A company offers a one-year warranty for the product that it manufactures. A history of warranty claims has been compiled, and the probable amounts of claims related to sales for a given period can be determined.
When a company sells a product subject to a warranty, it is probable that there will be expenses incurred in future accounting periods relating to revenues recognized in the current period. These expenses could be incurred due to damage or faulty materials. As such, a liability has been incurred to honor the warranty at the same date as the recognition of the revenue. Based on prior experience or technical analysis, the occurrence of warranty claims can be reasonably estimated and a probable dollar estimate of the liability can be made. The contingent liability for warranties meets both of the requirements from the accrual of a loss ...view middle of the document...
The amount of the loss can be reasonably estimated.
Even though: (1) there is a probable loss on the contract, (2) the amount of the loss can be reasonably estimated and (3) the likelihood of the loss was discovered prior to the issuance of the financial statements, the fact that the contract was entered into subsequent to the date of the financial statements precludes accrual of the loss contingency in financial statements prior to the incurrence of the loss. However, the fact that the material loss has been incurred subsequent to the date of the financial statements but prior to their issuance should be disclosed by means of a note in the financial statements. The disclosure should contain the nature of the contingency and an estimate of the amount of a probable loss or a range into which the loss will probably fall.
A company has adopted a policy of recording self-insurance for any possible losses resulting from injury to others by the company’s vehicles. The premium for an insurance policy for the same risk from an independent insurance company would have an annual cost of $4,000. During the period covered by the financial statements, there were not accidents involving the company’s vehicles that resulted in injury to others.
The fact that a company chooses to self-insure the contingency of injury to others caused by its vehicles is not enough of a basis to accrue a loss contingency that has not occurred at the date of the financial statements. An accrual or “reserve” cannot be made for the amount of insurance premium that would have been paid had a policy been obtained to insure the company against this particular risk. A loss contingency may only be accrued if prior to the date of the financial statements a specific even has occurred that will impair an asset or create a liability and an amount related to that specific occurrence can be reasonably estimated. The fact that the company is self-insuring this risk should be disclosed by means of a note to alert the financial statement reader to the exposure created by the lack of insurance.