Fallon Company, a toy manufacturer that also operates several retail outlets, is preparing its December 31, 2007 financial statements. It has identified the following legal situations that may qualify as contingencies:
1. A customer is suing the company for $800,000 in damages because her child was injured in November 2007 while riding an escalator that stopped suddenly in one of its stores. The child was hurt when he tripped and fell while walking “down” an escalator that was going “up.” Legal counsel feels that the child is partially at fault, but that it is probable that the lawsuit will be settled for between $50,000 and $100,000, with $80,000 being the most likely amount.
2. The company has discovered that a skateboard it began manufacturing and selling in 2007 has defective bearings, sometimes causing a wheel to fall off. The company has issued a “recall” notice in newspapers and magazines in which it offers to replace the bearings. It estimates a cost of $200,000 for these repairs. No lawsuits have been filed for injury claims, although the company feels that there is a reasonable possibility that claims may total as high as $2 million.
3. The company has an incinerator behind one of its retail outlets which is used to burn cardboard boxes received in shipments of inventory from suppliers. The state environmental protection agency filed suit against the company in August 2007 for air pollution. The company expects to stop using the incinerator and begin recycling. However, its lawyers believe that it is probable that a fine of between $40,000 and $60,000 will be levied against the company, although they cannot predict the exact amount.
4. In early 2007 the company signed a contract with a computer vendor to install “state of the art” cash registers in all of its retail outlets. Because of the vendor’s inability to acquire sufficient cash registers, the vendor canceled the contract. The company has filed a breach of contract suit against the vendor, claiming $300,000 in damages. The company’s lawyers expect that it will settle the suit “out of court” for $150,000.
For each situation, prepare the journal entry (if any) on December 31, 2007 to record the information for Fallon Company, and explain your reasoning. If no journal entry is recorded, explain how the information would be disclosed in Fallon Company’s 2007 annual report.