(Warranties and Loss Contingencies) The following two independent situations involve loss contingencies.

Part 1 Clarke Company sells two products, John and Henrick. Each carries a one-year warranty.

1. Product John—Product warranty costs, based on past experience, will normally be 1% of sales.

2. Product Henrick—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.

Instructions How should Clarke report the estimated product warranty costs for each of the two types of merchandise above? Discuss the rationale for your answer. Do not discuss deferred income tax implications, or disclosures that should be made in Clarke’s financial statements or notes.

Part 2 Toni Morrison Company is being sued for $4,000,000 for an injury caused to a child as a result of alleged negligence while the child was visiting the Toni Morrison Company plant in March 2004. The suit was filed in July 2004. Toni Morrison’s lawyer states that it is probable that Toni Morrison will lose the suit and be found liable for a judgment costing anywhere from $400,000 to $2,000,000. However, the lawyer states that the most probable judgment is $800,000.

Instructions How should Toni Morrison report the suit in its 2004 financial statements? Discuss the rationale for your answer. Include in your answer disclosures, if any, that should be made in Toni Morrison’s financial statements or notes.