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ACCA Applied Knowledge · Financial Accounting · Provisions and contingencies

Delta Co is being sued for damages of $400,000 over a product defect that occurred before the year end. Its lawyers advise that it is probable the claim will succeed and the best estimate of the payout is $300,000. What is the correct accounting treatment in the year-end financial statements?

Recognise a provision of $300,000. The defect is a past event, the lawyers consider the outflow probable, and the best estimate of the settlement is $300,000. The amount claimed is irrelevant, and contingent liability disclosure applies only where outflow is merely possible.

  1. ADisclose a contingent liability of $400,000 only
  2. BRecognise a provision of $300,000Correct
  3. CRecognise a provision of $400,000
  4. DMake no disclosure because the claim is not yet settled

Explanation

There is a present obligation from a past event (the defect), an outflow is probable and a reliable best estimate exists, so a provision is recognised at $300,000. Using the $400,000 claim amount is wrong because the provision is the best estimate, not the amount claimed.

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