Question 4ii

Note 2 – Pending legal cases
At a recent board meeting, we discussed legal cases which customers A and B are bringing against Epsilon in respect of the supply of products which were allegedly faulty. We supplied the goods in the last three months of the financial year.

We have reliably estimated that if the actions succeed, we are likely to have to pay out $10 million in damages to customer A and $8 million in damages to customer B.

Epsilon’s legal advisers have reliably estimated that there is a 60% chance that customer A’s claim will be successful and a 25% chance that customer B’s claim will be successful.

I know we have insurance in place to cover us against claims like this. It is highly probable that any claims which were successful would be covered under our policy. Therefore I would have expected to see a provision for legal claims based on the likelihood of the claims succeeding. However, I would also have expected to see an equivalent asset in respect of amounts recoverable from the insurance company. The financial statements do contain a provision for $10 million but no equivalent asset. Disclosure of the information relating to both of the claims and the associated insurance is made in the notes to the financial statements. How can it be the correct accounting treatment to include a liability but not the corresponding asset, given the above facts? (12 marks)

Required:
Provide answers to the questions raised by the director in notes 1–3. You should justify your answers with reference to relevant International Financial Reporting Standards.

Note: The mark allocation is shown against each of the three notes above.