Singapore Institute of Management

UOL International Programme

AC2091 Financial Reporting
Session 15: Provisions, Contingent Liabilities and Contingent Assets

Practice Questions <ANSWERS>

Question 1: Provisions & Contingencies

Hopewell sells a line of goods under a six-month warranty. Any defect arising during that
period is repaired free of charge. Hopewell has calculated that if all the goods sold in the
last six months of the year required repairs the cost would be $2 million. If all these
goods had more serious faults and had to be replaced the cost would be $6 million. The
normal pattern is that 80% of goods sold will be fault-free, 15% will require repairs and
5% will have to be replaced.

Required:

What is the amount of the provision required?

Provision required = [0.80 X 0] + [0.15 X $2m] + [0.05 X $6m] = $0.6m

Question 2: Provisions & Contingencies

During 2012, a lawsuit was filed against Jam Ltd. The lawsuit relates to faulty products
sold to customers. Jam Ltd intend to fight the lawsuit but they have received legal advice
indicating that there is a 50% chance that they will lose the case.

Required:

What are contingent liabilities? Outline how the lawsuit would be treated in the financial
statements of Jam Ltd. (UOL 2013 ZA Q4d)

Question 3: Provisions & Contingencies

A lawsuit has been filed against Piece Ltd. The company is fighting the lawsuit but its
outcome is uncertain. The directors of Piece Ltd consider that there is a 40% chance that
the lawsuit will be successful. If they lose the lawsuit, the expected settlement will be
approximately £300,000.

Required:

Discuss the accounting treatment for this lawsuit. Justify your answer with reference to
accounting standards when applicable. (UOL 2008 ZB Q5c)

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Question 3 (ANSWERS)

Key comments:
Insufficient information to deduce if there is a present obligation from obligating event.
However, there is a possible obligation depending on a future event (i.e. verdict of
lawsuit). Since there is a 40% chance of the company being found guilty, the probability
of outflow of economic benefits is not remote. As such, Piece should disclose the lawsuit
in the notes to accounts as a contingent liability. Details of the lawsuit and an estimate of
the financial effect, i.e. £300,000, should be disclosed.

Question 4: Provisions & Contingencies

The following items have arisen during the preparation of Borough’s draft financial
statements for the year ended 30 September 2011:

(i) On 1 October 2010, Borough acquired a newly constructed oil platform at a cost of
$30 million together with the right to extract oil from an offshore oilfield under a
government licence. The terms of the licence are that Borough will have to remove
the platform (which will then have no value) and restore the sea bed to an
environmentally satisfactory condition in ten years' time when the oil reserves have
been exhausted. The estimated cost of this in ten years' time will be $15 million.
Borough has an established, and well-publicised, practice of carrying out
environmental clean-ups at the end of every project. The appropriate discount rate for
this project has estimated at 8%.

Explain and quantify how the oil platform should be treated in the financial
statements of Borough for the year ended 30 September 2011. How will your answer
change if the government licence did not require an environmental clean-up?

(ii) Borough owns the whole of the equity share capital of its subsidiary Hamlet.
Hamlet’s statement of financial position includes a loan of $25 million that is
repayable in five years’ time. $15 million of this loan is secured on Hamlet’s property
and the remaining $10 million is guaranteed by Borough in the event of a default by
Hamlet. The economy in which Hamlet operates is currently experiencing a deep
recession, the effects of which are that the current value of its property is estimated at
$12 million and there are concerns over whether Hamlet can survive the recession
and therefore repay the loan.

Required:

Describe, and quantify where possible, how items (i) and (ii) above should be treated in
Borough’s financial statements for the year ended 30 September 2011. For (ii) only,
distinguish between Borough’s entity and consolidated financial statements and refer to
any disclosure notes. Do not consider any impairment in your answer.
(Adapted: ACCA, Dec 2011)

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Question 4 (KEY ANSWERS)

(i)
The relevant extracts from Borough’s financial statements as at 30 September 2011 are:

Statement of Financial Position (Extract) $’000

Non-current assets
Oil platform [30,000 + (15k X 0.463)] 36,945
(less): depreciation [36,945 / 10 years] (3,695)
Carrying amount 33,250

Non-current liabilities
Environmental provision
[(15k X 0.500] 7,500

Income Statement (Extract) $’000

Operating expenses
Depreciation 3,695
Interest expense [7,500 - (15k X 0.463)] 555

Although the information in the question says the environmental provision is not a legal
obligation, it implies that it is a constructive obligation (Borough has created an
expectation that it will pay the environmental costs) since the company has a past practice
of preserving the environment which is widely known to the public. Therefore, these
costs should be provided for.

(ii)
From Borough’s perspective, as a separate entity, the guarantee for Hamlet’s loan is a
contingent liability of $10 million. As Hamlet is a separate entity, Borough has no
liability for the secured amount of $15 million, not even for the potential shortfall for the
security of $3 million. The $10 million contingent liability would normally be described
and disclosed in the notes to Borough’s entity financial statements.

In Borough’s consolidated financial statements, the full liability of $25 million would be
included in the statement of financial position as part of the group’s consolidated non-
current liabilities – there would be no contingent liability disclosed.

The concerns over the potential survival of Hamlet due to the effects of the recession may
change the disclosure in Borough’s entity financial statements. If Borough deems it
probable that Hamlet is not a going concern the $10 million loan, which was previously a
contingent liability, would become an actual liability and should be provided for on
Borough’s entity statement of financial position and disclosed as a current (not a non-
current) liability.

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Question 5: Events after the Reporting Period

Discuss the treatment of events after the statement of financial position date and why this
treatment is necessary for users of financial statements.
(UOL 2012 ZA Q5d)

Question 6: Events after the Reporting Period

Waxwork’s current year end is 31 March 2009. Its financial statements were authorised
for issue by its directors on 6 May 2009 and the AGM (annual general meeting) will be
held on 3 June 2009. The following matters have been brought to your attention:

(i) On 12 April 2009, a fire completely destroyed the company’s largest warehouse and
the inventory it contained. The carrying amounts of the warehouse and the
inventory were $10 million and $6 million respectively. It appears that the company
has not updated the value of its insurance cover and only expects to be able to
recover a maximum of $9 million from its insurers. Waxwork’s trading operations
have been severely disrupted since the fire and it expects large trading losses for
some time to come.

(ii) A single class of inventory held at another warehouse was valued at its cost of
$460,000 at 31 March 2009. In April 2009 70% of this inventory was sold for
$280,000 on which Waxwork’s sales staff earned a commission of 15% of the
selling price.

Required:

Explain the required treatment of the items (i) and (ii) by Waxwork in its financial
statements for the year ended 31 March 2009. Assume all items are material and are
independent of each other.
(Adapted: ACCA, Jun 2009)

Question 6 (ANSWERS)

(i)
This is normally classified as a non-adjusting event as there was no reason to doubt that
the value of warehouse and the inventory it contained was worth less than its carrying
amount at 31 March 2009 (the last day of the reporting period). The total loss suffered as
a result of the fire is $16 million. The company expects that $9 million of this loss will be
recovered from an insurance policy. Recoveries from third parties should be assessed
separately from the related loss. As this event has caused serious disruption to trading,
IAS 10 would require the details of this non-adjusting event to be disclosed as a note to
the financial statements for the year ended 31 March 2009 as a total loss of $16 million
and the effect of the insurance recovery to be disclosed separately.

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The severe disruption in Waxwork’s trading operations since the fire, together with the
expectation of large trading losses for some time to come, may call in to question the
going concern status of the company. If it is judged that Waxwork is no longer a going
concern, then the fire and its consequences become an adjusting event requiring the
financial statements for the year ended 31 March 2009 to be redrafted on the basis that
the company is no longer a going concern (i.e. they would be prepared on a liquidation
basis).

(ii)
70% of the inventory amounts to $322,000 (460,000 x 70%) and this was sold for a net
amount of $238,000 (280,000 x 85%). Thus, a large proportion of a class of inventory
was sold at a loss after the reporting period. This would appear to give evidence of
conditions that existed at 31 March 2009 i.e. that the net realisable value of that class of
inventory was below its cost. Inventory is required to be valued at the lower of cost and
net realisable value, thus this is an adjusting event. If it is assumed that the remaining
inventory will be sold at similar prices and terms as that already sold, the net realisable
value of the whole of the class of inventory would be calculated as:

$280,000/70% = $400,000, less commission of 15% = $340,000

Thus, the carrying amount of the inventory of $460,000 should be written down by
$120,000 to its net realisable value of $340,000.

In the unlikely event that the fall in the value of the inventory could be attributed to a
specific event that occurred after the date of the statement of financial position then this
would be a non-adjusting event.

Question 7: Events after the Reporting Period

a) During the month of February 2017, all existing stocks of baby milk powder
manufactured by Sway Ltd were recalled after the local authorities found traces of
contaminants in several cans of the product. The directors of Sway Ltd were of
opinion that the recall had a negative impact on the future sales of their milk powder
(which is one of their key products) and assessed that the profitability for the financial
year ending 31 December 2016 would be significantly affected by the event. The
shareholders authorised the issue of financial statements for the year ended 31
December 2016 on 18 March 2017.

Explain, with reasons, how the company should account for the recall for the
financial year ended 31 December 2016 in accordance with the appropriate
accounting standard(s).

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b) On 24 January 2017, a fraudulent transaction was detected during a review of Lucky
Ltd’s retail operations. In order to meet his sales targets for year 2016, a salesman
had colluded with an accountant to record revenue of $60,000 on 31 December 2016
upon an order being placed by a customer on that date. The goods were delivered to
the customer on 3 January 2017. The total revenue recognised for year ended 31
December 2016 was $1.5 million. The financial statements for the year ended 31
December 2016 were subsequently authorised for issue by the board of directors on
16 February 2017.

Discuss how the company should account each situation above for the financial year
ended 31 December 2016 in compliance with the provisions of International
Accounting Standards (IAS).

Question 7: Events after the Reporting Period (ANSWERS)

a) This is an event after reporting period as it occurred after 31 December 2016 and
before the financial statements were issued on 18 March 2017. It is a non-adjusting
event as it relates to a condition, which is the recall of milk power products,
subsequent to balance sheet date. Henceforth, no adjustment is required in the
financial statements for the year ended 31 December 2016.

However, as the event would significantly affect the future sales/profitability of the
company’s key product, it is material information for which its omission could
influence the economic decision of users of the financial statements. Thus, the
company should separately disclose the nature and the estimated financial effect of
the event in the financial statements for the year ended 31 December 2016.

b) The discovery of the fraud is an event after reporting period since it occurred on 24
January 2017, which was after balance sheet date of 31 December 2016 and before
financial statements were authorized for issue on 16 February 2017.

This is an adjusting event as the discovery of the fraud pertains to a condition which
existed as at the balance sheet date, i.e., the company has overstated its revenue.
Since goods have not been delivered to the customer, significant risks and rewards
relating to the goods have not been transferred to the customer. Hence, revenue of
$60,000 has not been earned and thus cannot be recorded as such prior to delivery
date of 3 January 2017.

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Question 8: Provisions & Contingencies / Events after the Reporting Period (ANS)

a)
The potential liability to pay damages to C needs to be recognised as a provision because
the event giving rise to the potential liability (the supply of faulty products) arose prior to
31 March 2016, there is a probable transfer of economic benefits and a reliable estimate
can be made of the amount of the probable transfer.

The amount recognised should be the best estimate of the amount required to settle the
obligation at the reporting date. In this case, this estimate is the one made on 15 May –
just before the financial statements are authorised for issue. New information is likely to
have been presented to Delta regarding this existing condition, i.e. there is likely to have
been an adjusting event after reporting period. Therefore, a provision of $5·25 million
should be recognised as a current liability. There should also be a charge of $5·25 million
to profit or loss.

The potential amount receivable from S is a contingent asset as it arose from an event
prior to the year-end but at the date the financial statements are authorised for issue, the
ultimate outcome is uncertain. Contingent assets are unlikely to be recognised as assets in
the statement of financial position since their existence and estimated financial effect are
disclosed where the future receipt of economic benefits is probable.

b)
The information about the obsolescence of the components is an event after the reporting
date because it occurs after the reporting date but before the financial statements are
authorised for issue.

This event would be a non-adjusting event because it does not give information about
conditions existing at the reporting date.

At the reporting date, the inventory should be measured at the lower of cost ($10 million)
and net realisable value ($12 million).

The after-date obsolescence of the inventory and its financial implications for Delta
should be disclosed in a note to the financial statements.