You are the independent auditor engaged to audit Millay Corporation’s December 31, 2012, financial statements. Millay manufactures household appliances. During the course of your audit, you discovered the following contingent liabilities..

  1. Millay began production of a new dishwasher in June 2012 and, by December 31, 2012, sold 120,000 to various retailers for $500 each. Each dishwasher is under a one-year warranty. The company estimates that its warranty expense per dishwasher will amount to $25. At year-end, the company had already paid out $1,000,000 in warranty expenses. Millay’s income statement shows warranty expenses of $1,000,000 for 2012. Millay accounts for warranty costs on the accrual basis.
  2. In response to your attorney’s letter, Morgan Sondgeroth, Esq., has informed you that Millay has been cited for dumping toxic waste into the Kishwaukee River. Clean-up costs and fines amount to $2,750,000. Although the case is still being contested, Sondgeroth is certain that Millay will most probably have to pay the fine and clean-up costs. No disclosure of this situation was found in the financial statements.
  3. Millay is the defendant in a patent infringement lawsuit by Megan Drabek over Millay’s use of a hydraulic compressor in several of its products. Sondgeroth claims that, if the suit goes against Millay, the loss may be as much as $5,000,000; however, Sondgeroth believes the loss of this suit to be only reasonably possible. Again, no mention of this suit is made 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.