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 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 The inventory of the part ($10 million) is obsolete, but $1 million can be recovered as salvage or the parts in inventory can be rebuilt at a cost of $2 million (selling price of the inventory on hand would then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% of selling price required to market and ship the products, and the normal profit expected is 5% 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 lawyers 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 analysis below for the determination of loss recognition:
Provide for expected warranty expense .......... 2,000,000
Lower of cost or market inventory write-down ....... 2,000,000
Loss on government contract refund ............ —
Total write-offs and losses ................ $11,000,000
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