Problem 1. You are the independent auditor engaged to audit Christine Agazzi Corporation's 12/31/07, financial statements. Christine Agazzi manufactures household appliances. During the course of your audit, you discovered the following contingent liabilities.
a. Christine Agazzi began to production of a new dishwasher in 2007 and, by December 31, 2007, sold 100,000 to various retailers for $500 each. Each dishwasher is under a one-year warranty. The company estimates that its warranty expense per dishwasher will amount to $25. At year end, the company had already paid out $1,000,000 in warranty expenses. Christine Agazzi's income statement shows warranty expenses of $1,000,000 for 2007. Agazzi accounts for warranty costs on the accrual basis.
b. In response to your attorney's letter, Robert Smith, Esq., has informed you that Agazzi has been cited for dumping toxic waste into the Kishwaukee River. Clean up costs and fines amount to $3,300,000. Although the case is still being contested, Smith is certain that Agazzi will most probably have to pay the fine and clean up costs. No disclosure of this situation was found in the financial statements.
c. Christine Agazzi is the defendant in a patent infringement lawsuit by Heidi Goldman over Agazzi's use of a hydraulic compressor in several of its products. Smith claims that, if the suit goes against Agazzi, the loss of this suit to be only reasonably possible. Again, no mention of this suit occurs in the financial statements.
As presented, these contingencies are not reported in accordance with GAAP, which may create problems in issuing a clean audit report. You feel the need to note these problems in the work papers.
Instructions:
Heading each page with the name of the company, balance sheet date, and a brief description of the problem, write a brief narrative for each of the above issues in the form of a memorandum to be incorporated in the audit work papers. Explain what led to the discovery of each problem, what the problem really is, and what you advised your client to do (along with any appropriate journal entries) in order to bring these contingencies in accordance with GAAP?