ACCA F7 (INT) Financial Reporting - Study text - 2010

Подождите немного. Документ загружается.

Chapter 13: Provisions, contingent liabilities and contingent assets

The following guidelines apply to measuring a provision.

 In measuring a single obligation, the most likely outcome may be the best

estimate of the liability.

 However, if there are other possibilities which are mostly higher or mostly lower

than the most likely outcome, then the best estimate will be a higher or lower

amount.

 When there is a large population of potential obligations (for example, a

provision for multiple claims under guarantees) the obligation should be

estimated by calculating an expected value of the cost of the future obligations.

This is done by weighting all possible outcomes by their associated probabilities.

 If there is a considerable time lag before the settlement of the provision then the

amount provided should be discounted to a present value.

In some cases, a part or all of an entity’s provision may be recoverable from a third

party. For example, an entity paying out to a customer under the terms of a

guarantee may itself be able to claim money back from one of its own suppliers.

IAS37 requires that such a reimbursement:

 should only be recognised where receipt is ‘virtually certain’, and

 should be treated as a separate asset in the statement of financial position (i.e.

not netted off against the provision) at an amount no greater than that of the

provision.

Example

Entity G has a financial year ending 31 December. On 15 December Year 1, an

employee was injured in the workplace and has sued Entity G for compensation

under current health and safety legislation. Entity G’s solicitors believe that the

employee’s claim has a 60% chance of success. The solicitors estimate that, if

successful, the claim will be settled at $20,000.

Required

Consider whether or not Entity G should provide for the claim at 31 December Year

1 and, if so, at what amount.

Answer

If a provision is to be made:

 there must be a present obligation as a result of a past event

 it must be probable that an outflow of economic benefits will be required to settle

the obligation, and

 it must be possible to make a reliable estimate of the amount of the obligation.

Paper F7: Financial reporting (International)

226 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP

Applying this to the facts in the example:

(1) Entity G has a legal obligation under the health and safety legislation. The

obligation has arisen from a past event, which is the accident on 15 December

Year 1.

(2) It is probable that Entity G will have to pay the employee. A ‘60% chance of

success’ means that success is ‘more likely than not’. (A probability above 50%

meets the IAS37 definition of ‘probable’.)

(3) A reliable estimate can be made. This is $20,000.

Conclusion: A provision of $20,000 should be made at 31 December Year 1.

Example

A manufacturer gives warranties at the time of sale to buyers of its products. Under

the terms of the warranty, the manufacturer agrees to repair or replace any faulty

products free of charge within two years from the date of sale. Experience over the

past few years has shown that the cost of such repairs and replacements each year

has been about 5% of the total sales revenue from the products. Annual sales of the

product are $1 million.

Required

Consider whether or not the manufacturer should provide for warranty claims on

30 June Year 2 and, if so, at what amount.

Answer

If a provision is to be made:

 there must be a present obligation as a result of a past event

 it must be probable that an outflow of economic benefits will be required to

settle the obligation

 it must be possible to make a reliable estimate of the amount of the obligation.

Applying this to the facts in the example:

(1) The past obligating event is the sale of the products with the warranty during

the year. This gives rise to a legal obligation on 30 June Year 2.

(2) An outflow is probable for the warranties as a whole.

(3) A reliable estimate can be made. Annual sales are $1 million, annual costs

under the warranties are 5% of this amount (= $50,000) and the warranties are

given to customers for two years. The provision should therefore be 2 years ×

$50,000 = $100,000.

Conclusion: A provision of $100,000 should be made on 30 June Year 2.

Chapter 13: Provisions, contingent liabilities and contingent assets

1.6 Changes in provisions

It has already been stated that when the amount of a provision is increased, the

amount of the increase is treated as an expense. Similarly, when a provision is

reduced, the reduction is an addition to profit.

IAS37 requires that provisions should be reviewed at the end of each reporting

period and adjusted to the current ’best estimate’.

When a provision is included in the statement of financial position at a discounted

value (at present value) the amount of the provision will increase over time, to

reflect the passage of time. In other words, as time passes the amount of the gets

smaller, so the reported provision increases. This increase in value is included in

borrowing costs for the period.

1.7 Use of provisions

IAS37 also states that a provision may be used only for expenditures for which the

provision was originally recognised.

For example, suppose that a company has created a provision of $300,000 for the

cost of warranties and guarantees, and now finds that it will probably has to pay

$250,000 to settle a legal dispute for which it has made a provision of only $175,000,

which is $75,000 lower. It cannot choose to set off the ‘surplus’ $75,000 of payment

to settle the legal dispute against the provision for warranties and guarantees.

IAS37 comments that setting off expenditures against a provision that was

originally recognised for another purpose would result in concealing the effect of

two different events.

1.8 Accounting for specific types of provision

The following rules apply to specific types of provision.

Onerous contracts

An onerous contract is a contract where the unavoidable costs of

fulfilling/completing the contract now exceed the benefits to be received (the

contract revenue).

A provision should be made for the additional unavoidable costs of an onerous

contract. (The ‘additional unavoidable costs’ are the amount by which costs that

cannot be avoided are expected to exceed the benefits.)

Example

On 31 December Year 4, Entity H is half way through an eight year operating lease

on its factory when it moves to a new factory. Annual lease payments are $60,000. It

cannot cancel the lease or sub-let the factory.

Paper F7: Financial reporting (International)

228 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP

Required

Consider whether or not the conditions for making a provision are met and at what

amount, if any, a provision should be made.

Answer

A present legal obligation exists as a result of a past event (the signing of the lease).

An outflow of resources is probable. (These are the rentals for the remainder of the

term of the lease, which cannot be avoided.)

The amount can be measured reliably ($60,000 × 4 years, discounted to a present

value).

The discounted value of the future lease payments for four years may therefore be

recognised as a provision.

Restructuring

An entity may plan to restructure a significant part of its operations. Examples of

restructuring are:

 the sale or termination of a line of business

 the closure of business operations in a country or geographical region, or

relocation of operations from one region or country to another

 major changes in management structure, such as the removal of an entire ‘layer’

of management from the management hierarchy

 fundamental reorganisations changing the nature and focus of the entity’s

operations.

A provision may be made for the future restructuring costs only if a present

obligation exists.

A constructive obligation is likely to occur where, prior to the end of the reporting

period:

 a detailed formal plan exists for the reconstruction

 and this plan has raised a valid expectation, in the mind of those people affected

by the restructuring, that the reconstruction will occur.

This may mean, for example, that the board of directors has drawn up a formal plan

of restructuring, and has announced that plan to the work force or has made a

public announcement about it.

Any provision for restructuring costs that is created:

 should include only the expected direct expenses arising from the restructuring,

and

Chapter 13: Provisions, contingent liabilities and contingent assets

 should not include ongoing expenses such as:

− the costs of retraining or relocating continuing staff

− the cost of marketing

− the cost of investing in new systems.

Future operating losses

An entity may forecast that it will make a substantial operating loss in the next year

or several years. If so, its directors might want to ‘take all the bad news’

immediately, and create a provision for the future losses.

Provisions cannot be made for future operating losses. This is because they arise

from future events, not past events.

Environmental and similar provisions

An entity may be required to ‘clean up’ a location where it has been working when

production ceases. For example, an entity that operates an oil rig may have to repair

the damage it has caused to the sea bed once the oil has all been extracted.

An entity does not necessarily have to recognise a provision if it has caused

environmental damage, even if it intends to clean up the site. The normal rules

apply for the recognition of a provision: an entity recognises a provision only where

it has an obligation to rectify environmental damage as a result of a past event.

An entity has an obligation to ‘clean-up’ a site if:

 it is required to do so by law (a legal obligation); or

 its actions have created a constructive obligation to do so.

A constructive obligation might exist if (for example) an entity has actually

promised to decontaminate a site or if it has adopted environmentally friendly

policies and has made the public aware of this.

In some cases, a provision for making good environmental damage can only be

recognised if the environmental damage has already happened (a past event). The

following example illustrates this.

Example

An entity is about to begin to operate a coal mine. At the end of the reporting

period, the mineshaft has been prepared and all the necessary equipment has been

constructed and is in place, but no coal has yet been extracted. Under local law, the

entity is obliged to rectify all damage to the site once the mining operation has been

completed (this is expected to be several years from now). Management estimates

that 20% of the eventual costs of performing this work will relate to removing the

equipment and various buildings and the remaining 80% will relate to restoring the

damage caused by the actual extraction of coal.

Should a provision be recognised for the cost of restoring the damage?

Paper F7: Financial reporting (International)

230 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP

Answer

The entity has a legal obligation to rectify the environmental damage caused by the

actual digging of the mineshaft and construction of the site. An outflow of economic

benefits is probable.

Therefore the entity should recognise a provision for the best estimate of removing

the equipment and rectifying other damage which has occurred to date. This is

expected to be about 20% of the total cost of restoring the site.

Because no coal has yet been extracted, the entity has no obligation to rectify any

damage caused by mining. No provision can be recognised for this part of the

expenditure (estimated at about 80% of the total).

On the other had, when an energy company undertakes to construct a new nuclear

power station, and has a legal obligation to decontaminate the site when the power

station reaches the end of its life, a provision for future decontamination costs

should be made, and the cost included in the initial cost of the asset.

Accounting for a provision for environmental costs

When an entity has an obligation to clean up environmental damage, it normally

has to recognise a provision for expenditure which will take place many years in the

future.

The estimated full cost of the expenditure should be recognised as soon as an

obligation arises. However, the provision is discounted to its net present value if the

time cost of money is material. (An examination question will make this clear and

will give you the discount rate to use.)

As well as recognising a liability for future expenditure, an entity normally

recognises an asset. Usually the entity cannot carry out its operations without

agreeing to incur the expense of cleaning up any damage that it causes. This

expenditure meets the definition of an asset, because it gives the entity access to

future economic benefits in the form of sales revenue.

The double entry is:

 Debit: Non-current asset

 Credit Provision (rather than Debit Expense; Credit Provision).

The asset is then depreciated over its useful life in the same way as other non-

current assets.

Example

Entity Z has constructed an oil rig which is due to become operational on 1 January

Year 1. The entity has promised that when the oil rig is eventually decommissioned

it will restore the sea bed and clean up any contamination that it has caused. It is

estimated that the cost of decommissioning the oil rig will be $8 million and that

Chapter 13: Provisions, contingent liabilities and contingent assets

decommissioning will take place in ten years’ time. The risk free cost of capital for

the company is 10%. The oil rig is depreciated on a straight line basis over its

economic life of 10 years.

Required:

Explain how the cost of decommissioning the oil rig should be treated in the

financial statements for the year ended 31 December Year 1.

Answer

Entity Z has a constructive obligation to repair environmental damage as the result

of a past event (the construction of the oil rig). Therefore it must recognise a

provision for the decommissioning costs.

IAS 16 Property, plant and equipment states that the cost of an asset should include

the estimated costs of dismantling and restoring a site, if the entity has an obligation

to incur these costs. The decommissioning costs give Entity Z the right to future

economic benefits in the form of revenues from extracting and selling oil. Therefore

the decommissioning costs are also recognised as part of the cost of constructing the

oil rig.

Because the costs will not be incurred for ten years, the estimated cost of $8 million

is discounted to its present value. Discount factors can be found from tables. If you

have to discount a provision in the examination, you will be given the discount

factors that you need.

 At 1 January Year 1 the present value of $8 million is $3,088,000 (= $8 million ×

0.386).

 At 31 December Year 1 the present value of $8 million is $3,392,000 ($8 million ×

0.424).

 The increase in the liability during Year 1 (called the ‘unwinding of the

discount’) is recognised as a finance cost in the year (similar to interest).

At 1 January Year 1 Entity Z recognises:

 a provision of $3,088,000, and

 an asset for the same amount.

In Year 1 expenses should include:

 a finance cost of $308,800 (10% × $3,088,000) which is the unwinding of the

discount, and

 depreciation of $308,800 (= $3,088,000 ÷ 10).

In the statement of financial position at 31 December Year 1:

 the provision is measured at $3,392,000

 the asset is measured at its carrying amount = net book value of $2,779,200

(3,088,000 – 308,800).

Paper F7: Financial reporting (International)

By the end of Year 10, the provision will have increased to $8 million and the asset

will have been depreciated to a net book value of $0. The provision at the end of

Year 10 should therefore cover the clean-up costs. The effective double entry when

the clean-up costs are incurred will be:

Debit: Provision (using the provision)

Credit: Cash

Future repairs to assets

Some assets need to be repaired or to have parts replaced at intervals during their

lives.

For example, suppose that a furnace has a lining that has to be replaced every five

years. If the lining is not replaced, the furnace will break down.

Before IAS 37 was issued, entities would often recognise provisions for the cost of

future repairs or replacement parts. These might be built up in instalments over the

life of the asset or the relevant part of the asset.

IAS 37 effectively prohibits this treatment. The reasoning behind this is that an

entity almost always has an alternative to incurring the expenditure, even if it is

required by law (for example, for safety reasons). For example, the entity which has

to replace the lining of its furnace could sell the furnace or stop using it, although

this is unlikely in practice.

IAS 37 states that a provision cannot be recognised for the cost of future repairs or

replacement parts unless the entity has an obligation to incur the expenditure,

which is unlikely. The obligating event is normally the actual repair or purchase of

the replacement part.

Instead of recognising a provision, an entity should capitalise expenditure incurred

on replacement of an asset and depreciate this cost over its useful life. This is the

period until the part needs to be replaced again. For example, the cost of replacing

the furnace lining should be capitalised, so that the furnace lining is a non-current

asset; the cost should then be depreciated over five years. (Note: IAS 16 Property,

plant and equipment states that where an asset has two or more parts with

different useful lives, each part should be depreciated separately.)

Normal repair costs, however, are expenses that should be included in profit or loss

as incurred.

1.7 Disclosures about provisions

IAS37 requires the following disclosures about provisions in notes to the financial

statements.

For each class of provision:

 the opening and closing balances and movements in the provision during the

year

Chapter 13: Provisions, contingent liabilities and contingent assets

 a brief description of

− the nature of the obligation

− the expected timing of any settlement

− an indication of the uncertainties surrounding the amount and timing of any

settlement.

Paper F7: Financial reporting (International)

Contingent liabilities and contingent assets

 Definitions

 Recognising contingent liabilities or contingent assets

 Disclosures about contingent liabilities and contingent assets

 Summary: liabilities, provisions, contingent liabilities and contingent assets

2 Contingent liabilities and contingent assets

2.1 Definitions

‘Contingent’ means ‘dependent on something else happening’.

Contingent liability

A contingent liability is either of the following:

A contingent liability is:

 a possible obligation

 arising from past events

 whose existence will be confirmed only by the occurrence or non-occurrence of

one or more uncertain future events.

A contingent liability is:

 a present obligation

 arising from past events

 which is not recognised as an actual liability because

− an outflow of economic benefits is not probable, or

− the amount of the obligation cannot be estimated reliably.

A contingent liability arises when some, but not all, of the criteria for recognising a

provision are met. For example, a contingent liability exists, but not a provision or

an actual liability if:

 a reliable estimate cannot be made, or

 there is merely a possible obligation, not a probable obligation.

Example

Entity G is involved in a legal dispute with a customer, who is making a claim

against Entity G for losses it has suffered as a consequence of a breach of contract. If

Entity G’s solicitors believe that the likelihood of the claim succeeding is possible

rather than probable, then the claim should be treated as a contingent liability and

not as a provision.

ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing

Подождите немного. Документ загружается.