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Chapter 11 - Solution Manual

The second requirement for the accrual of a loss

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The second requirement for the accrual of a loss contingency states that the amount of the loss must be reasonably estimable. The concept of measurement requires that the event must be quantifiable in terms of a standard unit of measure (dollars). In the case of a loss contingency related to the period covered in the current financial statements, the exact timing and magnitude of the loss may not be known in advance, but based on past experience or other methods of analysis, a reasonable estimate of the loss contingency can be made. In making the estimate, the probability that a reasonable amount will be determined statistically is enhanced by a large population of accounts from which the probable loss will occur (law of large numbers). Also related to the reasonable estimation of the probable future loss, the concept of objectivity requires that the estimate be supported by quantitative data. The basis for the estimate must yield essentially the same estimate when computed by different individuals using the available supporting data. The concept of objectivity is supportive of the contention that future events will confirm
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223 the occurrence of a loss at the date of the financial statements. Of course the loss must be probable as well as estimable and justified in light of future events. Relevant accounting information can make a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct prior expectations. Consequently, reasonable estimation of the probable future loss provides financial statement users with information that has predictive value, feedback value, and timeliness. Case 11-10 Situation 1 When a company sells a product subject to warranty, it is probable that there will be expenses incurred in future accounting periods relating to revenues recognized in the current period. As such, a liability has been incurred to honor the warranty at the same date as the recognition of the revenue. Based on prior experience or technical analysis, the occurrence of warranty claims can be reasonably estimated and a probable dollar estimate of the liability can be made. The contingent liability for warranties meets both of the requirements for the accrual of a loss contingency, and the estimated amount of the loss should be reflected in the financial statements. In addition to recording the accrual, it may be advisable to disclose the factors used in arriving at the estimate by means of a footnote especially when there is a possibility of a greater loss than was accrued. Situation 2 Even though (1) there is a probable loss on the contract, (2) the amount of the loss can be reasonably estimated and (3) the likelihood of the loss was discovered prior to the issuance of the financial statements, the fact that the contract was entered into subsequent to the date of the financial statements precludes accrual of the loss contingency in financial statements for periods prior to the incurrence of the loss. However, the fact that a material loss has been incurred
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The second requirement for the accrual of a loss...

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