Activity 2 A customer has filed a suit against a trader who has supplied poor quality goods to him. It is known that the court judgment will be in favour of the customer and the trader will be required to pay the damages. However, the amount of legal damages is not known with certainity. The accounting year has already been ended and the books are now finalised to ascertain true profit or loss. The accountant of the trader has advised him not to consider the expected loss on account of payment of legal damages because the amount is not certain and the final judgment of the court is not yet out. Do you think the accountant is right in his approach.

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24-05-2024
Computers and Technology

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Activity 2 A customer has filed a suit against a trader who has supplied poor quality goods to him. It is known that the court judgment will be in favour of the customer and the trader will be required to pay the damages. However, the amount of legal damages is not known with certainity. The accounting year has already been ended and the books are now finalised to ascertain true profit or loss. The accountant of the trader has advised him not to consider the expected loss on account of payment of legal damages because the amount is not certain and the final judgment of the court is not yet out. Do you think the accountant is right in his approach.

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sitapoudellamichhane sitapoudellamichhane · Answer 1 · 2024-05-24T17:06:35+02:00

Answer:

The accountant's approach is not fully aligned with standard accounting principles. According to the accounting standards, specifically the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), companies are required to recognize provisions for liabilities and losses that are probable and can be reasonably estimated, even if the exact amount is not known.

Here’s a detailed explanation:

1. **Probable Liability**: The court judgment is expected to be in favor of the customer, indicating that the liability is probable.

2. **Reasonable Estimate**: While the exact amount of damages is unknown, a reasonable estimate can often be made based on similar cases, legal advice, or other relevant factors.

3. **Disclosure**: If the amount cannot be reasonably estimated, the contingent liability should still be disclosed in the financial statements.

4. **Matching Principle**: Expenses should be matched with the revenues of the period to which they relate. Ignoring the probable loss would overstate the profit of the current period and fail to present a true and fair view of the trader’s financial position.

In summary, the accountant should recognize a provision for the probable legal damages based on a reasonable estimate. If the amount cannot be reasonably estimated, it should be disclosed in the notes to the financial statements. Ignoring the expected loss entirely is not in accordance with accounting principles and would misrepresent the financial position of the trader.