Textbook Problem

Loss Contingencies

Part a. The two basic requirements for the accrual of a loss contingency are supported by several basic concepts of accounting. Three of these concepts are the period of time assumption, the recognition principle, and the qualitative characteristic of verifiability.

Required:

Discuss how the two basic requirements for the accrual of a loss contingency relate to the three concepts mentioned above.

Part b. The following three independent sets of facts relate to (1) the possible accrual or (2) the possible disclosure by other means of a loss contingency.

Situation I

A company offers a 1-year assurance-type warranty for the product that it manufactures. A history of warranty claims has been compiled and the probable amount of claims related to sales for a given period can be determined.

Situation II

Subsequent to the date of a set of financial statements, but prior to the issuance of the financial statements, a company enters into a contract that will probably result in a significant loss to the company. The amount of the loss can be reasonably estimated.

Situation III

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 $2,000. During the period covered by the financial statements, there were no accidents involving the company’s vehicles that resulted in injury to others.

Required:

Explain the accrual and/or type of disclosure necessary (if any) and the reason(s) why such disclosure is appropriate for each of the three independent situations described. Complete your response to each situation before proceeding to the next situation.