In relation to a failed acquisition, a firm of accountants has invoiced Gear for the sum of $300 000. Gear has paid $20 000 in full settlement of the debt and states that this was a reasonable sum for the advice given and is not prepared to pay any further sum. The accountants are pressing for payment of the full amount, but on the advice of its solicitors, Gear is not going to settle the balance outstanding. Additionally, Gear is involved in a court case concerning the plagiarism of software. Another games company has accused Gear of copying their games software and currently legal opinion seems to indicate that Gear will lose the case. Management estimates that the most likely outcome will be a payment of costs and royalties to the third party of $1 million in two years' time (approximately). The best case scenario is deemed to be a payment of $500 000 in one year's time and the worst case scenario that of a payment of $2 million in three years' time. These scenarios are based on the amount of the royalty payment and the potential duration and costs of the court case. Management has estimated that the relative likelihood of the above payments are: best case - 30% chance; most likely outcome - 60% chance; and worst case - 10% chance of occurrence. The directors are unsure as to whether any provision for the above amounts should be made in the financial statements.
(ii) In the event of the worst case scenario occurring, the directors of Gear are worried about the viability of their business as the likelihood would be that current liabilities would exceed current assets and it is unlikely that in the interim period there will be sufficient funds generated from operational cash flows.
The discount rate for any present value calculations is 5%.
Required:
Write a report to the directors of Gear Software explaining the implications of the above information contained in paragraphs (i) and (ii) for the financial statements.