POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

STA. MARIA, BULACAN CAMPUS

ACCO 20103 – Intermediate Accounting 3

Additional Exercises on Provisions and Contingent Liabilities

Name: ____________________________________________

PROVISION: CONTINUOUS RANGE OF OUTCOME(S)

1. On November 05, 2020, a Sheradez Company truck was in an accident with an auto driven by Joy. Sheradez received
notice on January 15, 2021, of a lawsuit for P4,000,000 damages for personal injuries suffered by Joy. Sheradez’ counsel
believes it is probable that Joy will be awarded an estimated amount in the range between P10,000 and P4,000,000, and
no amount is a better estimate of potential liability than any other amount. The accounting year ends on December 31
and the 2020 financial statements were issued on March 31, 2021. What amount of provision should Sheradez accrue at
December 31, 2020?
a. P 4,000,000 b. P 10,000 c. P2,005,000 d. P-0-

PROVISION: EXPECTED VALUE WITH ADJUSTMENT FACTOR

2. An entity is defendant in a patent infringement lawsuit. The entity’s lawyers believe there is a 30% chance that the court
will dismiss the case and the entity will incur no outflow of economic benefits. However, if the court rules in favor of the
claimant, the lawyers believe that there is a 20% chance that the entity will be required to pay damages of P200,000 (the
amount sought by the claimant) and an 80% chance that the entity will be required to pay damages of P100,000 (the
amount that was recently awarded by the same judge in a similar case). Other outcomes are unlikely. The court is expected
to rule in late December 2021. There is no indication that the claimant will settle out of court.

A 7% risk adjustment factor to the probability weighted expected cash flows is considered appropriate to reflect the
uncertainties in the cash flow estimates. An appropriate discount rate is 10% per year. At December 31, 2020 the entity
recognizes a provision for the lawsuit measured at:
a. Nil b. P89,880 c. P100,000 d. P81,709

3. Carmela Company is estimating a liability for claims in a legal dispute that is expected to be settled in a year’s time. It
estimates the following range of possible outcomes with their associated probabilities:

RANGE ESTIMATED OUTCOME PROBABILITY

High P 2,000,000 25%
Medium 1,200,000 35%
Low 600,000 40%

The current one-year treasury bills yield a return of 4%. An adjustment of 5% is considered appropriate for the risk that
the actual outcome will be different from estimated outcome. What amount of provision should the company recognize
assuming the risk adjustment in the measurement of provision is by adjusting the discount the future outflows to the
present value?
a. P 1,115,385 b. P 1,117,534 c. P 1,160,000 d. P 1,171,150

4. Using the data for Carmela Company, what amount of provision should the company recognize assuming the risk
adjustment in the measurement of provision is by calculating the expected present value of the future outflows and adding
a risk adjustment premium?
a. P 1,115,385 b. P 1,117,534 c. P 1,160,000 d. P 1,171,150

5. A property developer constructs commercial housing units on a hilly area. It has complied with all the regulatory
requirements for construction of real estates on hilly areas, including developing the necessary bunkers and contours to
prevent soil erosion. On October 30, 2020, some of the support bunkers and contours collapsed after an unusual heavy
rain. This caused extensive damages to houses at the foothill. The owners of those damaged houses have commenced
legal proceedings against the company for damages. However, the developer disputes the claim because it believes it has
complied with the regulations and taken the necessary steps to prevent soil erosion. The lawyers of the developer are of
the opinion that it is possible the developer may have to pay damages, based on settlement of similar court cases in the
past. The lawyers estimate that the case may only be concluded in 2 years’ time, considering any appeal to a higher court,
if necessary. The estimate of the possible outcomes excluding legal costs, with the associated probabilities are as follows:

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 POSSIBLE ESTIMATED PROBABILITY
OUTCOME OUTFLOWS
High P 20,000,000 10%
Medium 10,000,000 50%
Low 5,000,000 40%

Legal fees and other costs to defend the case are estimated at P1,000,000. The current one-year and two-year risk free
rates of interest are 4% and 5% respectively. The risk adjustment for errors in estimates of outflows is 10% as there are
significant uncertainties in the estimates of possible outcomes and their related outflows. The developer is currently
negotiating with the plaintiffs for an out-of-court settlement for P8,000,000. The plaintiffs have not decided on this offer
but their responses have been generally positive. The developer estimates that there is a 50% the out-of-court settlement
will materialize within a year. What amount of provision should the company recognize?
a. None b. P 8,862,070 c. P 9,088,828 d. P 9,748,277

6. Brand Company, an oil production company, has a widely published environmental policy in which it undertakes to clean
up all contamination it causes. On October 31, 2020, a contamination on a land occurs while transporting oil to a particular
country. Based on the past incidences of such contamination, a third party contractor is willing to undertake the cleaning
up on behalf of Brand Company. It estimates the cleaning up work would take about two years to complete and it provides
the following price quotation (based on current prices):

Year 1: P 20,000,000 Year 2: P 15,000,000

Due to general inflation and other price increases, the company estimates that the contractor prices would increase by
4% by the end of year 1 and another 4.5% at the end of year 2. Payments will be made at the end of each year. The current
one-year and two-year risk-free rates are 5% and 5.5% respectively and a 3% adjustment is required for the risks that the
actual outflows be different from the estimate. What is the amount of provision for decontamination should the company
recognized on October 31, 2020?
a. None b. P 34,431,836 c. P 34,909,547 d. P 35,464,791

CONTINGENCIES
During 2020, Smith Company filed suit against West Company seeking damages for patent infringement. In Smith’s December
31, 2020 financial statements, how should this be reported? The choices are:
A. Accrue and Disclose
B. Disclose only
C. Accrue only
D. Neither accrue and disclose

Assume the following independent cases:

7. It is virtually certain that Smith would be successful against West for an estimated amount of P 1,500,000.
8. It is probable that Smith would be successful against West for an estimated amount of P 1,500,000.
9. It is probable that Smith would be successful against West for an estimated amount of P 1,500,000. Before the financial
statement was issued, Smith was awarded P 1,000,000 and received full payment thereof.
10. It is probable that Smith would be successful against West for an estimated amount of P 1,500,000. After the financial
statement was issued, Smith was awarded P 1,000,000 and received full payment thereof.
11. It is reasonably possible that Smith would be successful against West for an estimated amount of P 1,500,000.
12. During the year 2020, Smith won a litigation award for P1,500,000 which was tripled to P4,500,000 to include punitive
damages. The defendant, who is financially stable, has appealed only the P3,000,000 punitive damages. Counsel is unable
to estimate the outcome of this appeal.

PREMIUMS TREATED AS SELLING EXPENSE

Paige Candy Company offers a coffee mug as a premium for every ten 50-cent candy bar wrappers presented by customers
together with P1.00. The purchase price of each mug to the company is 90 cents. In addition it costs 60 cents to mail each mu g.
The results of the premium plan for the years 2017 and 2018 are as follows (assume all purchases and sales are for cash).

2017 2018
Coffee mugs purchased 720,000 800,000
Candy bars sold 5,600,000 6,750,000
Wrappers redeemed 2,800,000 4,200,000
2017 wrappers expected to be redeemed in 2018 2,000,000
2018 wrappers expected to be redeemed in 2019 2,700,000

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 13. How much is the premium expense for the year 2017 and 2018 respectively?
a. P140,000 and P100,000
b. P140,000 and P245,000
c. P240,000 and P135,000
d. P240,000 and P245,000

14. What is the amount of premium liability as of December 31, 2017 and 2018, respectively?
a. P100,000 and P135,000
b. P100,000 and P112,000
c. P135,000 and P168,000
d. P135,000 and P240,000

WARRANTIES
Star Company has recently launched a new model of consumer car. Its cars are sold with a three-year warranty for manufacturing
defects. Past experience of similar models indicates that about 10% of the cars sold are with some defects, of which 4% are minor
defects, 3% are normal defects and 3% are major defects. For the year ended December 31, 2020, the company sold 10,000 units
of the new model. The following information relates to the estimate of costs of defects associated with the new model:

Cost of repair/unit Probability Minor Defects Normal Defects Major Defects

High 30% P1,500 P4,000 P7,000
Medium 60% 1,200 3,000 5,000
Low 10% 1,000 1,500 2,000

15. What amount of provision should the company recognized for the year ended December 31, 2020?
a. None b. P 1,445,000 c. P 1,590,000 d. P 3,043,000

Shana Corporation is a manufacturer of cellular phones. Shana grants a 1 year warranty on its products. The estimated liability
for Product warranty account shows the following entries for the year:
Beginning balance ₱270,000.00
Provision for the year (quarterly accrual) 240,000.00
Total 510,000.00

The Company accounts for warranties based on Company’s past experience warranty claims averaged 5% on net sales. Moreover,
the Company provides for quarterly accrual of the estimated warranty expenditure based on rough estimates.

The following additional information is available:

Gross credit sales ₱ 6,525,000.00

Gross cash sales 2,175,000.00
Cost of sales 4,413,600.00
Sales returns and allowances-credit sales 135,000.00
Sales returns and allowances-cash sales 45,000.00

The cost of sales included P498,600 cost of servicing the warranty claims for the year.

16. What is the correct balance of the estimated liability for product warranty at the end of the year?
a. P197,400 b. P317,400 c. P426,000 d. P437,400 e. P0

17. What is the balance of warranty expenses for the year?

a. P426,000 b. P696,000 c. P498,600 d. P270,000 e. P0

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