Question

The draft financial statements of Madras, a limited liability company, for the year ended 31

December 2022 is currently under review. The following points have been raised:
a. An ex-employee has started an action against the company for wrongful dismissal. The
company’s legal team have stated that the ex-employee is not likely to succeed. The following
estimates have been given by the lawyers relating to the case:
i. Legal costs (to be incurred whether the claim is successful or not) P50,000
ii. Settlement of claim if successful P150,000
Currently no provision has been made by the company in the financial statements.
b. The company has a policy of refunding the cost of any goods returned by dissatisfied
customers, even though it is under no legal obligation to do so. This policy of making refunds
is generally known. At the year end returns totalling P48,000 have been made.
c. A claim has been made against a company for injury suffered by a pedestrian in connection
with building work by the company. Legal advisers have confirmed that the company will
probably have to pay damages of P100,000 but that a counterclaim made against the building
subcontractors for P50,000 would probably be successful.
Required:
State with reasons what adjustments, if any, should be made by the company in the financial
statements.

Answer 1

Based on the given information, Madras Limited Liability Company (LLC) needs to make certain adjustments in their financial statements. Firstly, the company should make a provision for the legal costs of P50,000 related to the wrongful dismissal case. Even though the legal team is confident that the ex-employee will not be successful, the provision must be made as the costs are to be incurred regardless of the outcome. This will reflect the true financial position of the company and will ensure that the financial statements present a fair view of the company's affairs.

Secondly, the company needs to make a provision for the settlement of P150,000 if the ex-employee's case is successful. This provision needs to be made because there is a likelihood of an outflow of economic resources in the future, as a result of the company losing the case. This provision will reduce the company's profit and hence its tax liability.

Thirdly, the company needs to recognize the refunds of P48,000 made to dissatisfied customers as a liability. Even though Madras LLC is under no legal obligation to make refunds, their policy of making refunds is generally known. Hence, the company has a constructive obligation to make refunds and therefore, the refunds should be recognized as a liability in the financial statements.

Lastly, the company needs to make a provision for the damages payable to the pedestrian injured on their building site. The legal advisers have confirmed that the company will have to pay damages of P100,000. Hence, the company needs to make a provision for this amount as there is a likelihood of an outflow of economic resources in the future. However, as the company has a counterclaim against the building subcontractors for P50,000, this amount can be netted off against the provision. Therefore, Madras LLC needs to make a provision of P50,000 for the net amount of damages payable to the pedestrian.

In conclusion, Madras LLC needs to make the above-mentioned adjustments to their financial statements to ensure that the financial statements present a fair view of the company's affairs. These adjustments will also ensure that the company complies with the Generally Accepted Accounting Principles (GAAP) and will help stakeholders in making informed decisions based on the financial statements.