Problem Solving Survival Guide to accompany Financial Accounting, 8th Edition

SOLUTION TO EXERCISE G-1

1. Blow-Dry Manufacturing should include an estimated warranty liability in the current liability section of the balance sheet for $7,164 [(77,000 × 3% × $4.40) - $3,000]. Based on past experience, it is probable the company will have to expend goods and services to satisfy the warranty and the cost to do so is estimable.
2. Blow-Dry Manufacturing should only disclose this contingent liability by a note to accompany the financial statements. It is only reasonably possible that a liability exists at the balance sheet date due to the patent infringement lawsuit.
3. Blow-Dry Manufacturing Company need not disclose the IRS audit in the notes or include it in the body of the statements. It is only remotely possible that Blow-Dry will owe tax for the deduction in question.
4. Blow-Dry Company should include a $50,000 liability in the current liability section of the balance sheet. It appears probable that Blow-Dry will lose the suit and the amount is estimable. A journal entry should be made to accrue the loss to the current period (2014). The entry will include a debit to Loss from Lawsuit and a credit to Lawsuit Payable for $50,000.

Approach: Think about the definition of a contingent liability and how to account for one. A contingent liability is a potential liability that may become an actual liability in the future based on the outcome of some future event. The following guidelines apply:

1. If it is probable (likely) that a liability has been incurred and the amount ...