Provisions, contingencies

and events after the

reporting period
Supplementary Reading

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1 Provisions
1.1 Revision of the detail of the recognition and measurement of
provisions
You have covered the detail of IAS 37 Provisions, Contingent Liabilities and Contingent Assets in
your earlier studies in Financial Reporting. However, the detail is examinable in the Strategic
Business Reporting (SBR) examination so you should make sure you revise it. Attempting the activities
below will help you to consolidate your knowledge.
1.1.1 Recognition
A provision is recognised when:
(a) An entity has a present obligation (legal or constructive) as a result of a past event;
(b) It is probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; and
(c) A reliable estimate can be made of the amount of the obligation.

1.1.2 Present obligation

An obligation can either be legal or constructive.
A legal obligation is one that derives from a contract, legislation or any other operation of law.
A constructive obligation is 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. (IAS 37: para. 10)

Activity 1: Obligation
Explain in which of the following circumstances an obligation exists.
(a) On 13 December 20X9 the board of an entity decided to close down a division. The reporting
date of the company is 31 December. Before 31 December 20X9 the decision was not
communicated to any of those affected and no other steps were taken to implement the
decision.
(b) The details are as above; however the board agreed a detailed closure plan on 20 December
20X9 and details were given to customers and employees immediately.
(c) At its reporting date a company is obliged to incur clean-up costs for environmental damage
that has already been caused.
(d) At its reporting date, a company intends to carry out future expenditure to operate in a
particular way in the future.

1.1.3 Probable transfer of economic benefits

A transfer of economic benefits is regarded as 'probable' if the event is more likely than not to
occur (IAS 37: para. 23–24). This appears to indicate a probability of more than 50%. However,
where there is a number of similar obligations the probability should be based on a consideration of
the population as a whole, rather than one single item.

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Illustration 1
Transfer of economic benefits
If a company has entered into a warranty obligation then the probability of an outflow of resources
embodying economic benefits (transfer of economic benefits) may well be extremely small in respect
of one specific item. However, when considering the population as a whole the probability of some
transfer of economic benefits is quite likely to be much higher. If there is a greater than 50%
probability of some transfer of economic benefits then a provision should be made for the
expected amount.

1.2 Disclosure 'let out'

IAS 37 permits reporting entities to avoid disclosure requirements relating to provisions, contingent
liabilities and contingent assets if they would be expected to seriously prejudice the position of
the entity in dispute with other parties (IAS 37: para. 92). However, this should only be employed in
extremely rare cases. Details of the general nature of the provision/contingencies must still be
provided, together with an explanation of why it has not been disclosed.

1.3 IAS 37 decision tree

The decision tree below summarises the main recognition requirements of IAS 37 for provisions and
contingent liabilities.

l
l l
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l l

l l

(IAS 37: Imple mentation guidance B)

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Activity 2: Recognition of provisions

Warren Co gives warranties at the time of sale to purchasers of its products. Under the terms of the
warranty the manufacturer undertakes to make good, by repair or replacement, manufacturing
defects that become apparent within a period of three years from the year end. Should a provision
be recognised?

Activity 3: Recognition and measurement of provisions (1)

After a wedding in 20X8 ten people died, possibly as a result of food poisoning from products sold
by Callow Co. Legal proceedings are started seeking damages from Callow but it disputes liability.
Up to the date of approval of the financial statements for the year to 31 December 20X8, Callow's
lawyers advise that it is probable that it will not be found liable. However, when Callow prepares the
financial statements for the year to 31 December 20X9 its lawyers advise that, owing to
developments in the case, it is probable that it will be found liable.
What is the required accounting treatment:
(a) At 31 December 20X8?
(b) At 31 December 20X9?

Activity 4: Recognition and measurement of provisions (2)

(1) Proviso Co (Proviso) issued a one year guarantee for faulty workmanship on an item of
specialist equipment that it delivered to its customer. During the year, the customer began
taking legal action against Proviso for refusing to replace or repair the item of equipment
within the guarantee period. Proviso believes the fault is not covered by the guarantee, but
instead has arisen because the customer has not followed the operating instructions.
At the end of the reporting period, the company's lawyer advised Proviso that it is more likely
than not that it will be found liable. This would result in Proviso being forced to replace or
repair the equipment as well as pay a $10,000 fine.
Based on past experience with similar items of equipment, Proviso estimates that there is a
70% chance that the central core of the equipment would need to be replaced at a cost of
$40,000 and a 30% chance that the core could instead be repaired at a cost of $15,000.
(2) Proviso also manufactures small items of equipment which are sold with a one year warranty
guarantee. 12,000 items of this type were sold during the year. Based on past experience,
5% of items sold are returned for repair or replacement. One-third of the items returned are
able to be repaired at a cost of $50, while the remaining two-thirds are scrapped and
replaced at a cost of $150.
Required
Discuss the accounting treatment of these issues in the financial statements of Proviso at the end of the
reporting period.

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2 IAS 10 Events after the Reporting Period

2.1 Examples of events after the reporting period
The table below provides examples of adjusting and non-adjusting events. Look out for these events
in your SBR exam.

Adjusting events Non-adjusting events

The settlement of a court case that was ongoing
at the reporting date
The receipt of information indicating that an
asset was impaired at the reporting date
The determination of the proceeds of assets sold
or cost of assets bought before the reporting date
The determination of a bonus payment if there
was a constructive obligation to pay it at the
reporting date
The discovery of fraud or errors resulting in
incorrect financial statements
Acquisitions or disposals of subsidiaries
Announcement of a plan to discontinue an
operation or restructure operations
The purchase or disposal of assets
The destruction of an asset through accident
Ordinary share transactions including the issue
of shares
Changes in asset prices, foreign exchange rates
or tax rates
The commencement of litigation arising from an
event after the reporting period
Declaration of dividends after the end of the
reporting period

3 Exam standard activity

The next activity is similar to what you could expect to feature on provisions in the SBR exam as part
of a scenario question. Attempt the activity on your own, then review your answer against the answer
at the end of the chapter.

Activity 5
Omega is an entity that prepares financial statements to 31 March each year. On 1 July 20X9 the
directors decided to terminate production at one of the company's divisions. This decision was
publicly announced on 31 July 20X9. The activities of the division were gradually reduced from
1 October 20X9 and closure is expected to be complete by 31 March 20Y0. At 31 July 20X9 the
directors prepared the following estimates of the financial implications of the closure as follows:
(i) Redundancy costs were initially estimated at $2m. Further expenditure of $800,000 will be
necessary to retrain employees who will be affected by the closure but will remain with
Omega in different divisions. This retraining will begin in early January 20Y0. The latest
estimates are that redundancy costs will be $1.9m, with retraining costs of $850,000.
(ii) Plant and equipment having an expected carrying amount at 30 September 20X9 of $8m will
have a recoverable amount $1.5m. These estimates remain valid.
(iii) The division is under contract to supply a customer for the next three years at a pre-determined
price. It will be necessary to pay compensation of $600,000 to this customer. The
compensation actually paid, on 30 November 20X9, was $550,000.
(iv) The division will make operating losses of $300,000 per month in the last three months of
20X9 and $200,000 per month in the first three months of 20Y0. This estimate proved
accurate for October and November 20X9.

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Required
Compute and discuss the amounts that will be included in the statement of profit or loss and other
comprehensive income for the year ended 30 September 20X9 in respect of the decision to close the
division. Where financial information provided above does not result in a charge to profit or loss,
you should explain why this is so.

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Activity answers

Activity 1: Obligation
(a) There is no obligation at the reporting date as the decision has not been communicated.
(b) A constructive obligation exists at the reporting date and therefore a provision is made in the
20X9 financial statements assuming that the other recognition criteria are met.
(c) A legal obligation exists and therefore a provision for clean-up costs is made providing that
the other recognition criteria are met.
(d) No present obligation exists and under IAS 37 no provision can therefore be made. This is
because the entity could avoid the future expenditure by its future actions, maybe by changing
its method of operation.

Activity 2: Recognition of provisions

Warren Co cannot avoid the cost of repairing or replacing all items of product that manifest
manufacturing defects in respect of which warranties are given before the end of the reporting
period, and a provision for the cost of this should therefore be made.
Warren Co is obliged to repair or replace items that fail within the entire warranty period. Therefore,
in respect of this year's sales, the obligation provided for at the year end should be the cost of
making good items for which defects have been notified but not yet processed, plus an estimate of
costs in respect of the other items sold for which there is sufficient evidence that manufacturing
defects will manifest themselves during their remaining periods of warranty cover.

Activity 3: Recognition and measurement of provisions (1)

(a) At 31 December 20X8
On the basis of the evidence available when the financial statements were approved, there is
no obligation as a result of past events. No provision is recognised. The matter is disclosed as
a contingent liability unless the probability of any transfer is regarded as remote.
(b) At 31 December 20X9
On the basis of the evidence available, there is a present obligation. A transfer of economic
benefits in settlement is probable.
A provision is recognised for the best estimate of the amount needed to settle the present
obligation

Activity 4: Recognition and measurement of provisions (2)

Issue 1
At the end of the reporting period, Proviso Co disputes liability and therefore whether a present
obligation exists. However, given that it is more likely than not that Proviso will be found liable, a
present obligation is assumed to exist.
Given that a single obligation is being measured, a provision of $50,000 is made in the financial
statements for the most likely outcome, which is the payment of the fine ($10,000) and replacement
of the central core ($40,000).

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Issue 2
A present obligation exists at the end of the reporting period based on historical evidence of items
being repaired or replaced under the warranty guarantee agreement.
A large population of items is involved so expected values are used to determine the provision. A
provision of $70,000 (12,000  5%  1/3  $50) + (12,000  5%  2/3  $150) should be
recognised in the financial statements at the end of the reporting period.

Activity 5: Restructuring provision (exam standard for 8 marks)

IAS 37 Provisions, Contingent Liabilities and Contingent Assets states that a provision can be created
for restructuring where the entity:
 Has a detailed formal plan
 Has raised a valid expectation in those affected that it will carry out the restructuring
Omega clearly has a detailed formal plan, and has publicly announced its decision. A provision
should therefore be created. The following amounts will be included in its statement of profit or loss
for 20X9:
(i) Redundancy costs are provided for as they are necessarily entailed by the restructuring and do
not relate to Omega's ongoing activities. IAS 37 requires provisions to be measured at the
best estimate of the expenditure required. This would qualify as an adjusting even in line with
IAS 10 Events after the Reporting Period. Profit is therefore reduced by $1.9m.
The $800,000 required to retrain employees will not be provided for and will not affect profit,
as it relates to Omega's ongoing activities.
(ii) Although not part of the restructuring, plant and equipment with a carrying amount of $8m but
a recoverable amount of $1.5m are clearly impaired. IAS 36 Impairment of Assets requires
that they be restated at recoverable amount of $1.5m, resulting in the recognition of an
impairment loss of $6.5m in profit and loss.
(iii) The statement of profit or loss will recognise an expense of $550,000. In line with IAS 10, this
would qualify as an adjusting even after the reporting period, which the financial statements
should reflect.
(iv) IAS 37 does not permit a provision to include amounts in respect of future operating losses, as
they relate to the ongoing activities of the entity. There will be no charge to the statement of
profit or loss in respect of these losses for the year ended 30 September 20X9. Provisions
should only be made for events that took place in the past, whereas these expected losses take
place in the future.

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