Provision recognition

Class 1
To recognize the provision
• Obligation should exist on balance sheet date
• Future outflow of cash or resources is probable
• Amount of future outflow can be reliably measureable
• All the above should exist for recognition of a provision as a liability
Obligation should exist
• Obligation can exist because of
• Legal reasons
• Constructive reasons
• Legal reasons
• Contracts
• Explicit
• Implicit
• Laws
• Enacted
• Virtually certain to be enacted
Constructive reasons
• Actions or communication
• Lead other parties to conclude that the entity has accepted the obligation
• Will discharge the obligation at the appropriate time
• Communication can be
• Explicit – written publications or pronouncements
• Implicit – established practices over time
Example
• Dup chemicals accidently dumped some chemicals in the community
water reservoir on 21/12/2018. Assess whether a provision is needed
in the following situations:
a) Local laws state that it is illegal for firms to dump chemicals in the local
water reservoir
b) There are no local laws regarding the dumping of chemicals, however, Dup
chemicals has in its publications stated that it would ensure that it will
never dump chemicals in the local reservoir
c) There are no local laws and Dup has never put out any communications
about polluting the local reservoir, however, in 2015 and 2017 Dup has had
similar incidents of dumping chemicals in the local reservoir
Solution
a) Dup has a legal obligation to create a provision for the cleaning of
the local reservoir
b) Dup has a constructive obligation to create a provision because it
has made written communications which assert that it would clean
up the local reservoir in case it dumps chemicals in it
c) Dup has a constructive obligation to create a provision because it
has by actions in the past lead third parties to believe that Dup will
clean up the local reservoir due to its dumping activities
Measurement of provisions
• For the provision to go on the balance sheet, it should be reliably
measured
• There is uncertainty in the amount and timing of future outflows
• IAS 37: “the best estimate of the expenditure to settle the present
obligation”
• IAS 37 “the amount that the entity would rationally pay to settle or
transfer the liability”
• If the outflow is over a long period then take into account the time
value of money
Example
• ABC Inc. gives a warranty for 3 years for parts and labor on the smart
phones it sells. ABC has considered the following
a) Repair the phones in house
b) Send the phones to a third party to repair
c) Replace the phones irrespective of the fault
• What information would you use to estimate the warranty provision
in each case
Solution
a) In house repair
I. Past data on phones coming in for repair
II. Expected number of phones that will come in for repair
III. Past, current and expected costs of parts
IV. Past, current and expected costs of labor
b) Outsource repair
I. Charges for repair in the past
II. Type of repairs
III. Number of phones sent in for repair
c) Cost of inventory of phones replaced
Example continued
• ABC repairs the phones in house if the repair is easy to do. It sends
the phones out to its outsourced repair shop if the repair is hard to
do. If the repair is too expensive then ABC replaces the phone. How
will it estimate the warranty provision?
• In this case ABC can apply the “Expected Value” to find the estimated
provision
• Expected value is a probability weighted amount of the provision
Solution
• Say the average over the past 3 years has been
• 1000 phones returned for repair during warranty period
• 200 phones repaired in house (20%)
• 650 phones repaired by outsourced repair shop (65%)
• 150 phones replaced (15%)
• Update the above probabilities with estimates for future
• Average repair cost per phone returned for each type of repair
• $20 for in house repair
• $145 for outsourced repair
• $250 cost of inventory for replacement
Solution
• Update the repair cost per type of repair
• Estimate the total number of phones expected to be returned
• Use the revised probabilities of type of repair
• Multiply by the updated cost per type of repair
• Multiply by the number of phones estimated to be returned
• Add all the three categories = amount of provision