Question

The draft financial statements of Pedro, a limited liability company, for the year ended 31 December 2019 are currently under review. The following points have been raised:

• An ex-employee has started an action against Pedro for wrongful dismissal. The company’s legal team have stated that the ex-employee is likely to succeed. The following estimates have been given by the lawyers relating to the case:

          a) Legal costs (to be incurred whether the claim is successful or not) $10,000

          b) Settlement of claim if successful $30,000

Currently no provision has been made by Pedro in the financial statements.

• Pedro has a policy of refunding the cost of any goods returned by dissatisfied customers, even though it is under no legal obligation to do so. This policy of making refunds is generally known. At the year end, Pedro reliably estimated that returns totalling $5,200 will be made after the year-end.

• A customer has made a claim against Pedro for injury suffered following the purchase and use of a defective product. According to legal advisers it is not likely that Pedro will have to pay financial compensation of $150,000 to the customer. In turn, Pedro has made a counter-claim against the supplier of the defective product for $120,000 and believes it is probable that its claim against the supplier will be successful.

State with reasons what adjustments, if any, should be made by Pedro`s in the financial statements.

Answer 1

Situation 1	In the suit against the company by employee, the legal advisers are of the opinion the the employee may succeed. This indicates that there is a high chance of incurring the liability. Also, the legal team is able to estimate the amount of probable liability. In this case, a provision needs to be created in books of Accounts, indicating the amount of probable loss, with corresponding disclosures in notes, mentioning the details of suit. Hence, company needs to record a provision as follows: Legal costs Dr                           10000 Provision for legal costs                 10000 Penalty charges (Settlement)       30000 Provision for penalty charges                   30000 Adequate disclosures mentioning the details of the case and company's stand need to be given in notes.
Situation 2	Company could estimate the amount of returns (which would have an impact on revenue reported). In such case, the company needs to create a provision for returns, and reduce the sales with the estimated returns amount to depict the accurate picture of revenues. The company needs to record the following entry Sales returns Dr            5200 Provision for returns           5200 Sales returns will be shown as deduction from sales revenue to get net revenue. Provision will appear under current liabilities in Balance sheet. Company needs to give additional disclosures relating to the validly of estimated returns in notes.
Situation 3	In this situation, the company has a legal suit against it by the customer, the outcome of which is most likely that company will not incur a loss. A disclosure in financial statements is sufficient for this. Also, though company is likely to win the case against supplier, contingent gains cannot be disclosed following the principle of conservatism (prudence). Hence, no adjustment is required in books of Accounts.