ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)
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Chapter 17: Provisions and events after the balance sheet date
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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 IAS 37 definition of ‘probable’.)
(3) A reliable estimate can be made. This is $60,000.
Conclusion: A provision of $60,000 should be made at 31 December Year 1.
Example
An entity sells high-definition televisions with a 12-month warranty under which
customers are covered for the cost of repairs or replacement of manufacturing
defects found during the period after purchase. If every product sold required
minor repairs, the annual cost would be $0.5 million. If every product was replaced,
the annual cost would be $3 million.
Based on trading history, it is believed that 80% of all goods sold will have no
defects, 15% will have minor defects and 5% will need replacing.
The warranty period covers just 12 months, and a provision should therefore be
created for the expected value of $225,000 [(80% × $0 nil) + (15% × $0.5 million) +
(5% × $3 million)].
Discounting
Where the provision will not be settled for some years and so the effect of the time
value of money is material, the provision should be measured at its present value.
The discount rate used should be the pre-tax market rate that reflects the risks
specific to the liability.
Reimbursements
Where some or all of the costs to settle the provision will be reimbursed by another
party, the reimbursement should only be recognised when it is virtually certain that
the reimbursement will be received.
The reimbursement should be treated as a separate asset in the statement of
financial position.
The expense reported in profit or loss may be presented net of the
reimbursement.
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2.5 Accounting for specific provisions
The standard provides guidance on specific applications of the recognition and
measurement rules for provisions.
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.
However, the expectation of future losses may indicate the need for an impairment
loss to be recognised for some of the entity’s assets.
Onerous contracts
An onerous contract is a contract where the costs of fulfilling/completing the
contract now exceed the benefits to be received (the contract revenue).
A provision should be made for the additional costs of an onerous contract. (The
‘additional costs’ are the amount by which the costs are expected to exceed the
benefits.)
Example
On 31 December Year 6 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.
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.)
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.
Chapter 17: Provisions and events after the balance sheet date
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Restructuring
An entity may plan to restructure a significant part of its operations. It expects the
costs of restructuring to be high. 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 workforce 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
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.
Environmental provisions 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 automatically have to recognise a provision if it has caused
environmental damage, even if it intends to clean up the site. The normal rules
apply: 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.
A provision can only be recognised if the environmental damage has already
happened (a past event).
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Example
An entity is about to begin to operate a coal mine. At the end of the reporting period
the mine shaft 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?
Answer
The entity has a legal obligation to rectify the environmental damage caused by the
actual digging of the mine shaft 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).
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 Dr Asset; Cr Provision (rather than Dr Expense; Cr Provision).
The asset is depreciated over its useful life in the same way as other non-current
assets.
Chapter 17: Provisions and events after the balance sheet date
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Example
Entity Z has constructed an oil rig which is due to become operational on 1st
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 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 ten years.
Required:
Explain how the cost of decommissioning the oil rig should be treated in the
financial statements for the year ended 31st 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. In this example:
At 1 January Year 1 the present value of $8 million is $1,912,000 (8 million ×
0.239).
At 31 December Year 1 the present value of $8 million is $2,104,000 (8 million ×
0.263).
The increase in the liability during Year 1 (called the unwinding of the discount)
is recognised as a finance cost (similar to interest).
At 1 January Year 1 Entity Z recognises:
a provision of $1,912,000
an asset for the same amount.
The statement of comprehensive income for Year 1 includes in profit or loss:
a finance cost of $192,000 (10% × 1,912,000) which is the unwinding of the
discount; and
depreciation of $192,000 (1,912,000 / 10).
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In the statement of financial position at 31 December Year 1:
the provision is measured at $2,104,000
the asset is measured at its net book value of $1,720,000 (1,912,000 – 192,000).
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. This
is unusual. The obligating event is normally the actual repair or purchase of the
replacement part.
Instead of recognising a provision, an entity should capitalise the expenditure and
depreciate it over its useful life. This is the period until the next repair is required or
the part needs to be replaced again. For example, the cost of the furnace lining
would be capitalised and depreciated over five years. (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.)
2.6 Provisions: disclosure requirements
Prior to the introduction of IAS 37, only outline information was given on
provisions. It was not possible for the users of the financial statements to identify
the creation, use and release of provisions, because only the overall change for the
year was disclosed.
IAS 37 introduced stringent disclosure requirements to allow users to fully
understand the impact of provisions on the period’s financial statements.
For each class of provision (warranty, restructuring, refunds etc), an entity must
disclose:
the provision balance at the start and end of the period
additional provisions made during the period
amount of the created provision that was used in the period
Chapter 17: Provisions and events after the balance sheet date
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unused amounts reversed during the period, and
the movement due to the unwinding of any discounting.
The entity must also give:
a brief description of the need for the provision and the expected timing of its
use
an indication of any uncertainties surrounding the amount or timing of the
outflows, and
the amount of any expected reimbursement.
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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
3 Contingent liabilities and contingent assets
3.1 Definitions
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 (or provision) 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
no legal obligation or constructive obligation exists: there is merely a possible
obligation. Possible can be interpreted to mean less than 50% probability.
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, and they estimate the possibility at about 30% to 40%. The
claim should be treated as a contingent liability and not as a provision.
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Contingent asset
A contingent asset is:
a possible asset
arising from past events
whose existence will be confirmed only by the occurrence or non-occurrence of
one or more uncertain future events.
An example of a contingent asset might be a probable gain arising from a current
legal action that has been taken against a third party, where the likelihood of success
is considered to be quite high. The existence of the asset (the money receivable) will
only be confirmed by the outcome of the legal dispute.
3.2 Recognising contingent liabilities or contingent assets
Unlike provisions, contingent liabilities and contingent assets:
are not recognised in the financial statements, and
are not recorded in the ledger accounts of an entity.
In some circumstances the existence of a contingent asset or a contingent liability is
disclosed in the notes to the financial statements
Contingent liabilities are possible future liabilities (likelihood less than 50%) and
should be disclosed in a note to the financial statements unless the possibility of
any outflow in settlement is remote (the meaning of ‘remote’ is not defined in
IAS 37).
Contingent assets are potential future assets and should be disclosed where an
inflow in settlement is probable. ’Probable’ is defined by IAS 37 as ‘more likely
than not’. (However if the probability is very high, the item should be reported
as an actual asset and included in the statement of financial position.)
3.3 Disclosures about contingent liabilities and contingent assets
Where disclosure of a contingent liability or a contingent asset is appropriate, IAS 37
requires the following disclosures in notes to the financial statements:
A brief description of the nature of the contingent liability/asset
Where practicable:
− an estimate of its financial effect
− an indication of the uncertainties.
For contingent liabilities, the possibility of any reimbursement.
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3.4 Summary: liabilities, provisions, contingent liabilities and contingent
assets
The following table provides a summary of the rules about whether items should be
treated as liabilities, provisions, contingent liabilities or contingent assets:
Liability
Provision
Contingent liability
Contingent
asset
Present
obligation/
asset arising
from past
events?
Yes Yes Yes Only a
possible
obligation
Only a
possible asset
Will
settlement
result in
outflow/
inflow of
economic
benefits?
Expected
outflow
Probable
outflow –
and a
reliable
estimate
can be
made of the
obligation
Not
probable
outflow – or
a reliable
estimate
cannot be
made of the
obligation
Outflow
to be
confirmed
by
uncertain
future
events
Inflow to be
confirmed by
uncertain
future events
Treatment in
the financial
statements
Set up a
liability
Set up a
provision (a
type of
liability)
Disclose as a contingent
liability (unless the
possibility of outflow is
remote)
Only disclose
if inflow is
probable