13 Provisions

Question 1

Under IAS 37 a provision should be recognised when:

Answer 1

 An entity has a present obligation, legal or constructive  It is probable that a transfer of resources embodying economic benefits will be required to settle it  A reliable estimate can be made of its amount

Question 2

What does IAS 37 Provisions, contingent liabilities and contingent assets aim to ensure?

Answer 2

IAS 37 Provisions, contingent liabilities and contingent assets aims to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets and that sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount.

Question 3

What is a provision? what is a liability?

Answer 3

A provision is a liability of uncertain timing or amount. A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

Question 4

Recognition IAS 37 states that a provision should be recognised as a liability in the financial statements when:

Answer 4

 An entity has a present obligation (legal or constructive) as a result of a past event  It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation  A reliable estimate can be made of the amount of the obligation

Question 5

Meaning of obligation It is fairly clear what a legal obligation is. However, you may not know what a constructive obligation is. IAS 37 defines a constructive obligation as:

Answer 5

‘An obligation that derives from an entity’s actions where:  by an established pattern of past practice, published policies or a sufficiently specific current statement the entity has indicated to other parties that it will accept certain responsibilities; and  as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.’

Question 6

For the purpose of the IAS, a transfer of resources embodying economic benefits is regarded as ‘probable’ if the event is more likely than not to occur. This appears to indicate a probability of more than 50%. However, the standard makes it clear that where there is a number of similar obligations the probability should be based on considering the population as a whole, rather than one single item. True/ False

Answer 6

For the purpose of the IAS, a transfer of resources embodying economic benefits is regarded as ‘probable’ if the event is more likely than not to occur. This appears to indicate a probability of more than 50%. However, the standard makes it clear that where there is a number of similar obligations the probability should be based on considering the population as a whole, rather than one single item.

Question 7

The amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. The estimates will be determined by the judgement of the entity’s management supplemented by the experience of similar transactions. True/ False

Answer 7

The amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligation at the end of the reporting period.The estimates will be determined by the judgement of the entity’s management supplemented by the experience of similar transactions.

Question 8

Where the effect of the time value of money is material, the amount of a provision should be the Future value of the expenditure required to settle the obligation. An appropriate discount rate should be used. The discount rate should be a pre-tax rate that reflects current market assessments of the time value of money. The discount rate(s) should not reflect risks for which future cash flow estimates have been adjusted. True/ False

Answer 8

Where the effect of the time value of money is material, the amount of a provision should be the present value of the expenditure required to settle the obligation. An appropriate discount rate should be used. The discount rate should be a pre-tax rate that reflects current market assessments of the time value of money. The discount rate(s) should not reflect risks for which future cash flow estimates have been adjusted

Question 9

Reimbursements Some or all of the expenditure needed to settle a provision may be expected to be recovered from a third party. If so, the reimbursement should be recognised only when it is virtually certain that reimbursement will be received if the entity settles the obligation. How should reimbursement be treated and recognised.

Answer 9

 The reimbursement should be treated as a separate asset, and the amount recognised should not be greater than the provision itself.  The provision and the amount recognised for reimbursement may be netted off in profit or loss.

Question 10

Use of provisions A provision should be used only for expenditures for which the provision was originally recognised. Setting expenditures against a provision that was originally recognised for another purpose would conceal the impact of two different events. True/ False

Answer 10

Use of provisions A provision should be used only for expenditures for which the provision was originally recognised. Setting expenditures against a provision that was originally recognised for another purpose would conceal the impact of two different events.

Question 11

Future operating losses: Use of provisions A provision should be used only for expenditures for which the provision was originally recognised. Setting expenditures against a provision that was originally recognised for another purpose would conceal the impact of two different events. true/ False

Answer 11

Future operating losses: Provisions should not be recognised for future operating losses. They do not meet the definition of a liability and the general recognition criteria set out in the standard.

Question 12

What is an onerous contract?

Answer 12

An onerous contract is a contract entered into with another party under which the unavoidable costs of fulfilling the terms of the contract exceed any revenues expected to be received from the goods or services supplied or purchased directly or indirectly under the contract and where the entity would have to compensate the other party if it did not fulfil the terms of the contract.

Question 13

Examples of possible provisions It is easier to see what IAS 37 is driving at if you look at examples of those items which are possible provisions under this standard. Some of these we have already touched on.

Answer 13

Warranties. These are argued to be genuine provisions as on past experience it is probable, ie more likely than not, that some claims will emerge. The provision must be estimated, however, on the basis of the class as a whole and not on individual claims. There is a clear legal obligation in this case Major repairs. Self insurance Environmental contamination Decommissioning or abandonment costs. Restructuring

Question 14

Provisions for restructuring One of the main purposes of IAS 37 was to target abuses of provisions for restructuring. Accordingly, IAS 37 lays down strict criteria to determine when such a provision can be made. IAS 37 defines a restructuring as:

Answer 14

A programme that is planned and is controlled by management and materially changes one of two things.  The scope of a business undertaken by an entity  The manner in which that business is conducted

Question 15

The IAS gives the following examples of events that may fall under the definition of restructuring.

Answer 15

 The sale or termination of a line of business  The closure of business locations in a country or region or the relocation of business activities from one country region to another  Changes in management structure, for example, the elimination of a layer of management  Fundamental reorganisations that have a material effect on the nature and focus of the entity’s operations

Question 16

The question is whether or not an entity has an obligation – legal or constructive – at the end of the reporting period. For this to be the case:

Answer 16

 An entity must have a detailed formal plan for the restructuring.  It must have raised a valid expectation in those affected that it will carry out the restructuring by starting to implement that plan or announcing its main features to those affected by it.

Question 17

A mere management decision is not normally sufficient. Management decisions may sometimes trigger recognition, but only if earlier events such as negotiations with employee representatives and other interested parties have been concluded subject only to management approval. True/ False

Answer 17

A mere management decision is not normally sufficient. Management decisions may sometimes trigger recognition, but only if earlier events such as negotiations with employee representatives and other interested parties have been concluded subject only to management approval

Question 18

Costs to be included within a restructuring provision The IAS states that a restructuring provision should include only the direct expenditures arising from the restructuring, which are those that are both:

Answer 18

 Necessarily entailed by the restructuring; and  Not associated with the ongoing activities of the entity. The following costs should specifically not be included within a restructuring provision.  Retraining or relocating continuing staff  Marketing  Investment in new systems and distribution networks

Question 19

Disclosures for provisions fall into two parts.

Answer 19

 Disclosure of details of the change in carrying value of a provision from the beginning to the end of the year  Disclosure of the background to the making of the provision and the uncertainties affecting its outcome

Question 20

Contingent liabilities and contingent assets. An entity should not recognise a contingent asset or liability, but they should be disclosed. Now you understand provisions it will be easier to understand contingent assets and liabilities. IAS 37 defines a contingent liability as:

Answer 20

 A possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or  A present obligation that arises from past events but is not recognised because: – It is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or – The amount of the obligation cannot be measured with sufficient reliability.

Question 21

Treatment of contingent liabilities Contingent liabilities should not be recognised in financial statements but they should be disclosed. The required disclosures are:

Answer 21

 A brief description of the nature of the contingent liability  An estimate of its financial effect  An indication of the uncertainties that exist  The possibility of any reimbursement

Question 22

Contingent assets IAS 37 defines a contingent asset as:

Answer 22

A possible asset that arises from past events and whose existence will be confirmed by the occurrence or non-occurrence of one or more uncertain future events not wholly within control of the entity. A contingent asset must not be recognised. Only when the realisation of the related economic benefits is virtually certain should recognition take place. At that point, the asset is no longer a contingent asset!

Question 23

A company is engaged in a legal dispute. The outcome is not yet known. A number of possibilities arise:

Answer 23

 It expects to have to pay about $100,000. A provision is recognised.  Possible damages are $100,000 but it is not expected to have to pay them. A contingent liability is disclosed.  The company expects to have to pay damages but is unable to estimate the amount. A contingent liability is disclosed.  The company expects to receive damages of $100,000 and this is virtually certain. An asset is recognised.  The company expects to probably receive damages of $100,000. A contingent asset is disclosed.  The company thinks it may receive damages, but it is not probable. No disclosure

Question 24

Disclosure: contingent liabilities A brief description must be provided of all material contingent liabilities unless they are likely to be remote. In addition, provide

Answer 24

 An estimate of their financial effect  Details of any uncertainties  The possibility of any reimbursement

Question 25

Question 26

Summarise the objective of IAS37 and what it seeks to do?

Answer 26

 The objective of IAS 37 is to ensure that appropriate recognition criteria and measurement bases are applied to provisions and contingencies and that sufficient information is disclosed.  The IAS seeks to ensure that provisions are only recognised when a measurable obligation exists. It includes detailed rules that can be used to ascertain when an obligation exists and how to measure the obligation.  The standard attempts to eliminate the ‘profit smoothing’ which has gone on before it was issued.

Question 27

Events after the reporting period
IAS 10 sets out the criteria for recognising events occurring after the reporting date.
The standard gives the following definition.

Answer 27

Events occurring after the reporting period are those events, both favourable and unfavourable, that occur between the end of the reporting period and the date on which the financial statements are authorised for issue. Two types of events can be identified:  Those that provide evidence of conditions that existed at the end of the reporting period – adjusting  Those that are indicative of conditions that arose after the reporting period – non-adjusting

Question 28

Between the end of the reporting period and the date the financial statements are authorised (ie for issue outside the organisation), events may occur which show that assets and liabilities at the end of the reporting period should be adjusted, or that disclosure of such events should be given. True/ False

Answer 28

Between the end of the reporting period and the date the financial statements are authorised (ie for issue outside the organisation), events may occur which show that assets and liabilities at the end of the reporting period should be adjusted, or that disclosure of such events should be given

Question 29

An entity shall adjust the amounts recognised in its financial statements to reflect adjusting events before the reporting period. An entity shall not adjust the amounts recognised in its financial statements to reflect non-adjusting events after the reporting period. true/ Flase

Answer 29

An entity shall adjust the amounts recognised in its financial statements to reflect adjusting events after the reporting period. An entity shall not adjust the amounts recognised in its financial statements to reflect non-adjusting events after the reporting period.

Question 30

Give an example of additonal evidence whcihy becomes available afte rthe reporting period

Answer 30

An example of additional evidence which becomes available after the reporting period is where a customer goes into liquidation, thus confirming that the trade account receivable balance at the year end is uncollectable

Question 31

In relation to going concern, the standard states that, where operating results and the financial position have deteriorated after the reporting period, it may be necessary to reconsider whether the going concern assumption is appropriate in the preparation of the financial statements. Examples of adjusting events would be:

Answer 31

 Evidence of a permanent diminution in property value prior to the year end  Sale of inventory after the reporting period for less than its carrying value at the year end  Insolvency of a customer with a balance owing at the year end  Amounts received or paid in respect of legal or insurance claims which were in negotiation at the year end  Determination after the year end of the sale or purchase price of assets sold or purchased before the year end  Evidence of a permanent diminution in the value of a long-term investment prior to the year end  Discovery of error or fraud which shows that the financial statements were incorrect

Question 32

Events not requiring adjustment The standard then looks at events which do not require adjustment. The standard gives the following examples of events which do not require adjustments:

Answer 32

 Acquisition of, or disposal of, a subsidiary after the year end  Announcement of a plan to discontinue an operation  Major purchases and disposals of assets  Destruction of a production plant by fire after the reporting period  Announcement or commencing implementation of a major restructuring  Share transactions after the reporting period  Litigation commenced after the reporting period

Question 33

But note that, while they may be non-adjusting, some events after the reporting period will require disclosure. If non-adjusting events after the reporting period are material, non-disclosure could influence the economic decisions of users taken on the basis of the financial statements. Accordingly, an entity shall disclose the following for each material category of non-adjusting event after the reporting period:

Answer 33

(a) The nature of the event (b) An estimate of its financial effect, or a statement that such an estimate cannot be made

Question 34

The example given by the standard of such an event is where the value of an investment falls between the end of the reporting period and the date the financial statements are authorised for issue. The fall in value represents circumstances during the current period, not conditions existing at the end of the previous reporting period, so it is not appropriate to adjust the value of the investment in the financial statements. Disclosure is an aid to users, however, indicating ‘unusual changes’ in the state of assets and liabilities after the reporting period. True/ False

Answer 34

The example given by the standard of such an event is where the value of an investment falls between the end of the reporting period and the date the financial statements are authorised for issue. The fall in value represents circumstances during the current period, not conditions existing at the end of the previous reporting period, so it is not appropriate to adjust the value of the investment in the financial statements. Disclosure is an aid to users, however, indicating ‘unusual changes’ in the state of assets and liabilities after the reporting period

Question 35

The rule for disclosure of events occurring after the reporting period which relate to conditions that arose after that date, is that disclosure should be made if non-disclosure would hinder the user’s ability to make proper evaluations and decisions based on the financial statements. An example might be the acquisition of another business. True/ False

Answer 35

The rule for disclosure of events occurring after the reporting period which relate to conditions that arose after that date, is that disclosure should be made if non-disclosure would hinder the user’s ability to make proper evaluations and decisions based on the financial statements. An example might be the acquisition of another business.

Question 36

A provision is a …………………… of …………….. timing or amount.

Answer 36

A provision is a liability of uncertain timing or amount.

Question 37

A programme is undertaken by management which converts the previously wholly owned chain of restaurants they ran into franchises. Is this restructuring

Answer 37

Yes. The manner in which the business is conducted has changed.

Question 38

How should decommissioning costs on an oilfield be accounted for under IAS 37?

Answer 38

They should be capitalised as part of the initial expenditure on the oilfield.

Question 39

‘Provisions for major overhauls should be accrued for over the period between overhauls’. Is this correct?

Answer 39

No. It is not correct