Question

In 2015, Slim Drug Company began to notice problems with its obesity drug. The company stopped selling the drug near the end of 2015. In the last six months of 2016, the company was sued by 1,000 people who had an allergic reaction to the company's obesity drug. At the end of 2016, the company's attorneys believe there is a 60% chance the company will need to make payments in the range of $1,000 to $5,000 to settle each claim. At the end of 2017, while none of the cases have been resolved, the company's attorneys now believe there is an 80% chance the company will need to make payments in the range of $2,000 to $7,000 to settle each claim. In 2018, 400 claims were settled at a total cost of $1.2 million. Based on this experience, the company believes 30% of the remaining cases will be settled for $3,000 each, 50% will be settled for $5,000 and 20% will be settled for $10,000 each.

Using IFRS what journal entries would be required in 2016?

a. There would be no entry since no claims had be made

b. There would be a debit to prepaid legal provision expense and a credit to legal provision for claims of $3,000,000.

c. There would be a debit to litigation expense and a credit to legal provision for claims of $3,000,000

d. There would be recorded as a long-term liability as the claim is possible.

Using U.S. GAAP what journal entries would be required in 2016?

a. There would be a debit to accrued legal provision expenseand a credit to legal provision for claims of $3,000,000.

b. There would be no entry since no claims had be made

c. There would be a debit to litigation expense and a credit to legal provision for claims of $2,000,000

d. There would be recorded as a long-term liability as the claim is possible.

Answer 1

Answer- Before get into answering the question, first let's start with understanding of recognition of provision as per IFRS:

To recognize provision,IRS sets three criteria which are as follows:

There must be a present obligation as a result of the past event.

The outflow of economic benefits to satisfy the obligation must be probable. I.e. more than 50% probable.

The amount of economic benefits required to satisfy the obligation must be reliably estimated.

If all three criteria are met then you should recognize the provision.

Now let's take the case as in the case it is clearly mentioned that slim drug company'attorney believe that there is 60% chance that the company will have to make the payment. The obligation is the result of company's past activity and the obligation can be reliably estimated. So all three criteria for recognizing provision are met therefore the company should make the provision for legal obligation in the year 2016.and the entry for this will be debiting the accrued legal expense provisions by $300000 and crediting legal provisions for claims by $300000. So option (b) is the correct answer.

Using GAAP journal entries required in 2016:-

As per GAAP rule it is probable that the liability has incurred at the date of making financial statements. As in this case in the year 2016 the probability of incurring the liability is not more likely to incurred at the date of financial statement so it can be option (b) that there will no entry since no claims had be made or the liability is not more likely to incurred as in 2017 no claims has been made.