Question

In Year 1, Goodnight Sleep Company began to receive complaints from physicians that patients were experiencing unexpected side effects from the company’s sleep apnea drug. The company took the drug off the Market near the end of Year 1. During Year 2, the company was sued by 800 customers who had a severe allergic reaction to the company’s drug and required hospitalization. At the end of Year 2, the company’s attorneys estimated a 62% chance the company would need to make payments in the range of $2,500 to $7,000 to settle each claim, with all amounts in that range being equally likely. At the end of Year 3, while none of the cases had been resolved, the company’s attorney now estimated an 80% probability the company would be required to make payments in the range of $3,000 to $10,000 to settle each claim with all amounts in that range being equally likely. In Year 400 claims were settled at a total cost of $2.5 million. Based on this experience, the company believes 30% of the remaining cases will be settled at $5,500 each, 50% will be settled for $6,000 each and 20% will be settled for $6,200 each. Required: Prepare the journal entry (in good format) for Years 1 – 4 related to this litigation.

Answer 1

Journal Entry for Years 1- 4

Year 1

Year 1

No entries would be recorded at Year 1, since no claim had been made at that time

Year 2

Year 2

Using IFRS, the standard is "more likely than not " to require record a provision . Additionally AASB would require recording the midpoint of the range . The midpoint of the range of $1000 to $ 5000 is $ 3000 . The midpoint of $ 3000 needs to be muliplied by 1000 people making sue to company which equals to $3000*1000

General - Journal		Debit	Credit
Litigation Loss A/C		$ 3,000,000.00
Provision for Litigation			$ 3,000,000.00

Year 3

Year 3

Using same reasoning for Year 2 , the midpoint of $4500 needs to be multiplied by 1000 people making claims less the $3,000,000.00 liability already recorded in Year 2

General - Journal		Debit	Credit
Litigation Loss A/C		$ 1,500,000.00
Provision for Litigation			$ 1,500,000.00

Year 4

Year 4

Based on historical data provided the company with the abiltiy to settle the balance i.e. 600 claims with the estimation of accrual i.e. 32,40,000 as below for Year 4 600*30/100*3000= 5,40,000 600*50/100*5000=15,00,000 600*20/100*10000=12,00,000 Using IFRS , a provisiion of $30,00,000 was accrued in Year 2 and $ 15,00,000 was accrued in Year 3 . Additonally $12,00,000 f the accrual spent in Year 4 as cash setllement of 400 cases leaving the remaining accurual i.e. $ 33,00,000 ( $30,00,000+$15,00,000-$12,00,000). As a result accrual would be reduced by $60,000($ 32,40,000-$33,00,000) to get the needed accural of $ 32,40,000

General - Journal		Debit	Credit
Provision for Litigation		$60,000
Litigation Loss- Recovery			$60,000
Provision for Litigation		$ 12,00,000
Cash			$ 12,00,000