CR Liabilities xxxx -It is probable that the company will receive $100,000 in settlement of a lawsuit. Again, IAS 37. Even if it is probable that the plaintiff will win the case and receive a monetary award, it cannot recognize the contingent asset until such time as the lawsuit has been settled. It'd be really helpful if you go over IAS 37. It basically tells everything about you need to know on contingency and how it should be recognised.