This exercise will test your ability to properly account for situations involving contingent liabilities.
As the accountant for the Blow-Dry Manufacturing Company you are to analyze the following situations in preparing the balance sheet at December 31, 2014:
- The Blow-Dry Manufacturing Company grants a six-month warranty on each of the hair dryers it sells. Based on past experience, it is estimated that 3% of all hair dryers sold are returned; it costs the company an average of $4.40 to satisfy the warranty obligation for each unit returned. The company sold 77,000 hair dryers in the last half of 2014 and has spent $3,000 for warranty work on those units.
- The Speedy-Dry Manufacturing Company has filed a lawsuit for $100,000 in damages against the Blow-Dry Manufacturing Company for infringement of patent rights. Legal counsel for Blow-Dry states that it is reasonably possible, but not likely, that there will be an unfavorable outcome of the case because the Blow-Dry Company has good evidence to support its position.
- The Internal Revenue Service is currently auditing a tax return of the Blow-Dry Company for a prior year. It is remotely possible that the IRS may disallow a deduction of $4,200 on the tax return.
- The Blow-Dry Company is a defendant in a lawsuit. A former executive filed suit on November 7, 2014 based on his claim that the Blow-Dry Company did not comply with a written promise to pay him a $50,000 bonus for 2013. The company did not make the bonus payment because the executive resigned the last week of December 2013. Legal counsel for the company states that the written agreement will probably be held to apply even though the executive resigned. The suit is expected to be settled early in 2015.
Instructions
Explain how to account for each of the situations. Should a liability be included in the body of the balance sheet at December 31, 2014 or should there only be disclosure in the notes accompanying the financial statements or should the item not be recorded or disclosed? Justify your answer.