Provisions, contingent

IAS 37 liabilities and contingent

assets
10
LIABILITIES |1

A liability is a present obligation of the entity arising from past events, the settlement of
which is expected to result in an outflow from the entity of resources embodying economic
benefits.
Provision Trade payables Accruals
A provision is a liability of trade payables are accruals are liabilities to pay for goods
uncertain timing or amount. liabilities to pay for or services that have been received or
goods or services supplied but have not been paid,
Provisions can be that have been invoiced or formally agreed with the
distinguished from other received or supplier, including amounts due to
liabilities such as trade supplied and have employees (for example, amounts
payables and accruals been invoiced or relating to accrued vacation pay).
because there is uncertainty formally agreed Although it is sometimes necessary to
about the timing or amount of with the supplier estimate the amount or timing of
the future expenditure accruals, the uncertainty is generally
required in settlement. much less than for provisions.
Accruals are often reported as part of trade and other payables, whereas provisions
are reported separately.

A contingent liability is: A contingent asset is

(a) a possible obligation that arises from past events and a possible asset that
whose existence will be confirmed only by the occurrence arises from past events
or non-occurrence of one or more uncertain future events and whose existence
not wholly within the control of the entity; or will be confirmed only
(b) a present obligation that arises from past events but is not by the occurrence or
recognised because: non-occurrence of one
(i) it is not probable that an outflow of resources or more uncertain future
embodying economic benefits will be required to events not wholly within
settle the obligation; or the control of the entity.
(ii) the amount of the obligation cannot be measured
with sufficient reliability.
A present obligation arises if obligating event has happened.
An obligating event is an event that creates a legal or constructive obligation that results in
an entity having no realistic alternative to settling that obligation.
A legal obligation is an A constructive obligation is an obligation that derives from
obligation that derives from: an entity’s actions where:
(a) a contract (through its (a) by past practice, published policies or a specific
explicit or implicit current statement, the entity has indicated to others
terms); that it will accept certain responsibilities; and
(b) legislation; or (b) as a result, the entity has created a valid expectation
(c) other operation of that it will discharge those responsibilities.
law.
 ICMAP M4 Financial Accounting

MEASUREMENT
Best The amount of provision shall be the best estimate of the expenditure
estimate (rationally) required to settle the present obligation at the end of year.
Where the provision being
measured involves a large ‘Expected value’ is used
population of items
2| Where there is a continuous range
Dealing with of possible outcomes, and each
The mid-point of the range is used
uncertainties point in that range is as likely as any
other
The individual most likely outcome
Where a single obligation is being
may be the best estimate of the
measured
liability
Where the effect of the time value of money is material, the amount of a
Present
provision shall be the present value of the expenditures expected to be
value
required to settle the obligation.
Discount The discount rate (or rates) shall be a pre-tax rate (or rates) that reflect(s)
rate current market assessments.
SUMMARY OF ACCOUNTING TREATMENT
DEGREE OF PROBABILITY OBLIGATION ASSET
Virtually certain [95%+] Recognise a liability Recognise a normal asset
Probable [50%+] Recognise a provision Disclose a contingent asset
Possible [5% to 50%] Disclose a contingent liability Do nothing
Remote [less than 5%] Do nothing Do nothing

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 Class Notes

Note: in rare cases, it is not clear whether there is a present obligation. In these cases, a past event is
deemed to give rise to a present obligation if, taking account of all available evidence, it is more likely
than not that a present obligation exists at the end of the reporting period.
QUESTION 01
An entity sells goods with a warranty under which customers are covered for the cost of
repairs of any manufacturing defects that become apparent within the first six months after
purchase. If minor defects were detected in all products sold, repair costs of Rs. 1 million |3
would result. If major defects were detected in all products sold, repair costs of Rs. 4 million
would result. The entity’s past experience and future expectations indicate that, for the
coming year, 75 per cent of the goods sold will have no defects, 20 per cent of the goods
sold will have minor defects and 5 per cent of the goods sold will have major defects. (IAS
37)

Required:
Calculate the amount of provision to be recognised in respect of warranty.

QUESTION 02
X Limited has purchased and installed a plant at a total cost of Rs. 20,000 on January 01,
2011. The plant has a useful life of 3 years. There is a legal requirement to restore the site at
the end of useful life. It is estimated that Rs. 5,324 shall have to be incurred on 31
December 2013. The entity uses pre-tax discount rate of 10% wherever applicable. The
entity uses straight line method of depreciation. Assume that the plant has no residual value.

Required:
Pass the journal entries from the year 2011 to 2013.

QUESTION 03 Borough – D11

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 commenced the extraction of crude oil from a new well
on the seabed. The cost of a 10-year licence to extract the oil was Rs. 50 million. At
the end of the extraction, although not legally bound to do so, Borough intends to
make good the damage the extraction has caused to the seabed environment. This
intention has been communicated to parties external to Borough. The cost of this will
be in two parts: a fixed amount of Rs. 20 million and a variable amount of 2 cents per
barrel extracted. Both of these amounts are based on their present values as at 1
October 2010 (discounted at 8%) of the estimated costs in 10 years’ time. In the year
to 30 September 2011 Borough extracted 150 million barrels of oil. (5 marks)
(ii) Borough owns the whole of the equity share capital of its subsidiary Hamlet. Hamlet’s
statement of financial position includes a loan of Rs. 25 million that is repayable in
five years’ time. Rs. 15 million of this loan is secured on Hamlet’s property and the
remaining Rs. 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 Rs. 12 million and there are concerns over whether Hamlet can survive the
recession and therefore repay the loan. (4 marks)

Required:
Describe, and quantify where possible, how items (i) and (ii) above should be treated
in Borough’s statement of financial position for the year ended 30 September 2011.

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 ICMAP M4 Financial Accounting

APPLICATION OF RULES TO SPECIFIC SITUATIONS

Future operating losses
A reasonable expectation that carrying on trading / operations in future would result in loss.
These do not meet the definition of liability (as there is no present obligation);
Treatment
therefore, no provision is recognised.
4| Impairment An expectation of future operating losses is an indication that certain assets
indication of the operation may have been impaired.
Onerous contracts
It is a contract in which the unavoidable costs of meeting the obligations under the contract
exceed the economic benefits expected to be received under it.
The present obligation under the contract shall be recognised and measured
Treatment
as a provision
The unavoidable costs under a contract reflect the least net cost of exiting
Unavoidable
from the contract, which is the lower of the cost of fulfilling it and any
costs
compensation or penalties arising from failure to fulfil it.
Before a separate provision for an onerous contract is established, an entity
Impairment
recognises any impairment loss that has occurred on assets dedicated to
indication
that contract

Restructuring
It is a programme that is planned and controlled by management, and materially changes
either:
(a) the scope of a business undertaken by an entity; or
(b) the manner in which that business is conducted.
 sale or termination of a line of business;
 the closure of business locations in a country or region or the relocation
of business activities from one country or region to another;
Examples  changes in management structure, for example, eliminating a layer of
management; and
 fundamental reorganizations that have a material effect on the nature
and focus of the entity’s operations.
A provision for restructuring costs is recognised only when the general
Treatment
recognition criteria for provisions are met.
A constructive obligation to restructure arises only when an entity:
When
(a) has a detailed formal plan for the restructuring; and
constructive
(b) has raised a valid expectation in those affected that it will carry out
obligation
the restructuring by starting to implement that plan or announcing its
arises
main features to those affected by it.
A restructuring provision shall include only the direct expenditures arising
Measureme from the restructuring, which are those that are both:
nt - Include (a) necessarily entailed by the restructuring; and
(b) not associated with the ongoing activities of the entity.

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 Class Notes

QUESTION 04
On June 25, 2011 Singh & Co has decided to change its management and operational
structure in order to work efficiently and competitively. The plan has been formally approved
and announced to all major stakeholders. The implementation shall start from August 31,
2011. The following costs are expected to be incurred:
(a) Relocation allowance to employees Rs. 500,000
(b) Consultant fee for structural changes Rs. 700,000 |5
(c) New computer and distribution network systems Rs. 1,500,000
(d) General Staff training Rs. 50,000
(e) Advertisement of new and improved operations Rs. 120,000
(f) Implementation expenses specifically incurred for restructuring Rs. 450,000
(g) Expected gain on disposal of assets freed due to restructuring Rs. 40,000

Required:
Calculate the provision for restructuring for Singh & Co to be included in its financial
statements for the year ended June 30, 2011.

QUESTION 05 Manco – D10

Manco has been experiencing substantial losses at its furniture making operation which is
treated as a separate operating segment. The company’s year end is 30 September. At a
meeting on 1 July 2010 the directors decided to close down the furniture making operation
on 31 January 2011 and then dispose of its non-current assets on a piecemeal basis.
Affected employees and customers were informed of the decision and a press
announcement was made immediately after the meeting. The directors have obtained the
following information in relation to the closure of the operation:
(i) On 1 July 2010, the factory had a carrying amount of Rs. 3·6 million and is expected
to be sold for net proceeds of Rs. 5 million. On the same date the plant had a
carrying amount of Rs. 2·8 million, but it is anticipated that it will only realise net
proceeds of Rs. 500,000.
(ii) Of the employees affected by the closure, the majority will be made redundant at cost
of Rs. 750,000, the remainder will be retrained at a cost of Rs. 200,000 and given
work in one of the company’s other operations.
(iii) Trading losses from 1 July to 30 September 2010 are expected to be Rs. 600,000
and from this date to the closure on 31 January 2011 a further Rs. 1 million of trading
losses are expected.

Required:
Explain how the decision to close the furniture making operation should be treated in
Manco’s financial statements for the years ending 30 September 2010 and 2011. Your
answer should quantify the amounts involved. (10 marks)

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