ACCA P2 (INT) Corporate Reporting - Study text

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Chapter 17: Provisions and events after the balance sheet date

1.3 Accounting for adjusting events after the reporting period

IAS 10 states that if an entity obtains information about an adjusting event after the

reporting period, it should amend and update the financial statements to allow for

this new information.

‘An entity shall adjust the amounts recognised in its financial statements to reflect

adjusting events after the reporting period.’

This might seem common sense. If conditions existed at the end of the reporting

period, it is reasonable to expect that the financial statements should recognise those

conditions, even though the facts did not become known until later.

IAS 10 gives the following examples of adjusting events:

 The settlement of a court case after the end of the reporting period, confirming

that the entity had a present obligation as at the end of the reporting period as a

consequence of the case.

 The receipt of information after the end of the reporting period indicating that

an asset was impaired as at the end of the reporting period. For example,

information may be obtained that indicates the need to make a provision for a

bad debt against a trade receivable in the year-end statement of financial

position.

 Similarly, evidence might be obtained after the end of the reporting period

indicating that as at the end of the reporting period the net realisable value of

some inventory was less than its cost, and the inventory should therefore be

written down in value in the statement of financial position. The sale of

inventory at less than cost soon after the end of the reporting period would

provide such evidence.

 The determination after the end of the reporting period of the purchase cost of

an asset, where the asset had already been purchased before the end of the

reporting period, but the purchase price had not been finally agreed or decided.

Similarly, the determination after the end of the reporting period of the sale

price for a non-current asset, where the sale had been made before the end of the

reporting period but the sale price had not yet been finally agreed.

 The discovery of fraud or errors showing that the financial statements are

incorrect.



Example

At 31 December Year 1, Entity G is involved in a court case. It is being sued by a

supplier. On 15 April Year 2, the court decided that Entity G should pay the

supplier $45,000 in settlement of the dispute. The financial statements for Entity G

for the year ended 31 December Year 1 were authorised for issue on 17 May Year 2.

The settlement of the court case is an adjusting event after the reporting period:

 It is an event that occurred between the end of the reporting period and the date

the financial statements were authorised for issue.

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 It provided evidence of a condition that existed at the end of the reporting

period. In this example, the court decision provides evidence that the entity had

an obligation to the supplier at the end of the reporting period.

Since it is an adjusting event after the reporting period, the financial statements for

Year 1 must be adjusted to include a provision for $45,000. The alteration to the

financial statements should be made before they are approved and authorised for

issue.

1.4 Disclosures for non-adjusting events after the reporting period

Non-adjusting events after the reporting period are treated differently. A non-

adjusting event relates to conditions that did not exist at the end of the reporting

period; therefore the financial statements must not be updated to include the effects

of the event. IAS 10 states quite firmly: ‘An entity shall not adjust the amounts

recognised in the financial statements to reflect non-adjusting events after the

reporting period’.

However, IAS 10 goes on to say that if a non-adjusting event is material, a failure by

the entity to provide a disclosure about it could influence the economic decisions

taken by users of the financial statements. For material non-adjusting events IAS 10

therefore requires disclosure in a note to the financial statements of:

 the nature of the event, and

 an estimate of its financial effect, or a statement that such an estimate cannot be

made.

(Note: There are no disclosure requirements for adjusting events themselves as they

have already been reflected in the financial statements.)

IAS 10 gives the following examples of non-adjusting events:

 A fall in value of an asset, for example a large fall in the market value of some

investments owned by the entity, between the end of the reporting period and

the date the financial statements are authorised for issue. A fall in market value

after the end of the reporting period will normally reflect conditions that arise

after the reporting period has ended, not conditions already existing before then.

 The acquisition or disposal of a major subsidiary after the reporting period.

 The formal announcement after the reporting period of a plan to discontinue a

major operation.

 Announcing or commencing the implementation of a major restructuring.

 The destruction of a major plant by a fire after the reporting period. The

‘condition’ is the fire, not the plant, and the fire didn’t exist at the end of the

reporting period. The plant should therefore be reported in the statement of

financial position at its carrying amount as at the end of the reporting period.

The fire, and the financial consequences of the fire, should be disclosed in a note

to the financial statements.

Chapter 17: Provisions and events after the balance sheet date

1.5 Dividends and the going concern assumption

IAS 10 also contains specific provisions about proposed dividends and the going

concern presumption on which financial statements are normally based.

If equity dividends are declared after the end of the reporting period, they should

not be recognised as a liability in the statement of financial position, because they

did not exist as an obligation as at the end of the reporting period.

Dividends proposed after the end of the reporting period should be disclosed in a

note to the financial statements, in accordance with IAS 1.

There is one important exception to the normal rule that the financial statements

reflect conditions at the end of the reporting period. A deterioration in operating

results and financial position after the reporting period has ended might indicate

that the going concern assumption is no longer appropriate. If management decide

after the reporting period has ended that it intends to liquidate the entity or to cease

trading, the financial statements for the year just ended should be prepared on some

other basis (for example, on a break-up basis).

1.6 Problems of accounting for events after the reporting period

An entity may enter into a transaction shortly before the year end and then reverse

the transaction soon after the year end. The aim is to improve the position shown in

the year end accounts. This is known as ‘window dressing’.

For example, a company may write cheques to suppliers on the last day of the year

and enter the payments in the cash book. The cheques may not be sent out by post

until the new financial year has started, so that the entity has not been required to

pay actual money from its bank account. The effect of this may help to improve the

reported liquidity position of the entity, as measured by its current ratio (ratio of

current assets to current liabilities). If this ratio is already higher than 1.0, recording

a payment to reduce cash and reduce trade payables will increase the ratio further.

A higher current ratio indicates better liquidity.



Example

An entity has current assets of $20,000 and current liabilities of $15,000. On the last

day of the year, the entity writes cheques to $5,000 of its trade payables but does not

send the cheques to the suppliers until two weeks later.

After recording the payment transactions, current liabilities will be $10,000 and

current assets will be $15,000, giving a current ratio of 1.5:1. Prior to the transaction,

the current ratio was 1.3: 1.

Therefore, the effect has been to improve the liquidity position of the entity, because

the current ratio has increased and it now appears that the entity has proportionally

more assets to cover their liabilities.

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Some commentators have argued that where transactions are deliberately intended

to manipulate the reported financial position, disclosure should be required in the

notes to the financial statements, in order to alert users. Disclosure of the facts and

amounts would then allow the users to allow for the transaction when analysing the

financial statements.

However, IAS 10 does not currently address this problem of ‘window dressing’ the

financial statements and there is no requirement for such disclosures.

Chapter 17: Provisions and events after the balance sheet date

Provisions

 The history of accounting for provisions: ‘creative accounting’

 The objective of IAS 37

 Recognition of provisions

 Measurement of provisions

 Accounting for specific provisions

 Provisions: disclosure requirements

2 Provisions

2.1 The history of accounting for provisions: ‘creative accounting’

The introduction of IAS 37: Provisions, contingent liabilities and contingent assets

in 1999 represented a significant change to the accounting for provisions. Previously

there had been guidance on contingencies, but not provisions. The absence of

accounting rules for provisions allowed entities to ‘manipulate’ their financial

statements, especially their reported profit or loss in each year, by making

provisions, increasing provisions or reducing provisions to suit management’s

reporting requirements.

Companies made provisions based simply on ‘management intent’ and used the

argument of prudence to support their accounting treatment of provisions.

 Creating a provision would reduce profit in the current year.

 However, by creating a provision for expenses that would otherwise be charged

in future years, a company was able to improve reported profits in future years.

Quite often management would ‘change their mind’ about the intention that had led

to the creation of the provision, and the provision would be ‘released back’ to

increase profit in a subsequent year.

Provisions might contain a mixture of items such as provisions for future

reorganisation costs, redundancy costs, closure costs, warranty claims and staff re-

training costs. It was apparent that companies were exploiting the absence of rules

and using provisions to move profit from one year to the next.

Alternatively provisions might be created in a year of poor performance so as to

report the ‘bad news’ in the current year so that future profits could be made to

seem much better. This use of provisions was known as ‘big bath accounting’.



Example

A company had a disappointing year in 20X1. As a result, the chief executive officer

(CEO) resigned and a replacement CEO was appointed two months before the year-

end. The CEO introduced several initiatives and performance is expected to slowly

recover over the coming two years.

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In order to make his appointment appear highly successful, the new CEO might

want to create provisions to report a very bad year in 20X1 and blame this on his

predecessor, and use the provisions to improve results in later years.

For example, this might be achieved by the creation in 20X1 of a $1 million

provision for the cost of future restructuring plans.

In 20X2 the company might then decide to abandon the restructuring plans and so

reduce the provision to $0, thereby increasing profit in 20X2. Using the illustrative

figures below, this would allow the company to show a breakeven position in 20X2

under the management of the CEO following glosses in 20X1, and then to report

even better results in 20X3.

20X1

20X2

20X3

$000

Originalresult (2,000)

(1,000)

1,000

Provision

(1,000)

Releaseofprovision

1,000

Reportedresults (3,000)

1,000

2.2 The objective of IAS 37

The objective of IAS 37 was to eliminate the misleading use of provisions. It aims to

ensure that appropriate conditions are applied to the recognition of provisions (and

contingencies), and that suitable bases are used to measure the amount of

provisions. In addition it requires that sufficient information should be disclosed in

the notes to allow users to understand the various types of provision, their amounts

and the timing of their creation and release.

As a result of IAS 37 provisions can still be made, but only where there is some

degree of obligation (a real liability) on the part of the entity. A mere ‘management

intention’ is no longer sufficient.

IAS37 also deals with contingent liabilities and contingent assets. (Rules on

contingencies had previously existed in IAS 10 and so the introduction of IAS 37

presented less of an accounting problem.)

IAS 37 does not apply to provisions or contingencies covered by other accounting

standards:

 construction contracts (IAS 11)

 income taxes (IAS 12)

 leases (IAS 17), except for onerous operating leases

 employee benefits (IAS 19)

 insurance contracts (IFRS 4), and

 contingent liabilities acquired as part of a business combinations (IFRS 3).

Chapter 17: Provisions and events after the balance sheet date

The notes in this section on provisions and in the next section on contingencies are

based on the current version on IAS 37. An exposure draft was issued in 2005

proposing major changes to IAS 37. These are considered in a later section.

2.3 Recognition of provisions

A provision is a liability of uncertain timing or amount. As liabilities, provisions are

included in the statement of financial position and increases or reductions in

provisions are reported in profit and loss.

A liability should only be recognised when all of three conditions are met:

 The entity has a present obligation (legal or constructive) as a result of a past

event.

 It is probable that an outflow of resources will be required to settle the

obligation.

 A reliable estimate can be made of the amount of the provision.

Present obligation

There must be an obligation already in existence. Mere intention is not sufficient.

The obligation may be legal or constructive.

 A legal obligation is one arising from a contract, or some other aspect of the

law. For example, a company may sell goods with a two-year warranty if any

defect arises after the date of sale. The company now has legal obligation (a

contractual obligation) to make good by repair or replacement any defects that

arise.

Where details of a proposed new law have yet to be finalised, an obligation only

arises when the legislation is virtually certain to be introduced (‘enacted’).

 A constructive obligation is one arising from the entity’s actions, whereby

− through established past practice, published policies, or a 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 that it will discharge

those responsibilities.

For example, a retail store may have a policy of refunding purchases made by

dissatisfied customers, even though it is only legally obliged to issue a refund if the

goods are faulty. Its policy of making refunds is widely known. As a result of its

conduct, the company has created a valid expectation amongst its customers that it

will refund purchases. A constructive obligation therefore exists.

Past event

The event leading to the present obligation must be past, and must have occurred

before the reporting date (end of the reporting period) when the provision is first

recognised. No provision is made for costs that may be incurred in the future but

where no obligation yet exists. For example, if an entity is planning a reorganisation

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but does not yet have an obligation (legal or constructive) to undertake the

reorganisation, it cannot create a provision for reorganisation costs.

For an event to be an ‘obligating event’, it must be shown that the entity had no

realistic alternative to settling the obligation. This is the case only where the

settlement can be enforced by law or, in the case of a constructive obligation, that a

valid expectation has been created.



Example

Under new legislation an entity is required to fit smoke filters to its factories by 30

June Year 2. The entity has not fitted the smoke filters. In its accounts to 31

December Year 1, there is no present obligation as the legislation is not yet effective,

and so an obligating event has not yet occurred. No provision for the cost of the

smoke filters can be recognised in the accounts for Year 1.

Probable outflow of economic benefits

For a provision to exist, the outflow of benefits must be probable. ‘Probable’ is

defined by IAS 37 as ‘more likely than not’ (more than 50% probability). For

example, an entity may have given a guarantee but may not expect to have to

honour it. In such a situation, it cannot create a provision for the cost of expenses

that it may have to incur under the terms of the guarantee. This is because a

payment under the guarantee is not probable.

Reliable estimate of the obligation

IAS 37 also requires that a provision should not be recognised unless a reliable

estimate of the amount of the provision can be made. A reasonable estimate can be

based on a range of possible outcomes. In the extremely rare case where no estimate

can be made, a provision should not be made and the liability should be disclosed

instead as a contingent liability, in a note to the financial statements.



Example

In each of the following situations, consider whether a provision should be

recognised, assuming that the reporting period ends on 31 December in each case:

(1) An entity in the oil industry cleans up contamination caused by its operations

when required to do so under the laws of the particular country in which it

operates. One country in which it operates has no legislation requiring clean

up, and the entity has been contaminating the land for several years. At 31

December 20X4 it is virtually certain that a draft law requiring a clean-up of

land already contaminated will be enacted shortly after the year end.

(2) The government has introduced a number of changes to the regulation of the

financial services industry. As a result of these changes, entities will need to

re-train a large proportion of their employees in order to ensure compliance

with the financial services regulations. However, re-training is not a statutory

Chapter 17: Provisions and events after the balance sheet date

requirement. One entity affected by the new regulations had not done any re-

training before the end of the reporting period.

(3) On 18 December 20X6 the board of an entity decides to close down a division.

However, this decision was not communicated to any of those affected and no

further steps were taken to implement the decision before the end of the

reporting period.

(4) On 18 December 20X6 the board of an entity decides to close down a division.

On 23 December a detailed plan for closing down the division was prepared

by the board and announcements were made to employees concerning

redundancies. In addition, letters were sent to customers advising them of the

proposal and recommending alternative suppliers.



Answer

(1) By contaminating the land, the entity has created an obligation. There is

virtual certainty that the legislation will be introduced, giving a legal

obligation to the entity to clean up the land. This will result in a probable

outflow of cash and resources to perform the clean-up and so a provision

should be made for the best estimate of the clean-up operation.

(2) No provision should be created by the entity, because as at the end of the

reporting period there has not been a past event giving rise to a present

obligation. An obligation only arises where the settlement can be enforced by

law or the entity has created a valid expectation in other parties. Neither

applies in this situation.

(3) As there has not been an obligation created as at the end of the reporting

period, no provision should be created. For a constructive obligation to arise,

the entity must have communicated the plans to those affected (i.e. employees,

customers and suppliers) and implementation must be planned to start

shortly.

(4) In contrast to situation 3, an obligating event exists as at the end of the

reporting period, because the entity has communicated the plans to its

employees and customers. This gives rise to a constructive obligation, as the

entity has created an expectation which will lead to a probable outflow of cash

to settle redundancy payments and contract clauses. Therefore a provision

should be made for the best estimate of the costs of closure.

2.4 Measurement of provisions

The amount recognised as a provision should be the best estimate as at the end of

the reporting period of the expenditure required to settle the obligation. This

estimate will be determined by the judgment of management, together with

experience of similar transactions or reports by independent experts.

Risks and uncertainties should be taken into account in reaching the best estimate.

Events after the reporting period will provide useful evidence.

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However, entities should:

 avoid creating excessive provisions (which could be used as a way of

manipulating profits between financial years), or

 avoid underestimating provisions.

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. 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 its present value.

Provisions should be reviewed at the end of each reporting period and adjusted to

reflect the current best estimate. If it is no longer believed probable that the

provision is needed, it should be reversed (reduced to zero) or reduced to a smaller

amount.



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 $60,000.

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.

ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)

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