Sumsang designs and sells smartphones for personal and commercial use. During the current year, the product engineers notified management of a flaw in the design that could cause the latest model to spontaneously combust. After a further investigation, it was noted that a product recall was probable, with an estimated cost to the company of \$2,500,000. What influence might this information have on the current year financial statements?

• A. The company should accrue a liability for the entire \$2,500,000
• B. The company should accrue a liability for an amount less than \$2,500,000
• C. The company should disclose information about this contingency in the notes to the financial statement
• D. The company does not need to accrue a liability or disclose in the footnotes until the actual payments occur
• E. Both (a) and (c)
• F. Both (b) an (c)

Answer: (E)

Verified step by step guidance

1. Identify the nature of the event: The flaw in the smartphone design is a contingent liability because it is a potential obligation that may arise depending on the outcome of a future event, in this case, the product recall.
2. Determine the likelihood of the event: The problem states that a product recall is probable. According to accounting standards, if a contingent liability is probable and the amount can be reasonably estimated, it should be recognized in the financial statements.
3. Estimate the financial impact: The estimated cost of the recall is \$2,500,000. Since this amount is reasonably estimable, it should be used to accrue the liability.
4. Accrue the liability: The company should record a liability of \$2,500,000 in the financial statements. This involves debiting an expense account and crediting a liability account for the same amount.
5. Disclose in the notes: In addition to accruing the liability, the company should disclose information about the contingency in the notes to the financial statements, providing details about the nature of the liability and the estimated financial impact.