Question

L” is an enterprise which sells gaming cards to retailers, who then resell them to the general public. Customers who buy these cards scratch off a panel to reveal whether they have won a cash prize. There are several different ranges of cards, each of which offers a different assortment of prices. Prize winners send their winning cards to “L” and are paid by cheque. If the prize is major, then the prize-winner is required to telephone “L” to register the claim and then send the winning card to a special address for separate handling. All cards are printed and packaged under conditions of high security. Special printing techniques make it easy for “L” to identify forged claims, and it is unusual for customers to make false claims. Large claims are, however, checked, using a special chemical process that takes several days to take effect. The directors are currently finalising their financial statements for the year ended 31 March 2012. They are unsure about how to deal with the following items:i) A packaging error on a batch of ‘Chance’ cards meant that there were too many major prize cards in several boxes. “L” recalled the batch from retailers, but was too late to prevent many of the defective cards being sold. The enterprise is being flooded with claims. “L”’s lawyers have advised that the claims are valid and must be paid. It has proved impossible to determine the likely level of claims that will be made in respect of this error because it will take several weeks to establish the success of the recall and the number of defective cards. (ii) A prize-winner has registered a claim for a $200 000 prize from a ‘Lotto’ card. The financial statements will be finalised before the card can be processed and checked. (iii) A claim has been received for $100 000 from a ‘Winner’ card. The maximum prize offered for this game is $90 000, and so the most likely explanation is that the card has been forged. The police are investigating the claim, but this will not be resolved before the financial statements are finalised. Once the police investigation has concluded, “L” will make a final check to ensure that the card is not the result of a printing error. (iv) The enterprise received claims totalling $300 000 during the year from a batch of bogus ‘Happy’ cards that had been forged by a retailer in Newtown. The police have prosecuted the retailer and he has recently been sent to prison. The directors of “L” have decided to pay customers who bought these cards 50% of the amount claimed as a goodwill gesture. They have not, however, informed the lucky prize winners of this yet. Required 1. Identify the appropriate accounting treatment of each of the claims against “L” in respect of items (i) to (iv) above. Your answer should have due regard to the requirements of IAS 37 Provisions, Contingent Liabilities and Contingent Assets. 2. It has been suggested that readers of financial statements do not always pay sufficient attention to contingent liabilities even though they may have serious implications for the future of the enterprise. (i) Explain why insufficient attention might be paid to contingent liabilities. (ii) Explain how IAS 37 prevents enterprises from treating as contingent liabilities those liabilities that should be recognised in the balance sheet.

Answer 1

ACCOUNTING TREATMENT OF ITEMS (I) TO (IV) ACCORDING TO IAS-37- PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS

(I) Facts of the case: A packaging error on a batch of ‘Chance’ cards meant that there were too many major prize cards in several boxes. “L” recalled the batch from retailers, but was too late to prevent many of the defective cards being sold. The enterprise is being flooded with claims. “L”’s lawyers have advised that the claims are valid and must be paid. It has proved impossible to determine the likely level of claims that will be made in respect of this error because it will take several weeks to establish the success of the recall and the number of defective cards.

Solution: In this case, the fault lies on the part of the company manufacturing these cards, that is, “L”. Due to the packaging error, many Major cards were sold, due to which “L” has received a lot of claims. This is a case of Constructive obligation as it arose because the error was committed by the company itself and also a Legal obligation because, the company is legally bound to pay the amount to the winners.

We will have to divide this situation into two parts;

Part 1- Defective cards that have already been sold-

A Provision will have to be recognised for the same as many of these cards have been sold already and the claims will stand valid, even when checked by the chemical that checks forged claims. Therefore, there exists a present obligation that has arised because of past events. A reliable estimate needs to be made of the outflow that will be involved, taking into consideration, the approximate number of cards that the retailers would have sold.

Part 2- Defective cards being returned by retailers-

A Contingent Liability will be disclosed as there is a low probability of the remaining boxes being returned by the retailers and it cannot be estimated reliably. This is a possible obligation whose existence will be confirmed only on the happening of some future event, which in this case, is the receipt of boxes from the retailers.

(II) Facts of the case: A prize-winner has registered a claim for a $200 000 prize from a ‘Lotto’ card. The financial statements will be finalised before the card can be processed and checked.

Solution: In this case, a Provision will be recognised. This is due to the fact that the larger claims that are lodged with the company are unlikely to be forged, as is mentioned in the beginning of the question. Therefore, though the card has not been processed and checked; taking the Concept of Prudence into consideration, we will make an estimate of the outflow that is most likely to happen, to settle this onbligation.

(III) Facts of the case: A claim has been received for $100 000 from a ‘Winner’ card. The maximum prize offered for this game is $90 000, and so the most likely explanation is that the card has been forged. The police are investigating the claim, but this will not be resolved before the financial statements are finalised. Once the police investigation has concluded, “L” will make a final check to ensure that the card is not the result of a printing error.

Solution: A Contingent Liability will be disclosed in this case. This is because there is a remote probability that an outflow of resources will be required. As the maximum price offered in this type of card is $90,000 while it is written $1,00,000 in the card. Most probably, this will be a case of forged card. However, there can be a mistake on the part of “L” too. Therefore, a contingent liability will be disclosed, though the possibility is low.

(IV) Facts of the case: The enterprise received claims totalling $300 000 during the year from a batch of bogus ‘Happy’ cards that had been forged by a retailer in Newtown. The police have prosecuted the retailer and he has recently been sent to prison. The directors of “L” have decided to pay customers who bought these cards 50% of the amount claimed as a goodwill gesture. They have not, however, informed the lucky prize winners of this yet.

Solution: Neither a provision nor a contingent liability comes into picture. This is due to the fact that, there is no liability what so ever, in this case. The company “L” was not under an obligation to do so as the cards were forged and the culprit has been sent to prison already. The company is paying 50% amount as a gesture of Goodwill and the amount will be treated as an Expense in the Income Statement.

(i)REASON WHY INSUFFICIENT ATTENTION MIGHT BE PAID TO CONTINGENT LIABILITIES
In many cases, the stakeholders and the general public, might not pay attention to the contingent liabilities because they are not properly disclosed, neither are they highlighted, even if a material matter exists. Also, the amount is mostly not mentioned because it can't be measured with uncertainty. Due to these reasons, there are chances that people might not pay attention to them.

(ii) TREATMENT OF CONTINGENT LIABILITIES AS PER IAS-37
As per IAS-37 the Contingent Liabilities need to be disclosed properly, with material information being adequately highlighted. The disclosure should include:

a) An estimate of the financial effect on the enterprise
b) The timing of outflow that is probable
c) The probability of the outflow taking place

Thus, unlike other Liabilities that are a part of the Balance Sheet itself and are described clearly in notes to accounts, mentioning every detail about the same; Contingent liabilities are just disclosed, telling few material information only and are not a part of the Balance Sheet.