OVERVIEW
Objective
¾
To define provisions, contingent liabilities and contingent assets.¾
To explain the recognition and measurement of provisions, contingent liabilities and contingent assets.INTRODUCTION
DISCLOSURES RECOGNITION
APPLICATION OF THE RULES TO SPECIFIC
CIRCUMSTANCES
¾ Objective
¾ Scope
¾ Definitions
¾ The relationship between provisions and contingent liabilities
¾ Recognition of provisions ¾ Recognition issues ¾ Contingent assets and
liabilities
¾ Future operating losses
¾ Onerous contracts
¾ Specific application – Restructuring ¾ Specific application –
Decommissioning costs
MEASUREMENT
CHANGES IN PROVISIONS
¾ General rules
¾ Specific points
PROVISIONS FOR REPAIRS AND MAINTENANCE
¾ Refurbishment Costs –
No Legislative Requirement
¾ Refurbishment Costs –
1
INTRODUCTION
1.1
Objective
¾
To ensure that appropriate recognition criteria and measurement bases are applied to provisions contingent liabilities and contingent assets.
¾
To ensure that sufficient information is disclosed in the notes to the financial statements in respect of each of these items.1.2
Scope
¾
The rules will apply to all provisions and contingencies except for those covered by more specific requirements in other IASs. E.g. those found in IAS 11, Construction contracts IAS 19, Retirement benefit costs IAS 12, Income taxes, and IAS 17, Accounting for leases IFRS 3 Business Combinations
¾
IAS 37 addresses only provisions that are liabilities, i.e. not provisions for depreciation, doubtful debts etc.¾
IAS 37 applies to provisions for restructuring (including discontinued operations).1.3
Definitions
¾
Provisions are liabilities of uncertain timing or amount.¾
Aliability 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.¾
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.Commentary
¾
Alegal obligation is an obligation that derives from a contract, legislation, or
other operation of law.
¾
Aconstructive 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.
¾
A contingent liability is a possible obligation that arises from past events and whose existence will be confirmed only on the occurrence or non-occurrence of one or more uncertain future events that are not wholly within the control of the entity, or
a present obligation that arises from past events but is not recognised because
−
it is not probable that an outflow of benefits embodying economic benefits will be required to settle the obligation, or−
the amount of the obligation cannot be measured with sufficient reliability.Commentary
IAS 37 stresses that an entity will be unable to measure an obligation with sufficient reliability only on very rare occasions.
¾
Acontingent asset is a possible asset that arises from past events and whose existence will be confirmed only on the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.¾
Anonerous contract is one in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received from it.¾
Arestructuring is a programme that is planned and controlled by management, and materially changes either:1.4
The relationship between provisions and contingent liabilities
¾
In a general sense all provisions are contingent because they are uncertain in timing or amount.¾
IAS 37 distinguishes between the two by using the term “contingent” for assets and liabilities that are not recognised because their existence will be confirmed only on the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.¾
The standard distinguishes between provisions – because they are present obligations, and
contingent liabilities – which are not recognised because they are either
−
possible obligations, or−
present obligations, which cannot be measured with sufficient reliability.2
RECOGNITION
2.1
Recognition of provisions
¾
A provision should be recognised when: an entity has a present legal or constructive obligation to transfer economic benefits as a result of past events, and
it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation, and
a reliable estimate of the obligation can be made.
¾
If these conditions are not met a provision should not be recognised.2.2
Recognition issues
2.2.1
Present obligation
Illustration 1
Scenario
A manufacturer gives warranties at the time of sale to purchasers of its
product. Under the terms of the contract for sale the manufacturer undertakes to make good, by repair or replacement, manufacturing defects that become apparent within three years from the date of sale. On past experience, it is probable (i.e. more likely than not) that there will be some claims under the warranties.
Present obligation as a result of a
past obligating event? Sale of the product with a warranty gives rise to a legal obligation An outflow of resources? Probable
Conclusion Provide for the best estimate of the cost of making good under the
warranty of the goods sold by the end of the reporting period
¾
A provision should be made only if the liability exists independent of the entities future actions. The mere intention or necessity to undertake expenditure related to the future is not sufficient to give rise to an obligation.¾
If the entity retains discretion to avoid making any expenditure, a liability does not exist and no provision is recognised. the mere existence of environmental contamination, eg, even if caused by the entity’s activities, does not in itself give rise to an obligation because the entity could choose not to clean it up
a board decision alone is not sufficient for the recognition of a provision because the board could reverse the decision
if a decision was made that commits an entity to future expenditure no provision need be recognised as long as the board have a realistic alternative.
Commentary
Until the board makes public that offer, or commits itself in some other way to making the repairs there is no obligation beyond that of satisfying the existing statutory and contractual rights of customers.
Commentary
Clearly this is a matter for judgement after taking into account all available evidence.
Illustration 2
Scenario
After a wedding in 2006, ten people died, possibly as a result of food poisoning from products sold by the entity. Legal proceedings are started seeking
damages from the entity but it disputes liability. Up to the date of approval of the financial statements for the year to 31 December 2006, the entity’s lawyers advise that it is probable that the entity will not be found liable. However, when the entity prepares the financial statements for the year to 31 December 2007, its lawyers advise that, owing to developments in the case, it is probable that the entity will be found liable.
At 31 December 2006:
Present obligation as a result of a
past obligating event? On the basis of the evidence available when the financial statements were approved, there is no obligation as a result of past events.
An outflow of resources?
Conclusion No provision
At 31 December 2007:
Present obligation as a result of a
past obligating event? On the basis of the evidence available, there is a present obligation. An outflow of resources? Probable
Conclusion Provision should be recognised
2.2.2
Past event
¾
A past event that leads to a present obligation is called an obligating event.¾
An obligating event exists when the entity has no realistic alternative but to make the transfer of economic benefits. This may be due to; legal obligations or constructive obligations
¾
Examples of constructive obligations include an entity that has identified contamination in land surrounding one of its production sites. The entity is not legally obliged to clean up, but because of concern for its long-term reputation and relationship with the local community, and because of its published policies or past actions, is obliged to do so.
Illustration 3
Scenario
A retail store has a policy of refunding purchases by dissatisfied customers, even though it is under no legal obligation to do so. Its policy of making refunds is generally known.
Present obligation as a result of a
past obligating event? The obligating event is the sale of the product, which gives rise to a constructive obligation because the conduct of the store has created a valid expectation on the part of its customers that the store will refund purchases.
An outflow of resources? Probable, a proportion of goods are returned for refund.
Conclusion A provision is recognised for the best estimate of the costs of refunds.
Illustration 4
Scenario
An entity in the oil industry causes contamination and operates in a country where there is no environmental legislation. However, the entity has a widely published environmental policy in which it undertakes to clean up all
contamination that it causes. The entity has a record of honouring this published policy.
Present obligation as a result of a
past obligating event? The obligating event is the contamination of the land, which gives rise to a constructive obligation because the conduct of the entity has created a valid expectation on the part of those affected by it that the entity will clean up contamination
An outflow of resources? Probable.
¾
Provisions are not made for general business risks since they do not give rise to obligations that exist at the end of the reporting period.¾
It is not necessary to know the identity of the party to whom the obligation is owed in order for an obligation to exist.2.2.3
Reliable estimate of the obligation
¾
A reasonable estimate can always be made where an entity can determine a reasonable range of possible outcomes.¾
Only in extremely rare cases will it be genuinely impossible to make any quantification of the obligation and therefore impossible to provide for it. (In these circumstances disclosure of the matter would be necessary).2.3
Contingent assets and liabilities
¾
These should not be recognised. They are dependent on the occurrence or non-occurrence of an uncertain future event not wholly within the control of the entity.¾
It follows that they are not obligations which exists at the end of the reporting period.¾
There is an exception to non-recognition of contingent liabilities. IFRS 3 BusinessCombinations requires a subsidiaries contingent liabilities, that are present obligations, to be recognised and measured at fair value as part of the acquisition process, this will be considered in more detail in the group account sessions.
3
MEASUREMENT
3.1
General rules
¾
The amount provided should be the best estimate at the end of the reporting period of the expenditure required to settle the obligation. The amount is often expressed as the amount which could be spent to settle the obligation immediately, or to pay to a third party to assume it.¾
The best estimate may derive from the judgement of the management supplemented by experience of similar transactions, and evidence provided from experts (in some cases).
¾
An entity should take account of the uncertainty surrounding the transaction This may involve an expected value calculation (suitable in situations where there is a large population – e.g. determining the size of warranty provisions)
¾
The following factors should be taken into account when deciding on the size of the obligation the time value of money (the amount provided should be the present value of the expected cash flows)
evidence in respect of expected future events e.g.
−
change in legislation−
improvements in technology prudence.
Illustration 5
An entity sells goods with a warranty under which customers are covered for the cost of repairing any manufacturing defects discovered within the first 12 months after purchase. If minor defects were detected in all products sold, repair costs of 100,000 would result. If major defects were detected in all products sold, repair costs of 400,000 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 goods sold will have major defects.
Required:
Calculated the amount to be provided in the financial statements in respect of the warranty claims.
Solution
The expected value of the cost of repairs is:
(75% × 0) + (20% × 100,000) + (5% × 400,000) = 40,000
Commentary
3.2
Specific points
¾
Reimbursement – If some (or all) of the expected outflow is expected to be reimbursed from a third party, the reimbursement should be recognised only when it is virtually certain that the reimbursement will be received if the entity settles the obligation. The expense in respect of the provision may be presented net of the amountrecognised for a reimbursement.
The reimbursement should be treated as a separate asset and must not exceed the provision in terms of its value.
¾
Gains from the expected disposal should not be taken into account when measuring a provision.¾
The provision should be measured as a pre tax amount.4
CHANGES IN PROVISIONS
¾
Provisions may be used only for expenditures that relate to the matter for which they were originally recognised.Illustration 6
An entity becomes subject to an obligating event on 1 January 2007
The entity is committed to expenditure of $10m in 10 years time as a result of this event.
An appropriate discount factor is 8%. 1 January 2007
Initial measurement of the provision $10m ×
) 08 . 0 1 ( 1 10
+ = 4,631,935
Dr Profit or loss 4,631,935
Cr Provision 4,631,935
31 December 2007
Measurement of the provision $10m ×
) 08 . 0 1 ( 1 9
+ = 5,002,490
Presented as follows: $
Balance brought forward 4,631,935
Borrowing cost (unwinding of the discount) (8% × 4,631,935) _________ 370,555
Carried forward 5,002,490
_________ Provision
Dr Profit or loss 370,555
Cr Provision 370,555
31 December 2008
Measurement of the provision $10m ×
) 08 . 0 1 ( 1 8
+ = 5,402,689
Presented as follows: $
Balance brought forward 5,002,490
Borrowing cost (unwinding of the discount) (8% × 5,002,490) _________400,199
Carried forward _________5,402,689
Provision
Dr Profit or loss 400,199
5
APPLICATION OF THE RULES TO SPECIFIC CIRCUMSTANCES
5.1
Future operating losses
¾
Provisions should not be recognised for future operating losses because they do not arise out of a past event, and they are not unavoidable.
¾
An expectation of future losses is an indication that the assets of the entity may be impaired. The assets should be tested for impairment according to IAS 36.5.2
Onerous contracts
¾
If an entity has a contract that is onerous the present obligation under that contract should be recognised as a provision.Illustration 7
Scenario
An entity operates profitably from a factory that it has leased under an
operating lease. During December 2007 the entity relocates its operations to a new factory. The lease on the old factory continues for the next four years, it cannot be cancelled and the factory cannot be re-let to another user.
Present obligation as a result of a
past obligating event? The obligating event is the signing of the lease contract, which gives rise to a legal obligation.
An outflow of resources? When the lease becomes onerous, an outflow of resources embodying economic benefits is probable. (Until the lease becomes onerous, the entity accounts for the lease under IAS 17, Leases).
5.3
Specific application — Restructuring
¾
Examples of restructurings include sale or termination of a line of business closure of business locations in a region relocation from one region to another changes in management structure
fundamental reorganisations that have a material effect on the nature and focus of the entities operations.
¾
A provision in respect of a liability for restructuring should only be recognised when the general recognition criteria are met. These are applied as follows.¾
A constructive obligation to restructure arises only when an entity: has a detailed formal plan for the restructuring identifying as a minimum:
−
the business or part of a business concerned−
the principal locations affected−
the location, function, and approximate number of employees who will be compensated for terminating their services−
the expenditures that will be undertaken, and−
when the plan will be implemented.Commentary
If there is a long delay before the plan will be implemented then it is unlikely that the plan will raise a valid expectation that the entity is committed to the restructuring.
and has raised a valid expectation that it will carry out the restructuring by starting to implement the plan or by announcing its main features to those affected by it.
¾
A management decision to restructure does not give rise to constructive obligationunless the entity has (before the end of the reporting period)
started to implement the restructuring plan e.g. by the sale of assets, or
announced the main features of the plan to those effected in a sufficiently specific manner to raise a valid expectation in them that the restructuring will occur.
¾
No obligation arises for the sale of an operation until there is a binding sales agreement.¾
IFRS 3 Business Combinations does not allow a provision to be set up in respect of theIllustration 8
Scenario
On 12 December 2007 the board of an entity decided to close down a division. Before the end of the reporting period (31 December 2007) the decision was not communicated to any of those affected and no other steps were taken to
implement the decision.
Present obligation as a result of a
past obligating event? No An outflow of resources?
Conclusion No provision is recognised
Illustration 9
Scenario
On 12 December 2007, the board of an entity decided to close down a division making a particular product. On 20 December 2007 a detailed plan for closing down the division was agreed by the board; letters were sent to customers warning them to seek an alternative source of supply and redundancy notices were sent to the staff of the division.
Present obligation as a result of a
past obligating event? The obligating event is the communication of the decision to the customers and employees, which gives rise to a constructive obligation from that date, because it creates a valid expectation that the division will be closed.
An outflow of resources? Probable
Conclusion A provision is recognised at 31
December 2007 for the best estimate of the costs of closing the division.
¾
Provisions for restructuring should include only those expenditures that are both necessarily entailed by a restructuring, and5.4
Specific application — Decommissioning costs
¾
Sometimes an entity is committed to spend money when it closes down an asset, this is very common in the oil industry where once the oil rig has reached the end of its life the entity must dismantle the rig and put the environment back into a natural condition.¾
These type of costs are called decommissioning costs.¾
IAS 37 requires that when an entity has a present obligation to incur these costs then a provision must be set up. The provision could be set up on the initial recognition of the asset or part way through its life.¾
The provision will initially be recognised at the present value of the future expected cash outflow in respect of the obligation. The double entry will be to DR the asset.Commentary
Refer to your notes on IAS 16 to see the accounting treatment in respect of the debit entry.
Illustration 10
An entity purchased an asset on 1 January 2007.
The entity is committed to expenditure of $10m in 10 years time in respect of this asset. The obligation satisfies the recognition criteria in IAS 37.
An appropriate discount factor is 8%. 1 January 2007
Initial measurement of the provision $10m ×
) 08 . 0 1 ( 1 10
+ = 4,631,935
Dr Asset 4,631,935
Cr Provision 4,631,935
31 December 2007
Measurement of the provision $10m ×
) 08 . 0 1 ( 1 9
+ = 5,002,490
Presented as follows: $
Balance brought forward 4,631,935
Borrowing cost (8% ×4,631,935) 370,555
_________
Carried forward 5,002,490
_________ Profit or loss Provision
Dr Profit or loss
Cr Provision 370,555 370,555 370,555
Asset
Dr Profit or loss Cr Accumulated depreciation 463,193 463,193 463,193
4,631,935 ×1/10
833,748
6
PROVISIONS FOR REPAIRS AND MAINTENANCE
¾
Some assets require, in addition to routine maintenance, substantial expenditure every few years for major refits or refurbishment and the replacement of major components. IAS 16, Property, plant and equipment, gives guidance on allocating expenditure on an asset to its component parts where these components have different useful lives or provide benefits in a different pattern.6.1
Refurbishment Costs — No Legislative Requirement
Illustration 11
Scenario
A furnace has a lining that needs to be replaced every five years for technical reasons. At the end of the reporting period, the lining has been in use for three years.
Present obligation as a result of a
past obligating event? There is no present obligation. An outflow of resources?
Conclusion No provision
The cost of replacing the lining is not recognised because, at the end of the reporting period, no obligation to replace the lining exists independently of the company’s future actions – even the intention to incur the expenditure depends on the company deciding to continue operating the furnace or to replace the lining.
6.2
Refurbishment Costs — Legislative Requirement
Illustration 12
Scenario
An airline is required by law to overhaul its aircraft once every three years. Present obligation as a result of a
past obligating event? There is no present obligation. An outflow of resources?
Conclusion No provision
The costs of overhauling aircraft are not recognised as a provision for the same reasons as the cost of replacing the lining is not recognised as a provision in the previous example Even a legal requirement to overhaul does not make the costs of overhaul a liability, because no obligation exists to overhaul the aircraft independently of the entity’s future actions – the entity could avoid the future expenditure by its future actions, for example by selling the aircraft.
Instead of a provision being recognised, the depreciation of the aircraft takes account of the future incidence of maintenance costs, i.e. an amount equivalent to the expected
maintenance costs is depreciated over three years.
7
DISCLOSURES
¾
Disclose for each class of provision the carrying amount at the beginning and end of the period with movements by type including
−
additional provisions in the period including increases to existing provisions−
amounts used−
amounts reversed−
increase during the period of any discounted amount arising due to the passage of time or change in rate. a brief description of the nature of the obligation and expected timing of the expenditure.
an indication of the nature of the uncertainties about the amount or timing of the outflows
¾
An entity should disclose the following for each class of contingent liability unless the contingency is remote a brief description of the nature of the contingency; and where practicable, the uncertainties that are expected to affect the ultimate outcome of the
contingency,
an estimate of the potential financial effect, and the possibility of any reimbursement.
¾
An entity should disclose the following for each class of contingent asset when the inflow of economic benefits is probable a brief description of the nature of the contingency, and where practicable, an estimate of the potential financial effect.
¾
In extremely rare cases, disclosure of some or all of the information required above might seriously prejudice the position of the entity in its negotiations with other parties in respect of the subject matter for which the provision, contingent liability or asset is made. In such cases the information need not be disclosed, but entities should; explain the general nature of the dispute, and explain the fact, and reason why, that information has not been disclosed.
FOCUS
You should now be able to:
¾
explain why an accounting standard on provisions is necessary;¾
distinguish between legal and constructive obligations;¾
state when provisions may and may not be made and demonstrate how they should be accounted for;¾
explain how provisions should be measured;¾
define contingent liabilities and assets and describe their accounting treatment;¾
identify and account for: warranties and guarantees; onerous contracts;
environmental and similar provisions;
