Question

QUESTION 1

Fresh Limited , a manufacturer of toothpaste, was taken to court over alleged defamation charges when the company accused a rival toothpaste manufacturer of fraud. Before year end (31 December 2018), the lawyer of Fresh Limited advised that, although losing the case was unlikely, legal fees and settlement costs could amount to R 900 000 in the event that the court case was lost. On 04 February 2019, the judge presiding over the case ruled that Fresh should pay R 1 000 000 to the plaintiff as well as pay all of the plaintiff's legal fees, which amounted to R 180 000. The financial statements had not yet been authorised for issue at the time of the court ruling.

Required:

Discuss how this information should be treated in the financial statements of Fresh Limited for the year ended 31 December 2018.

QUESTION 2

Richy Limited has plant that cost R 345 000 on 01 January 2016. Installation and modification costs R 69 000 (including vat). Transfer costs paid to lawyer amounted to R 20 000. Transport costs for bringing the asset to location amounted to R 20 000. The plant was ready for use on 01 January 2016. The machines were cleared on 01 March 2016 at a cost of R 10 000. Due to the low order levels in April 2016 the plant stood idle. Depreciation is provided over its useful life of 5 years using the straight-line method to a nil residual value. Richy Limited measures plant under the revaluation model. The plant was revalued as follows:

31 December 2016 R 310 000

31 December 2017 R 300 000

31 December 2018 R 250 000

Richy Limited transfers the maximum amount from the realized portion of the revaluation surplus to equity. VAT must be calculated at 15%.

Required:

Disclose the above information in the notes to the financial statements for years ending 2016, 2017 and 2018. (Include in your answer the journal entries that must be recorded in the journal.)

Answer 1

Background:

- Fresh Limited has been sued by a rival toothpaste manufacturer for fraud;

- Before year end 31 December 2018, the Lawyer of Fresh Limited estimates that the chance of Fresh Limited losing the case was unlikely (i.e. the chances of wining the cases are likely);

- On 4 February 2019, after the the end of year 2018, the court ruled that Fresh Ltd. should pay R 1,000,000 along with legal charges R 900,000 to the rival toothpaste manufacturer

- At the time of court ruling, the financial statements had not been issued

Query:

How this information should be treated in the financial statements of Fresh Limited for the year ended 31 December 2018

Solution:

Creation of contingent liability

1. Given that as per Lawyer's estimates, the chances of losing the care are unlikely (i.e. chances of wining the case are likely), therefore, as per IAS 37 - Provisions, Contingent Liabilities and Contingent Assets - Contingent Liabilities mean a possible obligation depending on whether some uncertain future event occurs, or a present obligation but payment is not probable or the amount cannot be measured reliably.
2. In this scenario, the future event that is the settlement of the case is uncertain. The outcome may or may not result in the payment of penal charges (hence termed as a possible obligation).
3. Therefore, a contingent liability is required to be made in the financial statements. The contingent liability is reported outside the Balance Sheet, as a Notes to Balance Sheet.
4. The amount for such contingent liability will be R 900,000

Adjustment in financial books after the settlement of the case

1. Given that the court case was settled on 4 February 2019, i.e. when the financial statements had not yet been authorised for issue, the obligation to pay damages is an adjusting event, the conditions for which were existing on the balance sheet date i.e. on 31 December 2018
2. As per IAS 10 - Events after the reporting period (Balance Sheet date), adjusting events means any event that occurs after the end of the reporting period that provide further evidence of conditions that existed at the end of reporting period
3. As per IAS 37 - an entity must recognise a provision if, and only if a present obligation (legal or constructive) has arisen as a result of a past event (the obligating event)
4. Since a contingent liability was provided for R 900,000, now the obligation shall be classified as a provision in the financial statements and the financial statements will be adjusted accordingly
5. The provision shall be created for R 1,000,000 plus R 180,000. The Profit and Loss Account (PL A/c) will be debited with a total of R 1,180,000 and account Provision for Outstanding Liability will be credited with R 1,180,000.
6. The Provision for Outstanding Liability will appear under the 'Liabilities' head of the Balance Sheet for the year ended 31 December 2018