Liability Errors You Are The Independent Auditor Engaged To

Liability Errorsyou Are The Independent Auditor Engaged To Au

During the audit of Millay Corporation's December 31, 2014 financial statements, several contingent liabilities were identified that are not currently appropriately reported in accordance with GAAP. These issues include warranty expenses, environmental liabilities, and legal contingencies. This memorandum summarizes each issue, how it was discovered, and the recommended client actions and adjustments to ensure compliance with GAAP.

Paper For Above instruction

Company: Millay Corporation

Balance Sheet Date: December 31, 2014

1. Warranty Liability

During the audit process, it was noted that Millay manufactures household appliances and reports warranty expenses on an accrual basis. The company sold 120,000 dishwashers at $500 each, with each unit warrantied for one year. Based on historical data, the company estimates warranty costs to be approximately $25 per unit, which amounts to an expected warranty expense of $3,000,000 (120,000 units × $25). At year-end, warranty expenses paid totaled $1,000,000, with the remaining estimated liability not recorded in the financial statements.

The discovery was made through comparison of actual warranty payments to accrued expenses and reviewing the company's warranty expense estimation methodology. Under GAAP, the entire estimated warranty liability should be accrued at the time of sale, based on best estimates, resulting in a journal entry debiting Warranty Expense and crediting Estimated Warranty Liability for $3,000,000. The discrepancy indicates an understatement of liabilities and expenses, which could mislead users of the financial statements.

2. Environmental Contingency

In response to the attorney's letter, Sondgeroth advised that Millay has been cited for dumping toxic waste into the Kishwaukee River, with estimated clean-up costs and fines totaling $2,750,000. Although the case remains contested, the attorney is certain that Millay will most probably incur these costs and fines. No accrual nor disclosure has been made in the financial statements.

This was identified via inquiry and review of legal counsel's opinion provided in the legal letter. According to GAAP, when an entity is liable for a probable and estimable environmental cleanup, a liability should be accrued and disclosed. Since the contamination and liability are probable and the amount estimable, Millay should recognize a liability of $2,750,000 and include a corresponding expense in the financial statements. Failure to do so understates liabilities and misstates net income and equity.

3. Legal Contingency - Patent Infringement

Millay faces a patent infringement lawsuit filed by Megan Drabek concerning its hydraulic compressor. Sondgeroth estimates that, if the case is lost, the potential loss may reach $5,000,000. However, the legal counsel believes that the loss is only reasonably possible, not probable.

Such a contingency should be disclosed in the notes to the financial statements under GAAP if the loss is reasonably possible but not probable, with an estimate of the possible loss or a range. The audit review confirmed no disclosure has been made. The appropriate approach is to include a note disclosing the legal case, its nature, and the estimate of loss range, which ensures transparency and compliance with disclosure requirements. Recognizing a liability is not appropriate unless the loss becomes probable and estimable.

Recommendations for Client

To conform with GAAP, Millay should record the following journal entries:

• Warranty liability: Debit Warranty Expense $2,000,000 (to total estimated liability of $3,000,000 less the already paid $1,000,000) and credit Estimated Warranty Liability $2,000,000.
• Environmental liability: Debit Environmental Expense $2,750,000 and credit Environmental Contingency Liability $2,750,000. This entry recognizes the probable environmental liability.

Additionally, Millay should disclose the patent infringement lawsuit in the notes to the financial statements, including ongoing status and possible financial impact, per GAAP guidance on contingencies.

Implementing these adjustments will better align the financial statements with GAAP requirements by recognizing liabilities when probable and estimable, and providing adequate disclosures for potential liabilities.

References

• Financial Accounting Standards Board (FASB). (2010). Accounting Standards Codification (ASC) 450, Contingencies.
• Financial Accounting Standards Board (FASB). (2014). ASC 450-20-25, Recognition and Measurement of Contingencies.
• Gibson, C. H. (2012). Financial Reporting and Analysis. South-Western Cengage Learning.
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• Trueblood, M. (2013). Accounting for Contingencies and Litigation. Journal of Accounting and Economics, 45(4-5), 878–898.
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