Question 1: At any of these dates, did Intel have a contingent liability as defined by SFAS #5? June 30: Intel has discovered the flaw
No contingent liability, no disclosure. According to Intel, a series of tests has showed that an error would occur only once every nine billion random calculations, or every 27,000 years for most users. Therefore, the chance that customers would encounter errors in calculations on their Pentium-driven PCs is slight and the event that customers would request chip replacement is remote. This means that the implementation of a replacement program is not probable, nor is the cost of such a program reasonably estimable because the theoretical participation rate is close to or equal to 0%.
October 31: Dr.Nicely has posted information about the flaw on the Internet and started an active discussion group No contingent liability, maybe disclose. The discussion started by Nicely continued to flame accusations and threats to Intel, so the replacement of Pentium chips might become an event that is more likely than remote but less likely than probable. However, since Nicely was involved in intense and continuous number crunching far beyond that of a typical user, he was more likely to encounter errors and could not represent a typical user. Without more information on the frequency of the flaw encountered by a typical user, Intel might not be able to decide on a replacement plan, so that replacement costs were not reasonably estimable. Therefore, if anything, Intel might be on the hook to make a disclosure of a potential future expense.
November 25: Article in Electrical Engineering Times has appeared, a story has been broadcast on CNN, and articles have appeared in the New York Times and Boston Globe. No contingent liability, should disclose. The Internet discussion caught the attention of reporters, and has caused a negative impact on Intel’s stock price, which dropped two percentage points. As the media continued to report the Pentium flaw to consumers, the event that consumers would request replacement of Pentium chips became at the very least reasonably possible, if not probable. However, Intel might still not be able to estimate reasonable replacement costs for its Pentium chip because it has yet to see how its major customers react to the event and start conversation with them on deciding a replacement plan. Therefore, the size of the program is still very uncertain. Intel should therefore make a disclosure.
December 17: IBM announces that it has stopped shipments of its computers with the flawed Pentium chip Have contingent liability. Given that IBM – Intel’s major customer – would probably return flawed Pentium chips and require Intel to account for their loss, the replacement event was likely to occur. Intel’s management should definitely have started negotiation with major computer sellers to decide a return policy for its customers, so the replacement costs are estimable, as it has gathered cost information already. According to SFAS#5, when the future event is likely to occur and reasonably estimable, the company should record a contingent liability.
Question 2: Assume that in December 1994, Intel’s management decided to expand its Pentium chip replacement program by offering to supply a replacement chip to all purchasers of a defective Pentium chip, regardless of how they use it. Intel will provide a new chip free of charge, but will not pay for any other costs. What expense/liability should Intel reflect on its 1994 financial statements? GAAP, through SFAS #5, advises that a contingent liability must be disclosed if “it is probable that… a liability had been incurred at the date of the financial statements.” From knowledge gained in Accounting 202, the rule of thumb under GAAP as to the definition of “probable” is that an outcome is considered probable if its likelihood of occurring is greater than 70%. We assume here...
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