Lecture 28-29

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 Measuring provisions
The amount recognised as a provision should
be:
• A realistic-estimate
• A prudent estimate of the expenditure needed
to settle the obligation existing at the
reporting date

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 Methods of measuring uncertainties

Methods of measuring uncertainties include:

• Weighting the cost of all probable outcomes

according to their probabilities (expected
values)

• Considering a range of possible outcomes

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 Warranty provisions
Introduction
A warranty is often given in manufacturing
and retailing businesses.
It is either an:
1. Express (legal) or
2. Implied (constructive)
Obligation to make good or replace faulty
products.
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 Warranty provisions

A provision is required at the time of the sale

rather than the time of the
repair/replacement as the making of the sale
is the past event which gives rise to an
obligation.

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 Warranty provisions
This requires the seller to analyse past experience so
that they can estimate:

• How many claims will be made. If manufacturing

techniques improve, there may be fewer claims in
the future than there have been in the past.

• How much each repair will cost. As technology

becomes more complex, each repair may cost more.

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 Warranty provisions
The provision set up at the time of sale:

• Is the number of repairs expected in the future

times at the expected cost of each repair.

• Should be reviewed at the end of each

accounting period in the light of further
experience.

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 Guarantees
• In some instances (particularly in groups) one
company will make a guarantee to another to
pay off a loan, etc. if the other company is
unable to do so.
• This guarantee should be provided for if it is
probable that the payment will have to be
made.
• It may otherwise require disclosure as a
contingent liability.
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 Onerous contracts

• An onerous contracts 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.

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 Onerous leases
• An onerous lease is an onerous contract, i.e.
one where the unavoidable costs under the
lease exceed the economic benefits expected to
be gained from it.
• If leased premises have become surplus to
requirements but the lessee cannot find anyone
to sublet the premises to, the lessee will still
have to make the regular lease payments,
without being able to use the premises.
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 Onerous leases
• The signing of the lease is the past event
giving rise to the obligation to make the lease
payments.
• A payment for this payment should be
recognised as an expense in the income
statement in the period when the lease
becomes onerous.

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 Question 1 – Onerous contracts
A company has 10 years left to run on the lease
of a property that is currently unoccupied. The
present value of the future rentals at the
reporting date is Rs50,000. Subletting
possibilities are limited but the directors feel
that likely future subletting rental could have a
present value of Rs10,000.

• What is the accounting treatment?

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 Environmental provisions
• Environmental provision is a liability of uncertain
timing or amount, which was used to capture the
risks regard to environmental cost such as clean up
cost, dis- mantling cost, rehabilitation that
companies will expose in the future.
• A provision will be made for future environmental
costs if there is either a legal or constructive
obligation to carry out the work.
• This will be discounted to present value at a pre-tax
market rate.
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 Restructuring provisions
A restructuring is a programme that is planned
and controlled by management and materially
changes either:

• The scope of a business undertaken by an

entity, or
• The manner in which that business is
conducted.

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 Restructuring provisions
A provision may only be made if:

• A detailed, formal and approved plan exists

• The plan has been announced to those affected

The provision should:

• Include direct expenditure arising from restructuring
• Exclude costs associated with ongoing activities

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 Restructuring provisions
• In the context of a restructuring, a detalied, formal
and approved plan must exist, but this is not
enough, because management may change its
mind.

• A provision should only be made if the plan has also

been announced to those affected. This creates a
constructive obligation, because management is
now very unlikely to change its mind.

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 Question 1 – Restructuring provisions

On 14th June 2005 a decision was made by the

board of an entity to close down a division.
The decision was not communicated at that
time to any of those affected and no other
steps were taken to implement the decision by
the year end of 30th June 2005. the division
was closed in September 2005.
• Should a provision be made at 30th June 2005
for the cost of closing down the division?
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 Question 2 – Answer

• No constructive obligation exists.

• This is a board decision, which can be

reversed.

• No provision can be made

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 Question 2 – Restructuring provisions

On 14 June 2005 a decision was made by the

board of an entity to close down a division. On
28 June 2005 a detailed plan for closing down
the division was agreed by the board.
Redundancy notices were also sent out to the
staff of the affected division. The division was
closed in September 2005.
• Should a provision be made at 30th June 2005
for the cost of closing down the division?
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 Question 2 - Answer

• The detailed plan and the redundancy notices

create a valid expectation and therefore a
constructive obligation.

• Yes, a provision is required.

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• Contingent liabilities and
contingent assets

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 Contingent liabilities

A contingent liability is:

1. A possible obligation that arises from past

events and whose existence will be confirmed
only by the occurrence or non-occurrence of
one or more uncertain future events not
wholly within the control of the enterprise OR

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 Contingent liabilities
2. A present obligation that arises from past
events but is not recognised because:
• It is not probable that an outflow of resources
embodying economic benefits will be required
to settle the obligation; or
• The amount of the obligation cannot be
measured with sufficient reliability.

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 Contingent assets

A contingent assets is:

• A contingent assets is a possible asset that arises

from past events and whose existence will be
confirmed only by the occurrence or non-
occurrence of one or more uncertain future
events not wholly within the control of the
enterprise.
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 Example of contingencies

• A common example of contingencies arises in

connection with legal action. If company A
sues company B because it believes that it has
incurred losses as a result of company B’s fault
products, then company B may be liable for
damages. Whether or not the damages will
actually be paid depends on the outcome of
the case.
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 Example of contingencies

Solution:

• Until this is known, company B has a

contingent liability and company A has a
contingent asset.

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Accounting for contingent liabilities
Contingent liabilities:

• Should not be recognised in the statement of

financial position itself.

• Should be disclosed in a note unless the

possibility of a transfer of economic benefits is
remote.
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 Accounting for contingent assets
Contingent assets:

• Should not generally be recognised, but if the

possibility of inflows of economic benefits is
probable, they should be disclosed.

• If a gain is virtually certain, it falls within the

definition of an asset and should be recognised
as such, not as a contingent assets.
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• https://www.youtube.com/watch?
v=oWwdDKxzzfk

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