Reese Company sells two types of merchandise, Type A and Type B. Each carries a one-year warranty.
Type A merchandise: Product warranty costs, based on past experience, will normally be 1% of sales.
Type B merchandise: Product warranty costs cannot be reasonably estimated because this is a new product line.
However, the chief engineer believes that product warranty costs are likely to be incurred.
Reese Company is also being sued for $2,000,000 for an injury caused to a child as a result of alleged negligence while the child was visiting the Reese Company plant in March 2007. The suit was filed in July 2007. Reese’s lawyer states that it is probable that Reese will lose the suit and be found liable for a judgment costing anywhere from $200,000 to $900,000. However, the lawyer states that the most probable judgment is $400,000.
Required
1. How should Reese report the estimated product warranty costs for each of the two types of merchandise mentioned earlier? Explain the rationale for your answer. Do not discuss deferred income tax implications, or disclosures that should be made in Reese’s 2007 financial statements or notes.
2. How should Reese report the suit in its 2007 financial statements? Explain the rationale for your answer. Include in your answer disclosures, if any, that should be made in Reese’s financial statements or notes.