Solutions to GAAP : Graded Questions Provisions, contingencies and events after the reporting

period

Solution 18.9

a) Warning by the lawyers

Issue
The issue is whether the warning is to be recognised as a provision or not recognised but disclosed as a
contingent liability.

Definitions
A contingent liability is:
• a possible obligation that arises from past events and whose existence will be confirmed only by
the occurrence or non-occurrence of one or more uncertain future events not wholly within the
control of the entity; or
• a present obligation that arises from past events but is not recognised because:
- it is not probable that an outflow of resources embodying economic benefits will be required to
settle the obligation; or
- the amount of the obligation cannot be measured with sufficient reliability.

Discussion
• there is a possible obligation – no further cases have yet been brought against the company and
therefore there is no present obligation.
• there is a past event – poisoning of the long-life milk that leads to the guilty plea in the court case.
• The possible obligation will only be confirmed when the verdict is published and more potential
cases may be brought against Moo Limited. At present it is impossible to estimate the number of
cases or their financial impact.

The warning from Moo Limited’s lawyers that there may be more similar cases brought against the
company is a contingent liability. This would be disclosed in the notes but would not be recognised as
a liability. The nature of the contingent liability and the fact that an estimate is not possible would need
to be disclosed.

b) Estimated costs

Issue
The issue is whether the estimated costs are to be treated as an adjusting or non-adjusting event after
the reporting period.

Definitions
Events after the reporting period are those events, favourable and unfavourable, that occur between the
end of the reporting period and the date when the financial statements are authorised for issue.

Two types of events can be identified:

• those that provide evidence of conditions that existed at the end of the reporting period (adjusting
events after the reporting period); and
• those that are indicative of conditions that arose after the reporting period (non-adjusting events
after the reporting period).

Discussion
The estimations by the lawyers as to the settlement costs are an adjusting event as they give additional
information useful in estimating the obligation that was already in existence at year-end.

© Service & Kolitz, 2022 2023 Chapter 18: Page 17

 Solutions to GAAP : Graded Questions Provisions, contingencies and events after the reporting
period

Solution 18.9 continued …

b) Estimated costs continued …

A provision for settlement costs must be recognised in the financial statements for the year ended
31 December 20X2 since:
• there is a present obligation as the court proceedings have indicated that Moo Limited is responsible
for the poisoning
• there is a past event, being the poisoning of the customer
• the expected result is an out-of-court settlement of C220 000 (the lower of the two estimated costs,
being what Moo Limited would rationally pay at the end of the reporting period).

Although an estimate has been made (a settlement of C220 000), there is a high degree of estimation
and the timing of these payments is uncertain. Therefore, assuming that these estimates are considered
to be reliable, these amounts should be recognised in the statement of financial position but disclosed
separately under liabilities as a provision.

(Note that if the estimates were not considered to be reliable, a contingent liability would have to be
disclosed in the notes).

c) Findings by the specialists

The findings of the specialists in January 20X3 are an adjusting event since the inventory on hand at
year-end was already poisoned and because this finding came about before the financial statements
were authorised for issue on 15 February 20X3.

The inventory that is contaminated must be written down to zero:

• C5 000 x 50% (on hand) = C2 500 write-down is required;

d) Possible returns

The possible returns of further long-life milk seem remote and therefore there is no need to either
disclose or recognise a liability of any kind.

© Service & Kolitz, 2022 2023 Chapter 18: Page 18