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Test your understanding 4
Accrued and prepaid income
Libby Farquar receives income from two rental units as follows:
Unit 1
Unit 2
Period
$
Received
$
Received
1.10.X4 – 31.12.X4
2,150
30.9.X4
1,300 2.1.X5
1.1.X5 – 31.3.X5
2,150
27.12.X4
1,300 4.4.X5
1.4.X5 – 30.6.X5
2,150
25.3.X5
1,300 1.7.X5
1.7.X5 – 30.9.X5
2,200
21.6.X5
1,400 6.10.X5
1.10.X5 – 31.12.X5
2,200
21.9.X5
1,400 2.1.X6
1.1.X6 – 31.3.X6
2,200
29.12.X5
1,400 4.4.X6
What is Libby’s rental income in the statement of profit or loss for
the year ended 31 December 20X5?
A $5,400
B $8,700
C $14,000
D $14,100
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Chapter summary
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Test your understanding answers
Test your understanding 1
Rental expense
$
$
31 March cash
5,000
29 June cash
5,000
2 October cash
5,000
Accrual c/f
5,000 Profit or loss
20,000
––––––
––––––
20,000
20,000
––––––
––––––
Accrued
b/f
5,000
Test your understanding 2
Rental expense
$
$
1 January cash
1,200
3 March cash
1,200
14 June cash
1,200
25 September cash
1,400 Profit or loss
5,000
13 December cash
1,400 Prepayment c/f
1,400
–––––
–––––
6,400
6,400
–––––
–––––
Prepayment b/f
1,400
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Test your understanding 3
The correct answer is B
Electricity expense
$
$
6 February cash
2,800 Accrual b/f
2,000
8 May cash
3,000
5 August cash
2,750
10 November cash
3,100 Profit or loss
11,450
Accrual c/f
1,800
––––––
––––––
13,450
13,450
––––––
––––––
Accrual
b/f
1,800
Test your understanding 4
The correct answer is D
Rental income (Unit 1)
$
$
Prepaid
income
b/f
2,150
25.3.X5
cash
2,150
21.6.X5
cash
2,200
Profit or loss
8,700 21.9.X5 cash
2,200
Prepaid income c/f
2,200 29.12.X5 cash
2,200
–––––
–––––
10,900
10,900
–––––
–––––
Prepaid
income
b/f
2,200
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Rental income (Unit 2)
$
$
Accrued income b/f
1,300 2.1.X5 cash
1,300
4.4.X5
cash
1,300
1.7.X5
cash
1,300
Profit or loss
5,400 6.10.X5 cash
1,400
Accrued income c/f
1,400
–––––
–––––
6,700
6,700
–––––
–––––
Accrued income b/f
1,400
Total income: $8,700 + $5,400 = $14,100
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Receivables
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
explain and identify examples of receivables
•
understand the purpose of aged receivables analysis
•
record the adjustments in the ledger accounts to write of an
irrecoverable debt and one that is consequently recovered
•
record the adjustments in the ledger accounts to adjust the
allowance for receivables
•
identify the impact of the above adjustments on profits and
net assets.
PER
One of the PER performance objectives (PO6) is
to record and process transactions and events.
Working through this chapter should help you
understand how to demonstrate that objective.
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1 Overview
Introduction
This chapter introduces the accounting requirements relating to
irrecoverable debts and allowances for receivables that may not be fully
recovered.
Much of the content of this chapter is new. However, it is an important
foundation for your future ACCA studies, in particular for Financial
Reporting.
2
Cash and credit sales
If a sale is for cash, the customer pays for the goods/services at the point of
sale. The accounting entries for a cash sales are:
Dr Cash
$X
Cr Sales revenue
$X
If the sale is on credit terms the customer will pay for the goods/services after
receiving them. Typically trading terms allow customers 30 – 60 days when
purchasing goods and services on credit.
Under the accruals concept, the sale is recorded in the ledger accounts when
the right to the income is earned. That is usually the point at which the
goods/services are delivered. Therefore when sales are made on credit the
revenue is recorded with a corresponding asset that represents the customer's
commitment to pay. The asset is referred to as a 'receivable'.
The accounting entries to record the sale of goods on credit are:
Dr Receivables
$X
Cr Sales revenue
$X
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When the customer eventually settles the debt the accounting entries will be:
Dr Cash account
$X
Cr Receivables
$X
This then clears out the balance on the customer’s account.
The provision of credit facilities
The majority of businesses will sell to their customers on credit and state
a defined time within which they must pay (a credit period). The main
benefits and costs of doing so are as follows:
Benefits
•
The business may be able to enter new markets.
•
There is a possibility of increased sales.
•
Customer loyalty may be encouraged.
Costs
•
Can be costly in terms of lost interest since the business is
accepting payment later.
•
Cash flow of the business may deteriorate.
•
There is a potential risk of irrecoverable debts.
Aged receivables analysis
Where credit facilities are offered, it is normal for a business to maintain an
aged receivables analysis.
•
Analysis is usually a list, ordered by name, showing how much each
customer owes and how old their debts are.
•
The credit control function of a business uses the analysis to keep track of
outstanding debts and follow up any that are overdue.
•
Timely collection of debts improves cash flow and reduces the risk of them
becoming irrecoverable.
Credit limits
It is also normal for a business to set a credit limit for each customer. This is the
maximum amount of credit that the business is willing to provide.
The use of credit limits may:
•
reduce risk to business of irrecoverable debts by limiting the amount sold
on credit
•
help build up the trust of a new customer
•
be part of the credit control strategy of a business.
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3
Irrecoverable debts and allowances
The accruals concept dictates that when a sale is made, it is recognised in the
accounts, regardless of whether or not the cash has been received.
Occasionally customers either refuse to pay or cannot settle their outstanding
debts. Not only does this lead to a loss of cash income for a business it also
means that it may have an asset in its statement of financial position that it is
unlikely to be able to collect.
If it is highly unlikely that the amount owed by a customer will be received, then
this debt is known as an irrecoverable debt. Irrecoverable debts are 'written off’
by removing them from the ledger accounts completely. This course of action
would be necessary if a customer was in formal liquidation proceedings and it
was known that the outstanding debt will not be recovered.
If there is concern over whether a customer will pay but there is still hope that
the amount (or at least some of it) can be recovered an 'allowance' is created.
Unlike an irrecoverable debt, these items are left in the receivables’ ledger but a
separate and opposite account (receivables are debits, the allowance is a
credit) is set up that temporarily offsets the asset. If the balance is eventually
paid the allowance can be easily removed. This course of action would be
necessary if a customer was having cash flow difficulties but still considered
they would be able to pay if given a little more time.
4
Accounting for irrecoverable debts
An
irrecoverable debt
is a debt which is, or is considered to be, uncollectable.
With such debts it is prudent to remove them from the accounts and to charge
the amount as an expense for irrecoverable debts to the statement of profit or
loss. The original sale remains in the accounts as this did actually take place.
The double entry required to achieve this is:
Dr Irrecoverable debts expense $X
Cr Receivables
$X
Test your understanding 1
Araf & Co has total accounts receivable at the end of its accounting
period of $45,000. Of these items, it is discovered that one, Mr Xiun who
owes $790, has been declared bankrupt, and another who gave his name
as Mr Jones has totally disappeared owing Araf & Co $1,240.
Calculate the effect in the financial statements of writing off these
debts as irrecoverable.
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5
Accounting for irrecoverable debts recovered
There is a possible situation where a debt is written off as irrecoverable in one
accounting period, perhaps because the customer has been declared bankrupt,
and the money, or part of the money, due is then unexpectedly received in a
subsequent accounting period.
When a debt is written off the double entry is:
Dr Irrecoverable debts expense $X
Cr Receivables
$X (removing the debt from the accounts)
When cash is received from a customer the normal double entry is:
Dr Cash
$X
Cr Receivables
$X
When an irrecoverable debt is recovered, the credit entry (above) cannot be
taken to receivables as the debt has already been taken out of the receivables
balance.
Instead the accounting entry is:
Dr Cash
$X
Cr Irrecoverable debts expense $X
Some businesses may wish to keep a separate ‘irrecoverable debts recovered’
account to separate the actual cost of irrecoverable debts in the period.
Test your understanding 2
Celia Jones had receivables of $3,655 at 31 December 20X7. At that
date she wrote off a debt from Lenny Smith of $699. During the year to
31 December 20X8 Celia made credit sales of $17,832 and received
cash from her customers totalling $16,936. She also received the $699
from Lenny Smith that had already been written off in 20X7.
What is the final balance on the receivables account at 31 December
20X7 and 20X8?
20X7 20X8
$ $
A 2,956 3,852
B 2,956 3,153
C 3,655 4,551
D 3,655 3,852
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6
Allowance for receivables
There may be some debts included in the accounts where there is some cause
for concern but which are not yet definitely irrecoverable.
It is prudent to recognise the possible expense of not collecting the debt in the
statement of profit or loss, but the receivable must remain in the accounts in
case the customer does, in fact, settle the amount outstanding.
An allowance is set up which is a credit balance. This is netted off against trade
receivables in the statement of financial position to give a net figure for
receivables that are probably recoverable.
The allowance should consist only of specific amounts where, for example, the
customer is known to be in financial difficulty, or is disputing the invoice, or
payment is already overdue, or is refusing to pay for some other reason (e.g. a
faulty product), and therefore the amount owing may not be recovered.
Therefore, an allowance can only be established where there is some objective
evidence that a particular receivable may not be recovered in part or in full.
7
Accounting for the allowance for receivables
An allowance for receivables is set up with the following journal:
Dr Irrecoverable debts expense $X
Cr Allowance for receivables
$X
If there is already an allowance for receivables in the accounts (opening
allowance), only the movement in the allowance is charged to the statement of
profit or loss (closing allowance less opening allowance).
As the allowance can increase or decrease, there may be a debit or a credit in
the irrecoverable debts account so the above journal may be reversed.
When calculating and accounting for a movement in the allowance for
receivables, the following steps should be taken:
1
Write off irrecoverable debts.
2
Calculate the receivables balance as adjusted for the write-offs.
3
Ascertain the allowance for receivables required.
4
Compare to the brought forward allowance.
5
Account for the change in allowance to determine the expense or credit to
the statement of profit or loss.
6
In the financial statements, deduct the closing allowance for receivables
from the receivables balance.
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Illustration 1
On 31 December 20X1 Jake Williams had receivables of $10,000. At that
date, Jake estimated that there was evidence that amounts totalling $300
may not be recovered as those receivables were already overdue and he
therefore wanted to make a specific allowance for this amount.
During 20X2, Jake made sales on credit totalling $100,000 and received
cash from his customers of $94,000. At 31 December 20X2, Jake now
considered that there was doubt regarding the recoverability of amounts
totalling $700 which were overdue and which may not be recovered. The
allowance for receivables should therefore be increased from $300 to
$700.
During 20X3 Jake made sales of $95,000 and collected $96,000 from his
receivables. At 31 December 20X3 Jake now considered that amounts
totalling only $600 required an allowance for being overdue at that date.
The allowance for receivables should therefore be adjusted from $700 to
$600.
Calculate the allowance for receivables and the irrecoverable debt
expense as well as the closing balance of receivables for each of
the years 20X1, 20X2, 20X3.
You should work through the information methodically, year-by-year. This will
help you to understand the mechanics of how to account for trade receivables,
irrecoverable debts and the allowance for receivables.
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Solution to Illustration 1
Solution
20X1 Receivables
$
$
At 31 December
10,000 Profit or loss (ß)
10,000
––––––
––––––
10,000
10,000
––––––
––––––
Balance b/f
10,000
Allowance required = $300
Allowance for receivables
$
$
Balance c/f
300 31 Dec
Irrecoverable
debts
300
––––––
––––––
300
300
––––––
––––––
Balance
b/f
300
Irrecoverable debts expense
$
$
31 Dec
31 Dec
Allowance for receivables
300 Profit or loss
300
––––––
––––––
300
300
––––––
––––––
Statement of financial position presentation
$
$
Current assets
Receivables 10,000
Less: Allowance for receivables
(300)
––––––
9,700
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20X2 Receivables
$
$
Balance b/f
10,000
Sales 100.000
Cash
94,000
Balance
c/f
16,000
––––––
––––––
110,000
110,000
––––––
––––––
Balance b/f
16,000
Allowance required $700
Allowance for receivables
$
$
Balance
b/f
31
Dec
300
Balance c/f
700 increase in allowance
400
––––––
––––––
700
700
––––––
––––––
Balance
b/f
700
Irrecoverable debts expense
$
$
31 Dec
31 Dec
Allowance for receivables
400 Profit or loss
400
––––––
––––––
400
400
––––––
––––––
Statement of financial position presentation
$
$
Current assets
Receivables 16,000
Less: Allowance for receivables
(700)
––––––
15,300
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20X3 Receivables
$
$
Balance b/f
16,000
Sales 95.000
Cash
96,000
Balance
c/f
15,000
––––––
––––––
111,000
111,000
––––––
––––––
Balance b/f
15,000
Allowance required $600
Allowance for receivables
$
$
31 Dec
Balance b/f
700
Decrease in allowance
100
Balance b/f
600
––––––
––––––
700
700
––––––
––––––
Balance
b/f
600
Irrecoverable debts expense
$
$
31 Dec
31 Dec
Profit or loss
100 Allowance for
receivables
100
––––––
––––––
100
100
––––––
––––––
Statement of financial position presentation
$
$
Current assets
Receivables 15,000
Less: Allowance for receivables
(600)
––––––
14,400
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Test your understanding 3
John Stamp has opening balances at 1 January 20X6 on his trade
receivables account and allowance for receivables account of $68,000
and $3,400 respectively. During the year to 31 December 20X6 John
Stamp made credit sales of $354,000 and collected cash from his
receivables of $340,000.
At 31 December 20X6 John Stamp reviewed his receivables listing and
acknowledged that he is unlikely ever to receive debts totalling $2,000.
These are to be written off as irrecoverable. In addition, at that date he
estimated that amounts totalling $4,000 were overdue and that an
allowance for receivables was required to cover these amounts.
What is the amount charged to John’s statement of profit or loss for
irrecoverable debt expense in the year ended 31 December 20X6?
A $2,700
B $6,100
C $2,600
D $6,000
What will the effect be of Irrecoverable debts on both the statement
of profit or loss and the statement of financial position?
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Chapter summary
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Test your understanding answers
Test your understanding 1
As the two debts are considered to be irrecoverable, they must be
removed from receivables:
Receivables
$
$
Balance at period end
45,000 Irrecoverable debts
– Mr Xiun
790
Irrecoverable
debts
– Mr Jones
1,240
Balance
c/f
42,970
––––––
––––––
45,000
45,000
––––––
––––––
Balance b/f
42,970
Irrecoverable debts expense
$
$
Receivables
– Mr Xiun
790
Receivables
– Mr Jones
1,240 Profit or loss
2,030
––––––
––––––
2,030
2,030
––––––
––––––
Note that the sales revenue account has not been altered and the original
sales to Mr Xiun and Mr Jones remain. This is because these sales
actually took place and it is only after the sale that the expense of not
being able to collect these debts has occurred.
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Test your understanding 2
The correct answer is A
20X7 Receivables
$
$
Balance at period end
3,655 Irrecoverable debts
– Lenny Smith
699
Balance
c/f
2,956
––––––
––––––
3,655
3,655
––––––
––––––
Balance b/f
2,956
20X7 Irrecoverable debts expense
$
$
Receivables
– Lenny Smith
699 Profit or loss
699
––––––
––––––
699
699
––––––
––––––
20X8 Receivables
$
$
Receivables 2,956
Sales 17,832
Cash
received
16,936
Balance
c/f
3,852
––––––
––––––
20,788
20,788
––––––
––––––
Balance b/f
3,852
20X8 Irrecoverable debts expense
$
$
Profit or loss
699 Cash
699
––––––
––––––
699
699
––––––
––––––
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Test your understanding 3
The correct answer is C
Receivables
20X6 $
20X6
$
1 Jan Balance b/f
68,000 31 Dec Cash
340,000
31 Dec Sales revenue
31 Dec Irrecoverable
debts w/off
2,000
31 Dec Balance c/f
80,000
––––––
––––––
422,000
422,000
––––––
––––––
20X7
1 Jan Balance b/f
80,000
Irrecoverable debts expense
20X6 $
20X6
$
31 Dec Receivables
2,000
31 Dec Increase in
allowance for receivables
600 31 Dec Profit or loss
2,600
––––––
––––––
2,600
2,600
––––––
––––––
Allowance for receivables
20X6 $
20X6
$
1 Jan Balance b/f
3,400
31 Dec Balance c/f
4,000 31 Dec Irrecoverable
debts
600
––––––
––––––
4,000
4,000
––––––
––––––
20X7
1 Jan Balance b/f
4,000
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Note that only the one irrecoverable debts expense account is used both
to write off irrecoverable debts and to increase or decrease the allowance
for receivables. There is no need to use separate accounts for each type
of expense.
Working – Allowance for receivables
$4000 – b/f $3,400 = increase of $600
The
statement of financial position
will show a receivables balance of
80,000. Underneath this separately the allowance for receivables c/f
balance of $4,000 will be deducted to give a net receivables total of
$76,000.
The
statement of profit or loss
will show the $2,600 as an expense.
This expense will cause a decrease in overall profits.
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Payables, provisions
and contingent liabilities
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
classify items as current or noncurrent liabilities
•
identify and explain examples of payables
•
define and illustrate the different accounting treatments of
'provisions,' 'contingent liabilities,' and 'contingent assets'
•
calculate and record provisions and movements in
provisions.
PER
One of the PER performance objectives (PO6) is
to record and process transactions and events.
Working through this chapter should help you
understand how to demonstrate that objective.
Chapter
12
Payables, provisions and contingent liabilities
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1 Overview
Introduction
This chapter deals with the accounting requirements for payables,
provisions and contingent liabilities. In particular, it draws upon the
recognition and measurement criteria contained in IAS 37 Provisions,
contingent liabilities and contingent assets. The chapter also considers
classification of liabilities as either current liabilities or non-current
liabilities.
Much of the content of this chapter is new. However, it is an important
foundation for your future ACCA studies for Financial Reporting and also
Strategic Business Reporting.
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2
Categorisation of liabilities
It is important to consider the timing of settlement of a liability so that you can
ensure you allocate it to the correct category of the statement of financial
position. This can be significant to many multiple choice style questions, so take
care when making adjustments for liabilities. Typically trade payables (liabilities
for goods and services purchased), overdrafts and accruals are the main forms
of current liability examined in Financial Accounting. Loans (not bank
overdrafts) are the principal example of non-current liabilities.
The Conceptual Framework defines a liability as
'a present obligation of the
entity to transfer an economic resource as a result of past events'
. The
obligation must be capable of being reliably measured. IAS 37 Provisions,
contingent liabilities and contingent assets develops this principle by making
reference to a legal obligation and a constructive obligation. According to IAS
37, a constructive obligation may be established by an entity having established
or published policies and practices which creates a valid expectation on the part
of others that it will act in a certain way.
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A good example of a constructive obligation is a retail store which allows
customers to return unwanted goods, if the goods are of the wrong size, colour
or specification, without being defective, if the minimum legal obligation is to
only accept returned goods which have been returned because they are faulty
or defective in some way.
3
Cash and credit purchases
If a purchase is for cash, the business pays for the goods/services at the point
of sale. The double entry for a cash purchase is:
Dr Purchases/expenses
$X
Cr Cash
$X
If the purchase was made on credit terms the business will pay for the goods
and services following delivery. Typically trading terms allow 30 – 60 days to
settle outstanding debts when purchasing goods and services on credit.
Under the accruals concept, the purchase is recorded in the ledger accounts
when the expense has been incurred. That is usually the point at which the
goods/services are received/rendered. Therefore when purchases are made on
credit the cost is recorded with a corresponding liability that represents the
obligation to pay the supplier of the goods/services. The liability is referred to as
a 'payable.'
The double entry is recorded as follows:
Dr Purchases/expenses
$X
Cr Payables
$X
When the payable liability is actually paid the double entry to reflect this is:
Dr Payables
$X
Cr Cash
$X
4 Provisions
A
provision
is defined as
'a liability of uncertain timing or amount'
(IAS 37,
para 10).
For example, an entity may face a legal action for a breach of health and safety
law. The likely repercussion is that it may be fined if the court judgement is
made against them. The timing and severity of the fine will be decided by a
court at some future date. The key question is: should the entity reflect this
information in its financial statements?
If we assume that the potential fine could be significant (it could even lead to the
closure of the business) should the potential consequences be disclosed to the
shareholders in some way? As owners of the business, they are entitled to
know about this potentially significant issue that could damage the profits and
reputation of the business and, therefore, the financial value of their investment
in the entity.
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Accounting for a provision
The first potential course of action management can take is to recognise a
provision in the accounts. This is done by estimating the potential cost of the
uncertain event and recognising it immediately. As the amount would be settled
at a future date, a corresponding liability is recorded, as follows:
Dr Expenses
$X
Cr Provision
$X
The provision will need to be classified as either a current or non-current liability
as befits the situation.
Criteria for recognising a provision
Given the uncertainty relating to provisions there is significant scope for
accounting error, or even deliberate manipulation of provisions to alter profits.
To reduce this risk IAS 37 specifies three criteria for recognition of a provision.
A provision shall be recognised when:
•
an entity has a present obligation (legal or constructive) as a result of
a past event.
•
it is probable that an outflow of resources embodying economic
benefits will be required to settle the obligation, and
•
a reliable estimate can be made of the amount of the
obligation
(IAS
37, para 14).
Illustration 1
The criteria referred to above mean that a provision can only be recorded
in an accounting period if recognition of a liability has been triggered at
the year-end.
For example: Smith Co's year-end is 31 December 20X7. In November
20X7 Smith Co dismissed an employee. In February 20X8 a customer
slipped whilst on Smith Co’s premises and broke her arm.
In March 20X8 both the employee and the injured customer sue Smith Co
the former for unfair dismissal and the latter for compensation for injuries
suffered on Smith Co's premises.
Should an obligation be recognised at 31 December 20X7 for either
of these lawsuits?
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Solution to Illustration 1
There is a potential obligation at the year-end for the employee claiming
unfair dismissal. This is because the triggering event happened in
November 20X7, which is before the year-end.
There is no obligation to the injured customer at 31 December 20X7. The
event happened after the year-end date of 31 December 20X7.
Therefore, any financial consequences resulting from the claim made by
the customer will be reflected in the financial statements for the year
ended 31 December 20X8.
Obligations
Should an obligation be recognised at 31 December 20X7 for either of
these lawsuits?
A legal obligation is an obligation that derives from:
•
the terms of a contract,
•
legislation, or
•
other operation of law
(IAS 37, para 10).
A constructive obligation is an obligation that derives from an
entity’s actions where:
•
by an established pattern of past practice, published policies,
or a sufficiently specific current statement, the entity has
indicated to other parties that it will accept certain
responsibilities, and
•
as a result, the entity has created a valid expectation on the
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