Litigation, insurance and an onerous supply contract
Meridian Co is being sued by a customer over components supplied in March 20X5. Meridian's legal advisers confirm that a judgement is more likely than not to go against the company and quantify the loss at $1.4m; a negotiated settlement of $1.1m is being discussed but is described only as possible. Meridian's insurer has confirmed in writing that it will reimburse 70% of any damages paid. Separately, Meridian has a take-or-pay contract with two years remaining to buy 40,000 units a year at $12 each. Demand has collapsed: Meridian expects to use only 25,000 units a year and the units can now be bought in the market for $8. The contract cannot be cancelled without penalty, and no penalty amount has been agreed. For the contract, the finance director proposes a provision of $320,000 (40,000 units × $4 × 2 years) and for the lawsuit a provision of nil, on the grounds that the claim is 'only a possibility'.
1. Evaluate the finance director's treatment of the lawsuit and quantify what should be recognised and how it should be presented.
Read the worked answer
The 'possibility' argument is wrong. A present obligation exists (the supply and the claim), an outflow is probable (more likely than not), and a reliable estimate is available. IAS 37 therefore requires a provision.
Measurement
- Best estimate of the expenditure required to settle the obligation: the advisers' quantified likely outcome of $1.4m is the best estimate. The $1.1m settlement is only possible, so it cannot be used to reduce the provision.
- The insurer's written confirmation makes receipt virtually certain, so a separate reimbursement asset of 70% × $1.4m = $0.98m is recognised.
- Reimbursements are presented as a separate asset; offset against the provision is permitted only in the statement of profit or loss.
| Entry | $m |
|---|---|
| Dr litigation expense / Cr provision | 1.40 |
| Dr reimbursement asset / Cr other income | 0.98 |
| Net charge to profit or loss | 0.42 |
Note the asymmetry: a probable loss is provided for, but a possible gain is not recognised. The FD has applied the prudence argument in the wrong direction.
2. Quantify the correct onerous contract provision and explain precisely where the FD's $320,000 is wrong.
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Principle: an onerous contract provision is measured at the unavoidable costs of meeting the obligation - the lower of the cost of fulfilling the contract and any compensation or penalty for failing to fulfil it.
Calculation
- Units Meridian is obliged to buy but will not use: 40,000 − 25,000 = 15,000 units per year.
- Loss on those unavoidable units: $12 − $8 = $4 per unit.
- Remaining term: 2 years.
- Provision = 15,000 × $4 × 2 = $120,000.
The 25,000 units Meridian actually uses are consumed in earning revenue, so their cost is recovered through use; only the surplus units represent an unavoidable loss.
FD's errors
- He provided on the full 40,000 units, including the 25,000 that will be used - that is providing for an executory cost that will be matched by revenue.
- He ignored the possibility that the penalty for cancellation is lower than the cost of fulfilling; the provision cannot exceed the lower of the two figures.
- He did not check whether the penalty is agreed and reliably measurable - if cancellation is cheaper, that is the measure.
Correction: reduce the provision by $200,000, increasing profit and net assets by that amount.
3. State how each of the three items should appear in Meridian's financial statements (statement of financial position, profit or loss, notes).
Read the worked answer
| Item | SFP | P&L | Notes |
|---|---|---|---|
| Lawsuit provision | Provision $1.4m (current/non-current per expected settlement date) | $1.4m expense | Nature, uncertainty, expected timing; no discounting needed if settled within a year |
| Insurance reimbursement | Separate asset $0.98m; do not offset against the provision | $0.98m income (may be netted in P&L) | Contingent asset disclosure only if not virtually certain - here it is recognised |
| Onerous contract | Provision $0.12m | $0.12m expense | Contract terms, expected usage, penalty position |
Overall effect on profit compared with the FD's draft: +$0.98m (reimbursement) − $1.4m (lawsuit) + $0.20m (provision reduced from $320k to $120k) = a $0.22m reduction - small in profit terms but the gross presentation matters, because the SFP shows obligations of $1.52m and an asset of $0.98m, not a net $0.54m.