P13.13B (L0 3) (Liability Errors) You are the independent auditor engaged to audit Sequoia Corporations December 31, 2020, financial statements. Sequoia manufactures small appliances. During the course of your audit, you discovered the following contingent liabilities.

1. Sequoia began production of a new blender in August 2020 and, by December 31, 2020, sold 381,000 to various retailers for $60 each. Each blender is under a one-year warranty. The company estimates that its warranty expense per blender will amount to $4. At year-end, the company had already paid out $831,000 in warranty expenses. Sequoias income statement shows warranty expenses of $831,000 for 2020. Sequoia accounts for warranty costs on the accrual basis.

2. Sequoia is the defendant in a patent infringement lawsuit by Crusher Blenders, Inc. over Sequoias use of a blade design and ice crushing technique in its new blender. Sequoias general counsel claims that, if the suit goes against Sequoia, the loss would be approximately $25,000,000; however, their attorney believes the loss of this suit to be only reasonably possible. Again, no mention of this suit is made in the financial statements.

3. In response to your attorneys letter, Sequoias general counsel has informed you that Sequoia has been cited for burying toxic chemicals behind one of the plants. Clean-up costs and fines amount to $4,200,000. Although the case is still being contested, their attorney is certain that Sequoia will most probably have to pay at least $3,500,000 of the fine and clean-up costs. No disclosure of this situation was found in the financial statements.

As presented, these contingencies are not reported in accordance with GAAP, which may create problems in issuing a favorable audit report. You feel the need to note these problems in the work papers.

Instructions: Heading each page with the name of the company, balance sheet date, and a brief description of the problem, write a brief narrative for each of the above issues in the form of a memorandum to be incorporated in the audit work papers. Explain what led to the discovery of each problem, what the problem really is, and what you advised your client to do (along with any appropriate journal entries) in order to bring these contingencies in accordance with GAAP.