Skinner Company has the following contingencies: 1. Potential costs due to the d

Question

Skinner Company has the following contingencies: 1. Potential costs due to the discovery of a possible defect related to one of its products. These costs are probable and can be reasonably estimated. 2. A potential claim for damages to be received from a lawsuit filed this year against another company. It is probable that proceeds from the claim will be received by Skinner next year. 3. Potential costs due to a promotional campaign in which a cash refund is sent to customers when coupons are redeemed. Skinner estimated, based on past experience, that 70% of the coupons would be redeemed. Forty percent of the coupons were actually redeemed and the cash refunds sent this year. The remaining 30% of the coupons are expected to be redeemed next year. How should Skinner report the potential costs due to the discovery of a possible product defect? Explain why. How should Skinner report this year the potential claim for damages that may be received next year? Explain why. This year, how should Skinner account for the potential costs and obligations due to the promotional campaign?

Explanation / Answer

Answers:

1. Skinner should report the potential costs due to the discovery of a possible product defect as an expense (or provision) in the income statement and liability in the balance sheet (i.e. Provision for possible product defect). Further, Skinner should disclose the nature of the expense involved i.e. it is on account of a possible defect in one of its product. The accrual of expense, creation of liability and disclosure is necessary as the defect related costs are probable and the costs (or amount of liability) can be reasonably estimated.

2. Skinner should not account for the potential claim for damages that may be received next year either in the income statement or balance sheet due to the principle of conservatism. The principle of conservatism states that all probable or actual losses should be recognized while probable gains should be recognised in the year of receipt. As per the information given, the event (potential claim for damages) is probable, however, the amount cannot be reasonably estimated. Due to this we will not include a footnote or disclosure in the balance sheet.

3. Initially, Skinner should report the coupon redemption as an expense (or provision for coupon redemption) in the income statement and as a liability in the balance sheet. This will be done for the equivalent value of 70% of the coupons which are expected to be redeemed. However, 40% of the coupons are redeemed during the year. This was paid in cash and correspondingly the equivalent value of 40% of the coupons will be deducted from liability created in the balance sheet. At the end of the year, we will only have a liability on the balance sheet for equivalent value of 30% of the coupons expected to be redeemed next year.

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