Financial Accounting: An Integrated Statements Approach, 2nd Edition

Chapter 10 Liabilities 461

CONTINGENT LIABILITIES

Some past transactions will result in liabilities if certain events occur in the future.

These potential obligations are called contingent liabilities. For example, Ford Motor

Companywould have a contingent liability for the estimated costs associated with

warranty work on new car sales. The obligation is contingent upon a future event,

namely, a customer requiring warranty work on a vehicle. The obligation is the result

of a past transaction, which is the original sale of the vehicle.

If a contingent liability is probable and the amount of the liability can be reason-

ably estimated, it should be recorded in the accounts. Ford Motor Company’s vehicle

warranty costs are an example of a contingent liability that is recorded. The warranty

costs are probable because warranty repairs will be required on some vehicles. In

addition, the costs can be estimated from past warranty experience.

To illustrate, assume that during June a company sells a product for $60,000 on

which there is a 36-month warranty for repairing defects. Past experience indicates that

the average cost to repair defects is 5% of the sales price over the warranty period. The

entry to record the estimated product warranty expense for June is as follows:

This transaction matches revenues and expenses properly by recording warranty costs

in the same period in which the sale is recorded. When the defective product is re-

paired, the repair costs are recorded by debiting Product Warranty Payable and cred-

iting Cash, Supplies, or other appropriate accounts. Thus, if a customer required a $200

part replacement on August 16, the entry is as follows:

If a contingent liability is probable but cannot be reasonably estimated or is only pos-

sible, then the nature of the contingent liability should be disclosed in the notes to the

financial statements. The accounting treatment of contingent liabilities is summarized

in Exhibit 15.

Identify the characteristics
of contingent liabilities.

4

June 30 Product Warranty Expense 3,000

Product Warranty Payable 3,000

SCF BS IS

— Lc SET Ec

Aug. 16 Product Warranty Payable 200

Supplies 200

SCF BS IS

— AT LT —

Disclose

Liability

Record

Liability

Accounting

Treatment

Disclose

Liability

Estimable

Measurement

Not Estimable

Probable

Likelihood

of Occurring

Possible

Contingency

Exhibit 15

Accounting Treatment of Contingent Liabilities

Q.A business sells to a
customer $120,000 of
commercial audio equip-
ment with a one-year re-
pair and replacement
warranty. Historically, the
average cost to repair or
replace is 2% of sales.
How is this contingent
liability recorded?

A.A debit to Product
Warranty Expense for
$2,400 and a credit to
Product Warranty Payable
for $2,400.