Oak Industries, a manufacturer of radio and cable TV equipment and an operator of subscription TV systems, had a multitude of problems. Subscription services in a market area, for which $ 12 million of cost had been deferred, were being terminated and the customers were not paying on time ($ 4 million receivables in doubt). The chances are 50- 50 that the business will survive another two years.

An electronic part turned out to have defects that needed correction. Warranty expenses are estimated to range from $ 2 million to $ 6 million. The inventory of this part ($ 10 million) is obsolete, but $ 1 million isobso-lete, but $1million can be recovered in salvage, or the parts in inventory can be rebuilt at a cost of $ 2 million (selling price of the inventory on hand would then be $ 8 million with 20 percent of the selling price required to market and ship the products, and the normal profit expected is 5 percent of the selling price).

If the inventory were scrapped, the company would manufacture a replacement inventory at a cost of $ 6 million, excluding marketing and shipping costs and normal profit. The company has defaulted on completion of a military contract, and the government is claiming a $ 2 million refund. Company attorneys think the dispute might be settled for as little as $ 1 million. The auditors had previously determined that an overstatement of income before taxes of $ 7 million would be material to the financial statements. These items were the only ones left for audit decisions about possible adjustment. Management has presented the following analysis for the determination of loss recognition:

Write off deferred subscription costs ……………………..  $ 3,000,000

Provide allowance for bad debts ………………………….        4,000,000

Provide for expected warranty expense …………………..   2,000,000

Lower- of- cost- or- market inventory write- down……… 2,000,000

Loss on government contract refund……………………….    ????????

Required: 

Prepare your own analysis of the amount of adjustment to the financial statements. Assume that none of these estimates have been recorded yet and give the adjusting entry you would recommend. Give any supplementary explanations you believe necessary to support your recommendation.