Problem - The Heinrich Tire Company recalled a tire in its subcompact line in December 2013. Costs associated with the recall were originally thought to approximate $42 million. Now, though, while management feels it is probable the company will incur substantial costs, all discussions indicate that $42 million is an excessive amount. Based on prior recalls in the industry, management has provided the following probability distribution for the potential loss
Loss Amount Probability
$32 million 20%
$22 million 50%
$12 million 30%
An arrangement with a consortium of distributors requires that all recall costs be settled at the end of 2014. The risk-free rate of interest is 8%.
1) Applying the expected cash flow approach of SFAC No. 7, estimate Heinrich's liability at the end of the 2013 fiscal year
2) Prepare the journal entry to record the contingent liability (and loss)
3) Prepare the journal entry to accrue interest on the liability at the end of 2014.
4) Prepare the journal entry to pay the liability at the end of 2014, assuming the actual cost is $21.7 million. Heinrich records an additional loss if the actual cost are higher or a gain if the cost are lower.
5) By the traditional approach to measuring loss contingencies, what amount would Heinrich record at the end of 2013 for the loss and contingent liability?