Top Sound International designs and sells high-end stereo equipment for auto and home use. Engineers notified management in December 2021 of a circuit flaw in an amplifier that poses a potential fire hazard. Further investigation indicates that a product recall is probable, estimated to cost the company $4 million. The fiscal year ends on December 31.
Required:1. Should this contingent liability be reported, disclosed in a note only, or neither? Explain.2. What loss, if any, should Top Sound report in its 2021 income statement?3. What liability, if any, should Top Sound report in its 2021 balance sheet?4. What entry, if any, should be recorded?

1. The contingent liability should be reported in the financial statements. According to generally accepted accounting principles, a contingent liability must be recognized in the financial statements, if at the end of the accounting period, it is established that the liability is likely to occur and the amount of the contingent liability can be reasonably estimated.

2. The amount of the loss that should be reported by Top Sound in its 2021 income statement is $4 million.

3. The liability that Top Sound should report in its 2021 balance sheet is a contingent liability of $4 million.

4. The entry is a debit to the Contingent Loss Account and a credit to the Contingent Liability in the sum of $4 million.

Explanation:

a) Data:

Cost of product recall = $4 million

b) This product recall will give rise to contingent liability and loss in the financial statements of Top Sound. To establish this liability, Top Sound first recognizes it in the income statement as a loss before recording it in the balance sheet as a contingent liability. A contingent liability should be recognized when the event is likely, and the amount of the liability can be reasonably estimated.