Question

Analyze the following independent situations. Determine how each contingency should be treated. Question content area bottom Part 1 a. Hanna Company is being sued by a former employee. Hanna Company believes that there is a remote chance that the employee will win. The employee is suing Hanna Company for damages of​ $20,000. Describe the situation in a note to the financial statements. b. Alijah Oil Refinery had a gas explosion on one of its oil rigs. Alijah Oil Refinery believes it is likely that it will have to pay environmental​ clean-up costs and damages in the future due to the gas explosion. Alijah Oil Refinery cannot estimate the amount of the damages. Describe the situation in a note to the financial statements. c. Lambert Enterprises estimates that it will have to pay​ $20,000 in warranty repairs next year

Answer 1

In the situation where Hanna Company is being sued, the contingency should be treated as a contingent liability and disclosed in the financial statements. Alijah Oil Refinery should also disclose their situation as a contingent liability since they believe they will have to pay for clean-up costs and damages due to the gas explosion. Lambert Enterprises' estimation of warranty repairs is not a contingent liability, but a known and probable liability.

Step-by-step explanation:

Part a: In the case of Hanna Company being sued by a former employee, since Hanna Company believes that there is a remote chance that the employee will win, the situation should be disclosed in the notes to the financial statements as a contingent liability. Contingent liabilities are potential liabilities that may arise in the future depending on the outcome of uncertain events. In this case, the potential liability is $20,000 in damages if the employee wins the lawsuit.

Part b: For Alijah Oil Refinery, since they believe it is likely that they will have to pay environmental clean-up costs and damages due to the gas explosion, but cannot estimate the amount, the situation should be disclosed in the notes to the financial statements as a contingent liability. In this case, the contingency is the obligation to pay for clean-up costs and damages, and the amount is uncertain.

Part c: In the case of Lambert Enterprises estimating that they will have to pay $20,000 in warranty repairs next year, this is not a contingent liability. It is a known and probable liability because Lambert Enterprises has a legal or constructive obligation resulting from a past event, and it is probable that an outflow of resources will be required to settle the obligation.