Provisions, contingencies and an adjusting event
Kestrel Engineering Ltd is finalising its financial statements for the year ended 31 December 20X4. A customer has started legal proceedings claiming £150,000 for defective work. The company's lawyers advise that Kestrel is more likely than not to be found liable; the best estimate of the settlement is £90,000, expected to be paid in two years' time. An appropriate pre-tax discount rate is 5%. A supplier has lodged a claim for £70,000 over a contract dispute; lawyers assess the chance of an outflow as possible but not probable. Kestrel gives a two-year warranty on its products. Sales for the year were £4,000,000 and historical warranty claims have averaged 2% of sales. The warranty provision brought forward was £30,000 and claims paid during the year were £22,000. A customer owing £25,000 was in serious financial difficulty at the year end and went into liquidation on 15 February 20X5, before the financial statements were approved. No allowance has been made for this debt. The directors want to minimise the liabilities reported.
1. Advise how the legal claim should be recognised and measured, including the journal entry.
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A provision should be recognised. There is a present obligation arising from a past event (defective work), the outflow is probable because the lawyers say Kestrel is more likely than not to lose, and a reliable estimate exists. The 60% likelihood is not multiplied into the amount; it is the recognition test. The best estimate of the obligation is £90,000, but because payment is expected in two years, the time value of money is material and the provision should be discounted:
£90,000 ÷ (1.05)^2 = £81,633 (rounded)
Journal: Dr Legal claim expense £81,633; Cr Provision for legal claim £81,633.
In 20X5 the provision is increased by the unwinding of the discount: £81,633 × 5% = £4,082, charged as a finance cost. In 20X6 a further £4,286 is charged, bringing the provision to the £90,000 expected settlement. Omitting the provision would understate liabilities and overstate profit and net assets.
2. Calculate the warranty provision charge for the year and explain the accounting entries.
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The closing warranty provision should be based on the expected future obligation:
2% × £4,000,000 = £80,000
The charge for the year is the amount needed to move from the opening provision to the closing provision after allowing for claims paid:
| Item | £ |
|---|---|
| Closing provision required | 80,000 |
| Add claims paid in the year | 22,000 |
| Less opening provision | (30,000) |
| Warranty charge for the year | 72,000 |
Journal: Dr Warranty expense £72,000; Cr Warranty provision £72,000.
The £22,000 of claims paid reduces the provision when paid, so it is added back in the charge calculation. The opening provision is not simply increased by 2% of sales; it is replaced by the best estimate of the remaining obligation at the reporting date. This is a judgement based on historical claims experience and should be reviewed for changes in product mix or quality.
3. Explain the treatment of the supplier claim and the customer who went into liquidation after the year end.
Read the worked answer
Supplier claim: this is a possible obligation, not a probable one, because the lawyers assess the chance of outflow as possible but not probable. No provision should be recognised. Instead, disclose a contingent liability of £70,000, unless the possibility of outflow is remote. Recognising a provision would understate profit and overstate liabilities without a present obligation that meets the recognition criteria.
Customer liquidation: the customer was already in serious financial difficulty at 31 December 20X4, and the liquidation before the financial statements were approved provides evidence of that condition. This is an adjusting event. The receivable should be written off: Dr Irrecoverable debt expense £25,000; Cr Trade receivables £25,000. Profit and net assets both fall by £25,000. If the liquidation had been caused solely by a new event after the year end, such as a fire at the customer's premises, it would be non-adjusting and only disclosed. The directors cannot omit required provisions or write-offs simply to minimise reported liabilities; that would misstate the financial statements.