Exercise 9-5B: Contingent liabilities

The following legal situations apply to Zier Corp. for Year 1:

1. A customer slipped and fell on a slick floor while shopping in the retail store. The customer has filed a $5 million lawsuit against the company. Zier’s attorney knows that the company will have to pay some damages but is reasonably certain that the suit can be settled for $750,000.
2. The EPA has assessed a fine against Zier of $320,000 for hazardous emissions from one of its manufacturing plants. The EPA had previously issued a warning to Zier and required Zier to make repairs within six months. Zier began to make the repairs, but was not able to complete them within the six-month period. Because Zier has started the repairs, Zier’s attorney thinks the fine will be reduced to $120,000. He is approximately 80 percent certain that he can negotiate the fine reduction because of the repair work that has been completed.
3. One of Zier’s largest manufacturing facilities is located in “tornado alley.” Property is routinely damaged by storms. Zier estimates it may have property damage of as much as $450,000 this coming year.

Required

For each of the preceding items, determine the correct accounting treatment. Prepare any required journal entries.

Exercise 9-6B: Effect of warranties on income and cash flow

To support himself while attending school, Steve Owens sold computers to other students. During the year, Steve purchased computers for $150,000 and sold them for $280,000 cash.

He provided his customers with a one-year warranty against defects in parts and labor. Based on industry standards, he estimated that warranty claims would amount to 5 percent of sales. During the year, he paid $1,545 cash to replace a defective hard drive.

Required

a. Prepare the journal entries to record the

(1) Purchase of inventory.

(2) Sale of computers.

(3) Warranty expense.

(4) Payment for repairs.

b. Post the preceding transactions to T-accounts.

c. Prepare an income statement and statement of cash flows for Steve’s first year of operation.

d. Explain the difference between net income and the amount of cash flow from operating activities.

Exercise 9-7B: Effect of warranty obligations and payments on financial statements

The Malon Appliance Co. provides a 120-day parts-and-labor warranty on all merchandise it sells. Malon estimates the warranty expense for the current period to be $2,450. During this period, a customer returned a product that cost $1,950 to repair.

Required

a. Show the effects of these transactions on the financial statements using a horizontal statements model like the example shown next. Use + for increase, − for decrease, and NA for not affected. In the Cash Flow column, indicate whether the item is an operating activity (OA), investing activity (IA), or financing activity (FA).

b. Prepare the journal entry to record the warranty expense for the period.

c. Prepare the journal entry to record payment for the actual repair costs.

d. Discuss the advantage of estimating the amount of warranty expense.