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Professional Level

SBR - Strategic Business Reporting

Dasun MendisMBA(USQ), BSc Finance Special (Hons), FCCA, ACA, MCSI

IAS37 - Provisions, Contingent Liabilities and Contingent Assets

• Definition of a provision, contingent liability and contingent asset

• Recognition and measurement criteria for provisions, contingentliabilities and contingent assets

• Apply IAS37 to specific circumstances

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Liabilities - present obligation to transfer an economic resource as a result of past

events

Provisions - liabilities

of uncertain timing

or amount

• Present obligation (Legal or constructive nature) as a result of a pastevent

• Probable outflow of economic benefits

• Estimated reliably

Liability: Recognise & Disclose

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• An intention to make a payment is not enough on its own to justify aprovision. There must be an actual obligation to make a payment

• Legal― Contract

― Law / legislation

• Constructive― Established pattern of past practice

― Published policies

― Sufficiently specific current statement

(Indication to other parties that certain responsibilities are accepted and creation of a valid expectation that they will be discharged)

Obligations

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Guidelines:

• Virtually certain: ≥ 95%

• Probable (more likely than not): > 50%*

• Possible: ≤ 50%

• Remote: ≤ 5%

* In the standard

• Through use:― Only for expenditures for which provision was recognised originally

― As a result, expenditures do not affect profit or loss

• Through revision of estimate:― If an outflow of economic benefits is no longer probable

― Reversal affects profit or loss

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• Contingent liabilities:― Possible obligations arising from a past event to be confirmed by future

events not wholly within the control of the entity, or

― Present obligations arising from a past event:

o Of which the outflow of economic benefits is not probable, or

o That cannot be measured reliably

• Contingent assets: possible assets arising from a past event to beconfirmed by future events not wholly within control of entity

• Contingent liabilities:― Should not be recognised in the statement of financial position

― Should be disclosed in a note unless the possibility of a transfer ofeconomic benefit is remote

• Contingent assets:― should not generally be recognised, but if the possibility of inflow of

economic benefit is probable, they should be disclosed

― If gain is virtually certain, it falls within the definition of an asset andshould be recognised as such, not as a contingent asset

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• Best estimate:― Single item – most likely outcome

― Large population of similar items – expected value

• Discounting required, when effect is material by using pre-taxdiscounting rate

• In reaching the best estimate, the risk and uncertainties that surroundthe underlying events, should be taken into account

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• In Statement of Financial Position, expected reimbursements to berecognised as a separate receivable, if virtually certain. However, inStatement of Profit or Loss, they can be netted off

• Expected gains from disposal of assets should not be recognised asreduction of provision

• Re-measurement of provisions― Review and adjust provisions at each reporting date

― If outflow is no longer probable, reverse the provision

Company A sells a product with one year warranty

• 2019: number of items sold – 100,000

• Costs to repair one item:― Minor defects – $100

― Major defects – $400

• Past statistics:

― No defects for 75% goods

― Minor defects for 20% goods

― Major defects for 5% goods

Required:

What provision should be made for warranty costs?

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Expected value of the liability in respect of items sold in 2019

Calculation Result, $

No defects 100,000 x 75% x 0 0

Minor defects 100,000 x 20% x 100 2,000,000

Major defects 100,000 x 5% x 400 2,000,000

Total 4,000,000

Measurement of a provision for a lawsuit

• Information provided by the legal advisors

Required:

What provision should be made?

Estimated cost, $Mn Probability

Case is won - 30%

Prior settlement 8 40%

Case is lost 12 30%

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• Do not provide for...― Future operating losses (rainy days)

― Currency risks

― Political risks

― Maintenance / refurbishment of own assets

― General restructuring projects

― General business risks

• There is either a legal or constructive obligation to make good orreplace faulty products

• A provision is required at the time of the sale rather than the time ofthe repair/replacement as the making of the sale is the past eventwhich gives rise to an obligation

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Smart sells domestic appliances such as washing machines.

On 31 December 20X9, Smart decides to start selling washing machines witha warranty. Under the terms of the warranty, Smart will repair washingmachines at no charge to the customer if they break within the warrantyperiod. The entity estimates, based on past correspondence with customers,that 20% of the washing machines sold will require repair within thewarranty period at an average cost to Smart of $5,000 per machine.

Smart sold 200 washing machines on 31 December 20X9.

The time value of money should be ignored.

Required:

Calculate the warranty provision required.

A provision is required.

A past event (the sale) has created a legal obligation to spend moneyon repairing machines in the future.

The best estimate can be determined using an expected value:

200 machines × 20% × $5,000 = $200,000.

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Unavoidable costs

Economic benefit>

Onerous contract

NB! If a contract can be terminated without paying penalty, then it is NOT onerous

• Present obligation under the onerous contract should be recognisedas a provision

• Measurement at the lower of (regardless of management’s intention):― Cost of terminating the contract; or

― Net cost of continuing with the contract

• Review the assets dedicated to the onerous contract for impairment

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Image is a company that owns several shops and which has a year end of 31December 20X8.

One of the shops is loss-making. At 31 December 20X8, Image forecasts thatthis shop will make a loss of $500,000 in the year ended 31 December 20X9.

On 31 December 20X8, Image closed down a different shop. At that date, therewere still three years left to run on the shop's lease. Lease rentals are$1,000,000 per annum. The landlord will allow Image to cancel the lease if itpays a one-off fee of $2,000,000. The time value of money should be ignored.

Required:

Discuss the accounting treatment of the above in the financial statements forthe year ended 31 December 20X8.

IAS37 states that no provision should be made for future operatinglosses. Therefore, no provision should be made for the $500,000forecast losses.

The second shop is held under an onerous lease. Provisions can bemade for onerous contracts because there is an obligation arising from apast event. A provision should be recognised for the lower of the cost offulfilling the lease and the cost of terminating the lease. Fulfilling thelease will cost Image $3,000,000 ($1,000,000 × 3 years), but it will onlycost $2,000,000 to terminate the lease. This means that a provisionshould be made for $2,000,000.

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• General principle― Repairs and maintenance of own assets cannot be provided for

― Provision cannot normally be recognised for replacement parts

• Example:― An airline is required by law to overhaul its aircraft once every three

years

― No present obligation to incur the expense – even if the futureexpenditure is required by law, the entity could avoid it by selling theasset

― No provision is recognised

An entity has a reporting date of 31 December 20X7 and intends torepair an item of plant next year. The cost has been reliably estimated atthe reporting date at $10,000. The repair is made in the followingaccounting period at a cost $12,000.

Required:

What provision (if any) should be recognised in the statement offinancial position in the year ended 20X7?

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No provision should be made for future repairs despite it beingprobable and capable of being reliably measured. This is because thereis no obligation at the year end. The repairs expenditure of $12,000 isexpensed to profit or loss as it is incurred.

Under new legislation, an entity is required to fit smoke filters to itsfactories by 30 June 20X8. At the reporting date of 31 December 20X7,the entity has not fitted the smoke filters.

Required:

Should a provision be made at the reporting date for the estimatedcost of fitting the filters?

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No provision should be made for this future expenditure despite it beingprobable and capable of being reliably measured. There has been noobligating past event (the fitting of the filters)

• A provision is recognized if there is an obligation (legal or constructive)to repair environmental damage

• Merely causing damage or intending to clean-up a site does not createan obligation

• An entity may have a constructive obligation to repair environmentaldamage. This will be the case if (for example), an entity publicizespolicies that include environmental awareness or explicitly undertakesto clean up the damage caused by its operations

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• There must have been a past obligating event. A provision can only beset up to rectify environmental damage that has already happened.

• If expenditure results in future economic benefits an equivalent assetcan be recognized. This is depreciated over the useful life, which is thesame as the ‘life’ of the provision.

On 1 January 20X6, Hamilton spent $5m on erecting infrastructure andmachinery near to an area of natural beauty. These assets will be usedover the next three years. Hamilton is well known for its environmentallyfriendly behaviour and is therefore expected to restore the site after itsuse.

The estimated cost of removing these assets and cleaning up the area on1 January 20X9 is $3m.

The pretax, risk specific discount rate is 10%. Hamilton has a reportingdate of 31 December.

Required:

Explain how the above should be treated in the financial statements ofHamilton.

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Hamilton has a constructive obligation to restore the area to its originalcondition as a result of a past event (erecting the infrastructure). Therefore, itshould recognise a provision at 1 January 20X6. The best estimate of theexpenditure is $3m, but this must be discounted to its present value of$2,253,000 ($3m × 0.751).

Hamilton could not carry out its operations without incurring the cleanupcosts. This means that incurring the costs gives it access to future economicbenefits. The estimated clean-up costs are therefore included in the cost ofthe property, plant and equipment (PPE):

Dr PPE $2,253,000

Cr Provisions $2,253,000

Each year, the discount unwinds and the provision increases. The unwinding ofthe discount is charged to the statement of profit or loss as a finance cost.

Movement on provision 20X6 20X7 20X8 20X9

$000 $000 $000 $000

Opening balance 2,253 2,478 2,727 3,000

Finance cost at 10% 225 249 273 –

Utilisation – – – (3,000)

––––– ––––– ––––– –––––

Closing balance 2,478 2,727 3,000 –

––––– ––––– ––––– –––––

Initial cost of PPE $000

Cash paid 1 January 20X6 5,000

PV of clean-up costs 2,253

–––––

Total 7,253

–––––

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The effect on the financial statements is shown below:

Statements of profit or loss 20X6 20X7 20X8 20X9

$000 $000 $000 $000

Operating costs

Depreciation ($7,253/3 years) 2,418 2,418 2,417 –

––––– ––––– ––––– –––––

Finance costs

Unwinding of discount 225 249 273 –

––––– ––––– ––––– –––––

Statements of financial position 20X6 20X7 20X8 20X9

PPE

Cost 7,253 7,253 7,253 –

Depreciation (2,418) (4,836) (7,253) –

––––– ––––– ––––– –––––

Carrying value 4,835 2,417 – –

––––– ––––– ––––– –––––

Liabilities

Clean-up provision 2,478 2,727 3,000 –

––––– ––––– ––––– –––––

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• A restructuring is a program that is planed and controlled bymanagement and has a material effect on:― the scope of a business in terms of the product or service

― Manner in which the business is undertaken

• A restructuring could include:― Sale or termination of a line of business

― The closure of business locations in a country or region

― The relocation of business activities from one country or region toanother

• A restructuring provision can only be recognized where an entity has aconstructive obligation to carry out the restructuring

• A constructive obligation exists only if:― There is a detailed formal plan for restructuring. This must identify the

businesses, locations and employees affected as well as an estimate ofthe cost and time involved

― Those affected have a valid expectation that the restructuring will becarried out. For example, the plan is already being implemented or ithas been announced to those affected by it.

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• The constructive obligation must exist at the year end. (An obligationarising after the year end may require disclosure under IAS 10 Eventsafter the reporting period as a non adjusting event after the reportingdate)

• A board decision alone does not create a constructive obligationunless:― The plan is already being implemented. For example, assets are being

sold, redundancy negotiations have begun

― The plan has been announced to those affected by it. The plan musthave a strict timeframe without unreasonable delays

― The board itself contains representatives of employees or other groupsaffected by the decision

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Include if:

• Unavoidable, and

• Not associated with on going activities

Exclude if:

• Relocating staff

• Retraining staff

• Marketing products

• Investment in new systems and distribution network

• Future operating losses

• Profit on disposal of assets

On 15 January 20X5, the Board of Directors of White voted to proceedwith two re-organisation schemes involving the closure of two factories.White’s reporting date is 31 March, and the financial statements will beauthorised for issue on 30 June.

Scheme 1

The closure costs will amount to $25,000,000. The factory is rented on ashort term lease, and there will be no gains or losses arising on thisproperty. The closure will be announced in June, and will commence inAugust.

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Scheme 2

The costs will amount to $8,000,000 (after crediting $2,000,000 profit on disposal of certain machines). The closure will take place in July, but redundancy negotiations began with the staff in March.

Required:

For each of the two schemes discuss whether a provision should be recognised and, if so, at what amount.

Scheme 1

The obligating event is the announcement of the plan, which occurs in June.This is after the year-end, so there can be no provision. However, theannouncement in June should be disclosed as a non-adjusting event after thereporting date.

Scheme 2

Although the closure will not begin until July, the employees will have had avalid expectation that it would happen when the redundancy negotiationsbegan in March. Therefore, a provision should be recognised. The provisionwill be for $10,000,000 because the expected profit on disposal cannot benetted off against the expected costs.

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At a board meeting on 1 July 2012, Parrot’s directors made the decisionto close down one of its factories on 31 March 2013. The factory and itsrelated plant would then be sold.

A formal plan was formulated and the factory’s 250 employees weregiven three months’ notice of redundancy on 1 January 2013.Customers and suppliers were also informed of the closure at this date.

The directors of Parrot have provided the following information:

Fifty of the employees would be retrained and deployed to othersubsidiaries within the group at a cost of $12,500,000; the remainderwill accept redundancy and be paid an average of $500,000 each.

Factory plant has a carrying amount of $220,000,000, but is onlyexpected to sell for $50,000,000 incurring $5,000,000 of selling costs;however, the factory itself is expected to sell for a profit of$120,000,000.

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The company rents a number of machines under operating leases whichhave an average of three years to run after 31 March 2013. The presentvalue of these future lease payments (rentals) at 31 March 2013 was$100,000,000; however, the lessor has said they will accept $85,000,000which would be due for payment on 30 April 2013 for their cancellationas at 31 March 2013.

Penalty payments due to non-completion of supply contracts areestimated at $20,000,000.

Required:

Explain and quantify how the closure of the factory should be treatedin Parrot’s financial statements for the year ended 31 March 2013.

On its own, a board decision to close the factory is not sufficient tojustify the creation of a provision under IAS 37 Provisions, ContingentLiabilities and Contingent Assets. However, by formulating a plan andinforming interested parties (employees, customers and suppliers), thisis likely to constitute a constructive obligation for a restructuringprovision by raising a valid expectation of the closure.

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The amounts that should be provided for at 31 March 2013 are:

$

– redundancy (200 employees x 500,000) 100,000,000

– impairment loss on plant

(220,000,000 – (50,000,000 – 5,000,000)) 175,000,000

(may be shown as a separate provision)

– onerous contract (lower amount) 85,000,000

– penalty payments 20,000,000

––––––

380,000,000

––––––

The $380,000,000 should be charged to the statement of profit or lossfor the year ended 31 March 2013 and the same amount reported inthe statement of financial position as at 31 March 2013 as a currentliability/plant impairment (assuming all parts of the factory closure willbe completed within the next 12 months).

The factory and the plant would be disclosed in the statement offinancial position as non-current assets held for sale at the lower oftheir carrying amount (the factory) or fair value less cost to sell (theplant).

The $12,500,000 retraining costs cannot be provided for as they arepart of future activities and the anticipated $120,000,000 profit on thedisposal of the factory cannot be recognised until it is realised.

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• The amount recognized should be the best estimate of theexpenditure required and it should take into account expected futureevents.

• This means that expenses should be measured at their actual cost,where this is known, even if this was only discovered after thereporting date (this is an adjusting event after the reporting date perIAS 10)

Financial year end of Panda is 31 March 20X2. On 28 February 20X2, thedirectors of Panda decided to close down a division. This decision wasannounced to the employees affected on 15 March 20X2 and the actualclosure occurred on 30 April 20X2, prior to the 20X2 financial statementsbeing authorised for issue on 15 May.

Expenses and other items connected with the closure were as follows:

$m

Redundancy costs (estimated) 22

Staff retraining (actual) 10

Operating loss for the 2 months to 30 April 20X2

(estimated at 28 February) 12

Profit on sale of property 5

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The actual redundancy costs were $20 million and the actual operating loss for the two months to 30 April 20X2, was $15 million.

Required:

What is the amount of the restructuring provision to be recognised in the financial statements of Panda for the year ended 31 March 20X2?

The only item which can be included in the provision is the redundancycosts, measured at the actual amount of $20 million.

IAS 37 prohibits the recognition of future operating losses, staffretraining and profits on the disposal of assets.

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THANK YOU