Contingencies in Financial Reporting

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Questions and Answers

Which of the following situations would be considered a contingency?

A company is sued for patent infringement, and the outcome of the lawsuit is uncertain. (correct)

A company decides to raise prices on its products due to increased costs of materials.

A company signs a contract for a new building, and construction is delayed due to unforeseen weather events.

A company invests in a new product line, and the sales are lower than projected.

A company makes a profit larger than expected due to a successful marketing campaign.

Which of the following situations would typically be accrued as a loss contingency?

A company is obligated to pay a customer a refund due to a defective product. (correct)

A company's factory is damaged in a fire, and the insurance claim is pending.

A company's investment in a new product line is expected to generate a lower return than initially projected.

A company is threatened with a lawsuit by a competitor for unfair business practices.

Which of the following statements is TRUE regarding contingencies?

Contingencies should always be accrued, regardless of the likelihood of loss.

Companies should disclose all contingencies in the financial statements, even those that are not accrued. (correct)

Gain contingencies are typically recognized in the financial statements when they are probable and the amount can be reasonably estimated.

All contingencies are loss contingencies because uncertainty always involves the possibility of losing something.

Which of the following is an example of a loss contingency that is NOT typically accrued?

The risk of a fire damaging the company's property. (D) Signup and view all the answers

Which of the following situations would likely be accrued as a loss contingency?

A company is facing a potential increase in its taxes due to a change in tax laws. (B) Signup and view all the answers

Which of the following is NOT a characteristic of a contingency?

It is always expected to be resolved within the current fiscal year. (C) Signup and view all the answers

Under which of the following conditions would a company accrue a loss contingency related to a pending lawsuit?

The likelihood of loss is probable, and the amount of loss can be reasonably estimated. (A) Signup and view all the answers

What is a key difference between a loss contingency and a gain contingency?

Loss contingencies involve a potential decrease in value, while gain contingencies involve a potential increase in value. (B) Signup and view all the answers

Under what condition must a company recognize a liability for a lawsuit?

If the cause for litigation occurred on or before the date of the financial statements. (B) Signup and view all the answers

What is the key factor in determining whether to accrue a liability for a lawsuit?

The opinion of legal counsel regarding probable outcomes. (C) Signup and view all the answers

What type of warranty is an assurance-type warranty considered?

A warranty included in the price at the time of sale. (A) Signup and view all the answers

How should a company treat warranty costs associated with assurance-type warranties?

They should be accrued in the period goods are sold. (D) Signup and view all the answers

What is the estimated liability for Fluffy Cake Mix at December 31, 2025?

$12,000 (A) Signup and view all the answers

What should a company assess for unfiled suits to determine if a liability should be accrued?

The degree of probability of claims and unfavorable outcomes. (D) Signup and view all the answers

What is the cash outflow to record the purchase of mixing bowls for Fluffy Cake Mix in 2025?

$40,000 (A) Signup and view all the answers

What is a potential risk of disclosing a probable negative outcome in financial statements?

It could weaken the company's legal position. (A) Signup and view all the answers

How much Premium Expense is recorded as a selling expense in the income statement for Fluffy Cake Mix in 2025?

$18,000 (C) Signup and view all the answers

What type of warranty generally does not create a separate performance obligation?

Assurance-type warranty. (C) Signup and view all the answers

What is the primary reason gain contingencies are not recorded in financial statements?

They should not be recognized before realization. (B) Signup and view all the answers

Which account is credited when the premium offers are estimated in the accounting records?

Premium Liability (B) Signup and view all the answers

In the case of the employee lawsuit against Kroger, why is no liability recognized?

The lawyer believes the company will not lose the case. (A) Signup and view all the answers

How many box tops did Fluffy Cake Mix customers redeem?

60,000 (A) Signup and view all the answers

When should a company record a warranty liability?

When a reasonable estimate of future costs exists. (A) Signup and view all the answers

What component would increase the Premium Liability on Fluffy Cake Mix's balance sheet?

Estimated future redemptions (D) Signup and view all the answers

In the warranty example with Candy Machinery Company, what total expected warranty expense did they estimate?

$20,000 (B) Signup and view all the answers

What characteristic defines service-type warranties?

They provide additional services beyond the basic warranty. (A) Signup and view all the answers

If High-Tech's settlement amount becomes known shortly, how should this be recorded?

As a receivable and gain. (A) Signup and view all the answers

What was the total cash inflow from the sales of cake mix in 2025?

$900,000 (A) Signup and view all the answers

What common business practice is often associated with warranties?

Using warranties as a sales promotion technique. (C) Signup and view all the answers

What should be disclosed in notes to the financial statements regarding gain contingencies?

Only under high probability of realization. (A) Signup and view all the answers

What impact do warranty costs typically have on companies?

They can significantly affect the financial statements. (D) Signup and view all the answers

What happens if the legal counsel determines that a company is likely to lose a lawsuit?

The company should record a liability if it's estimable. (D) Signup and view all the answers

What is a critical aspect of managing warranty costs?

Estimating future expenses for warranty claims. (A) Signup and view all the answers

What determines whether Kroger should recognize a liability for the lawsuit as of December 31, 2025?

The opinion of Kroger's lawyers about the probability of winning the case. (B) Signup and view all the answers

What condition must be met for a company to accrue a liability for a potential lawsuit?

It must be probable that the lawsuit will be filed. (A) Signup and view all the answers

Under which condition should a company recognize warranty costs?

When a product is sold, even if defects are not yet known. (C) Signup and view all the answers

What must a company determine in order to record a contingent liability?

The probability that it incurred a liability (D) Signup and view all the answers

What is an assurance-type warranty?

A commitment to fix any defects that occur during the warranty period. (A) Signup and view all the answers

How is a contingent liability recorded in the accounts?

As a debit to a loss account and a credit to a liability account (A) Signup and view all the answers

What should Candy Machinery Company record when it incurs actual warranty costs for the year 2025?

Warranty Expense and Warranty Liability. (A) Signup and view all the answers

When must a company accrue an estimated warranty liability?

If the likely costs can be reasonably estimated. (C) Signup and view all the answers

In the case of Macklin Manufacturing, what is the net loss recorded due to expropriation?

$8,000,000 (A) Signup and view all the answers

If Kroger determines it is probable they will lose the lawsuit, what must they do by December 31, 2025?

Accrue a liability for the estimated amount of the damages. (B) Signup and view all the answers

Which of the following factors do companies consider before recording a liability for litigation?

The probability of an unfavorable outcome (A) Signup and view all the answers

Which of the following is NOT an example of warranty costs?

Cost of marketing the warranty offer. (A) Signup and view all the answers

What happens if the estimate of a loss is within a range of values?

The lowest amount in the range is used if no better estimate exists (C) Signup and view all the answers

What type of circumstance generally does not require recording contingencies in financial statements?

General risk contingencies in business operations (D) Signup and view all the answers

For how long does Candy Machinery's warranty on the vending machines last?

One year. (B) Signup and view all the answers

What is the appropriate entry to record the loss for a guarantee liability if Good Person Company estimates it at $1,800,000?

Debit Loss on Loan Guaranty $1,800,000, Credit Guarantee Liability $1,800,000 (B) Signup and view all the answers

What is the total expected warranty expense for Candy Machinery Company based on the sale of 100 vending machines?

$20,000. (B) Signup and view all the answers

For service-type warranties, what is true compared to assurance-type warranties?

They create a separate performance obligation. (B) Signup and view all the answers

What could be a consequence of misinterpreting the term 'probable' in relation to contingent liabilities?

Underreporting of liabilities (C) Signup and view all the answers

What happens if the probability of losing a lawsuit is assessed to be less than 50%?

The company does not need to record a liability. (A) Signup and view all the answers

When a liability needs to be recorded due to a lawsuit, when must the cause occur?

On or before the date of the financial statements (D) Signup and view all the answers

Which item is NOT considered a common loss contingency?

Future business growth (B) Signup and view all the answers

What must a company consider when estimating potential liabilities for pending litigation?

The probability of claims being asserted and their outcomes. (C) Signup and view all the answers

What must a company disclose in accordance with the full disclosure principle?

Supplementary information that could influence user judgement (A) Signup and view all the answers

If an asset is expropriated and the company expects compensation, how should that be reflected in the financial statements?

A reduction in asset value should be recorded based on estimated compensation (D) Signup and view all the answers

Which company factor is considered when assessing the probability of an unfavorable litigation outcome?

The nature of the litigation (D) Signup and view all the answers

What should be done if there is uncertainty in estimating the loss amount?

Use the minimum amount within the range unless a better estimate exists (C) Signup and view all the answers

Which of the following statements accurately represents the accounting treatment for service-type warranties?

Service-type warranties are recognized as a separate performance obligation and recorded in Unearned Warranty Revenue. (D) Signup and view all the answers

In the context of warranties, what is the primary purpose of recording a warranty liability?

To reflect the estimated cost of future warranty repairs and replacements. (C) Signup and view all the answers

What is the key difference between assurance-type warranties and service-type warranties?

Assurance-type warranties cover defects that existed at the time of sale, while service-type warranties cover additional services beyond those defects. (B) Signup and view all the answers

How is revenue recognized on service-type warranties?

On a straight-line basis over the warranty period. (A) Signup and view all the answers

What journal entry is used to record the initial sale of a product with a service-type warranty?

Debit: Cash; Credit: Sales Revenue; Credit: Unearned Warranty Revenue (B) Signup and view all the answers

Which of the following costs associated with service-type warranties are typically expensed as incurred?

Advertising costs related to the warranty program (A), Salaries and wages of employees involved in warranty services (B), General and administrative expenses related to the warranty program (C) Signup and view all the answers

In the context of warranty accounting, what is the purpose of an adjusting entry at year-end?

To estimate the future warranty costs related to products sold during the year. (C) Signup and view all the answers

How does a company account for warranty costs incurred in the following year related to products sold in the current year?

Decreases the warranty liability by the amount of the cost. (C) Signup and view all the answers

What is the typical accounting treatment for consideration payable to customers in a revenue arrangement?

It is recognized as a reduction of sales revenue. (C) Signup and view all the answers

How does a company typically record premium offers to customers in return for box tops or other items?

Debit: Premium Expense; Credit: Premium Liability (D) Signup and view all the answers

What is the main objective of offering premiums, coupons, and rebates to customers?

To improve customer loyalty and increase sales. (A) Signup and view all the answers

What is the difference between an assurance-type warranty and a service-type warranty?

Assurance-type warranties are included in the product price, while service-type warranties are offered at an additional cost. (B) Signup and view all the answers

Which of the following entries records the payment of warranty costs related to sales made in the previous year?

Debit: Warranty Liability; Credit: Cash (B) Signup and view all the answers

What is the purpose of recording warranty revenue?

To recognize the revenue earned from selling service-type warranties. (D) Signup and view all the answers

What is the correct accounting treatment for warranty expenses related to assurance-type warranties?

Expense the costs immediately as they are incurred. (A) Signup and view all the answers

What is the main purpose of recording warranty liability?

To estimate the future costs of repairing or replacing defective products under warranty. (B) Signup and view all the answers

When should a company accrue a loss contingency related to a guarantee of indebtedness?

When both the probability of loss and the amount of the loss are reasonably estimable. (A) Signup and view all the answers

What is the accounting treatment for a loss contingency related to an expropriation of a plant asset?

Debit a loss account and credit the plant asset account. (D) Signup and view all the answers

If a company has a contingent liability that is reasonably possible but not probable, how should it be disclosed in the financial statements?

Disclosed in a note to the financial statements. (C) Signup and view all the answers

What is the accounting treatment for a contingent liability when the exact payee or payment date is unknown?

The liability should be recorded because it is probable that the company incurred a liability, even without knowing the exact payee or payment date. (D) Signup and view all the answers

Which of the following is NOT a common loss contingency that companies may face?

Inventory obsolescence. (D) Signup and view all the answers

When considering a potential loss contingency related to litigation, which of the following factors is NOT a primary consideration?

The reputation of the opposing counsel. (C) Signup and view all the answers

When determining the amount to accrue for a loss contingency, what should be used if the estimate involves a range of values?

The best estimate within the range, or the minimum amount if no estimate is better. (C) Signup and view all the answers

What is the primary concern expressed by accountants regarding the interpretation of "probable," "reasonably possible," and "remote" in relation to loss contingencies?

The reliance on legal opinions, which may be biased and protective. (A) Signup and view all the answers

Which of the following best describes the full disclosure principle in relation to loss contingencies?

Companies must disclose significant loss contingencies, even if they are not probable. (D) Signup and view all the answers

Which of the following is an example of a general risk contingency that is generally NOT reported in the financial statements?

The possibility of an economic recession. (B) Signup and view all the answers

Which of the following is a true statement about the accounting treatment for loss contingencies related to guarantee and warranty costs?

Guarantee and warranty costs should be accrued based on historical experience with similar products. (B) Signup and view all the answers

What is the primary reason why companies disclose risks in their financial statements?

To help investors make informed investment decisions. (A) Signup and view all the answers

Which of the following best describes the accounting treatment for a loss contingency related to a claim or assessment?

The liability should be recorded if it is probable that the company will lose the lawsuit or settle the claim. (B) Signup and view all the answers

Which of the following is an example of a loss contingency that might be disclosed in the notes to the financial statements but not accrued as a liability?

A potential environmental cleanup liability with a low probability of occurrence. (D) Signup and view all the answers

Which of the following is a true statement regarding the accounting treatment for a loss contingency related to consideration payable?

Consideration payable should be accrued based on the present value of the consideration. (D) Signup and view all the answers

What is the primary difference between accruing a loss contingency and disclosing it in the notes to the financial statements?

Accruing a loss contingency involves recording a liability on the balance sheet, while disclosing it in the notes provides information about the potential loss without recognizing it on the balance sheet. (D) Signup and view all the answers

According to the revenue recognition principle, when should revenue be recorded?

When the related performance obligation is satisfied. (C) Signup and view all the answers

If a company offers a premium to customers and estimates that 60% of the premiums will be redeemed, how should the company account for the estimated redemptions?

Record a liability equal to the estimated cost of premiums to be redeemed. (A) Signup and view all the answers

What is the primary reason companies do not record gain contingencies?

Companies follow a conservative policy and prefer not to recognize gains until they are realized. (A) Signup and view all the answers

Which of the following would be considered a gain contingency?

A possible refund from the government related to a tax dispute. (A) Signup and view all the answers

When should a company recognize a loss contingency?

When the loss is probable and the amount of the loss is reasonably estimable. (C) Signup and view all the answers

What is the appropriate accounting treatment for a premium offered to customers if the estimated redemption rate is 60% and the actual redemptions are 40%?

Adjust the premium expense and liability at the end of the period to reflect the actual redemption rate. (C) Signup and view all the answers

What is the primary purpose of the expense recognition principle?

To ensure that expenses are recorded in the period in which they are incurred. (C) Signup and view all the answers

Which of the following would be considered a loss contingency that is likely to be accrued?

A product warranty offered to customers, where the estimated claims are significant and reasonably estimable. (B) Signup and view all the answers

What is the primary difference between a gain contingency and a loss contingency?

Gain contingencies involve potential increases in assets, while loss contingencies involve potential decreases in assets. (B) Signup and view all the answers

Why is it important for a company to estimate the redemption rate of premium offers?

To record the appropriate liability for the estimated cost of redeeming the premiums. (D) Signup and view all the answers

Which of the following is not considered a loss contingency that may be accrued?

A general or unspecified business risk, such as competition from new entrants. (D) Signup and view all the answers

What is the appropriate accounting treatment for a gain contingency that is probable and reasonably estimable?

Disclose the gain contingency in the notes to the financial statements. (B) Signup and view all the answers

A company offers a premium to customers and estimates that 70% of the premiums will be redeemed. During the accounting period, customers redeemed 60% of the premiums. How should the company adjust its accounts at the end of the period?

Decrease the premium expense and premium liability by the difference between the estimated redemption rate and the actual redemption rate. (C) Signup and view all the answers

What is the warranty expense recognized in 2025 based on the information provided in the content?

20,000 (B) Signup and view all the answers

What is the total amount of warranty liability recognized in 2025?

20,000 (D) Signup and view all the answers

What is the total amount of warranty expense recognized in 2026 based on the information provided in the content?

16,000 (D) Signup and view all the answers

Why is the warranty expense recognized differently in 2025 compared to the warranty costs incurred in 2026?

The warranty expense in 2025 is an estimate of future costs, while the warranty costs incurred in 2026 are actual costs. (A) Signup and view all the answers

What is the warranty liability reported on the balance sheet at the end of 2026?

0 (D) Signup and view all the answers

What is the total amount of service-type warranty revenue recognized in 2028?

300 (B) Signup and view all the answers

What is the amount of the assurance-type warranty liability that is recognized on the balance sheet at the end of 2025?

200 (B) Signup and view all the answers

Why is the service-type warranty recognized differently from the assurance-type warranty?

The service-type warranty is recognized as a performance obligation because it provides services beyond the initial purchase, while the assurance-type warranty is recognized as a liability because it is a contractual obligation to repair defects. (C) Signup and view all the answers

What is the journal entry required to record the sale of the car and related warranties on January 2, 2025?

Debit Cash for $30,900; Credit Sales Revenue for $30,000, Credit Unearned Warranty Revenue $900 (A) Signup and view all the answers

What is the journal entry required to record the warranty costs incurred for the assurance-type warranty in 2025?

Debit Warranty Expense for $500, Credit Cash for $500 (B) Signup and view all the answers

What is the total amount of warranty expense recognized for the car sold on January 2, 2025, by the end of 2025?

700 (D) Signup and view all the answers

How is the revenue recognized for the service-type warranty in 2028?

The revenue is recognized over the period the customer holds the service-type warranty. In this case 3 years. (B) Signup and view all the answers

Which of the following costs related to the service-type warranty would be expensed as incurred?

General and administrative expenses (A), Advertising expenses (B), Employee salaries and wages (D) Signup and view all the answers

What is the purpose of offering premiums, coupons, and rebates to customers?

To increase sales by attracting new customers and encouraging existing customers to purchase more. (B) Signup and view all the answers

In what period is consideration payable recorded?

The period in which the customer makes a purchase. (B) Signup and view all the answers

Study Notes