ACC803 Advanced

Financial Reporting

Week 4: Accounting for Provisions, Contingent Liabilities and Contingent

Assets

4.1 Provisions.
4.2 Contingent Liabilities and Contingent Assets.
 Introduction
IAS 37 relevant standards that deals with definition, recognition, measurement and disclosure
or Provisions, Contingent Liabilities and Contingent Assets.

Provision- is a liability of uncertain timing and amount.

Contingent Liability-
i) a possible obligation arising from past events whose existence will be confirmed only by the
occurrence or non occurrence of one or more uncertain future events that are not completely
within the control of the entity.
ii) A present obligation that arises from past events but is not recognized because either it is not
possible to measure the amount of the obligation with sufficient reliability or it is not probable
that an outflow of resources will be required to settle the obligation.

Contingent Assets- a possible asset arising from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future events
that are not completely within the control of the entity.
 Executory contract- a contract under which neither party ( to the
contract) has performed its obligations or both the parties ( to the contract)
have performed their obligations partially to an equal extent.

Onerous contract a contract in which the unavoidable costs of

meeting the obligations under the contract exceed the economic benefits
expected to be received under the contract.

Restructuring a program that is planned and controlled by the

management and materially changes either the scope of a business
undertaking by an entity or the manner in which that business is
conducted.
Recognition of Provisions
Provision is recognized when all of these conditions
are met.
i) An entity has a present obligation resulting
from a past event.
ii) It is probable that an outflow of resource
embodying economic benefits would be
required to settle the obligation.
iii) A reliable estimate can be made of the amount
of the obligation.
An obligations could be a legal obligation or a constructive obligation.

A legal obligation could be:

i) Be contractual
Ii) Arise due to a legislation
Iii) Result from other operation of law.

A constructive obligation- results from an entity's action where:

i) by an established pattern of past practice, published policies or a sufficiently
specific current statement, the entity has indicated to other (third) parties that it will
accept certain responsibilities.

ii) As a result, the entity has created a valid expectation in the minds of those parties
that it will discharge those responsibilities.

It should be probable that the outflow of resources embodies economic benefits

would occur. The term probable is more likely than not i.e. the chance of
occurrence are more than 50%.
 Example
Excellent Inc. is a oil entity that is exploring oil off the shores of Excessoil Islands. It has employed
oil exploration experts from around the globe. Despite all efforts, there is a major oil spill that
has grabbed the attention of the media.
Environmentalists are protesting and the entity has engaged lawyers to advise it about legal
repercussions.
In past the other oil entities have had to settle with the environmentalists paying huge amounts
in out of court settlements.
The legal council of Excellent Inc. has advised it that there is no law that would require it to pay
anything for the oil spill.
The parliament of Excessoil Islands is currently considering such legislation but that legislation
would probably take another year to be finalized as of the date of the oil spill.
However in its television advertisements and promotional brochures, Excellent Inc. often has
clearly state that it is very conscious of its responsibilities towards the environment and will
make good any losses that may result from its exploration.
This policy has been widely publicized and the CEO has acknowledged this policy is official
meetings when members of the public raise questions to him on this issue.

Required:
Does the above give rise to an obligating event that requires Excellent Inc. to make a provision for
the cost of making good to oil spill?
 Solution
Present obligation as a result of past event- The obligating event is the oil
spill. Because there is no legislation in place yet that would make a clean
up mandatory for any entity operating in Excessoil Islands, there is no Legal
Obligation.
However, the circumstances surrounding the issue clearly indicate that
there is a constructive obligation since the company, which its advertised
policy and public statements, has created an expectation in the minds of
the public at large that it will honor its environment obligations.

An outflow of resources embodying economic benefits in settlement.

Probable.

Conclusion: A provision should be recognized for the best estimate of the

cost to clean up the oil spill.
 Measurement of provision
The amount to be recognized as a provision is the best estimate of the
expenditure required to settle the present obligation at the end of the
reporting period.
While a reliable estimate is usually possible, in rare circumstances, it may
not be possible to obtain a reliable estimate. In such cases the liability is
to be disclosed as a contingent liability ( and not recognized as a
provision).

Best estimate is a matter of judgment and is usually based on past

experience with similar transactions, evidence provided by technical or
legal experts or additional evidence provided by events after the
reporting period.
Risks and uncertainties surrounding events and circumstances should be
considered in arriving at the best estimate of a provision.
 Example
A car dealership also owns a workshop that it uses for servicing cars under
warranty. In preparing its financial statements, the car dealership needs
to ascertain the provision of warranty that it would be required to
provide at year end. The entitys past experience with warranty claims is:

60% of cars sold in a year have zero defects

25% of cars sold in a year have normal defects
15% of cars sold in a year have significant defects.

The costs of rectifying a normal defect in a car is $10000. The cost of

rectifying a significant defect in a car is $30000.

Required:
Compute the amount of provision for warranty needed at year end.
 Solution
The expected value of the provision for warranty needed at
year end is:
(60% * 0) + (25% * $10000)+ (15% *$30000) = $7000.
.

Where the effect of time value is material, the amount of

provision is to be discounted to its present value using a
pretax discount rate that reflect current market assessments
of time value of money and the risks specific to the liability.
 Changes in Provisions and use of provisions.

Changes in provisions shall be reviewed at each balance sheet

date, and the amount of the provision should be adjusted
accordingly to reflect the current best estimate.

When it is no longer probable that an outflow of resources

would be required to settle the obligation, the provision
should be reversed.

A provision should be used only for the purpose for which it

was originally recognized or set up.
 Future operating losses
It is not permissible to recognize a provision for future
operating losses, because they do not meet the criteria for
recognition of a provision.

As future losses are not present obligation arising from past

obligating events and could be a future action of the entity.
( say by disposing of the business), they do not clearly meet
the recognition criteria for provisioning.

Hence IAS37 does not allow for them to be provided for a

year end.
 Onerous Contracts
Although executory contracts are outside the general purview of IAS37.

It is required to recognize a provision under an executory contract that is onerous

An onerous contract that is covered under IAS37 is an executory contract where the
unavoidable costs exceed the benefits expected.

Example
An entity is bound under the terms of a franchise agreement for a local brand that it has
marketed for years. Based on market survey and a cost benefit study, the entity decide to
stop marketing the local brand and entered into a new agreement to market an
international brand. Although the entity does not derive any economic benefit from the
franchise agreement for the local brand, there is an obligation to pay a limp sum amount to
the franchiser agreement for the local brand, there is an obligation to pay a lump sum
amount to the franchiser under the non cancellable franchise agreement for a period of two
years. Thus the entity would need to make a provision for the commitment under the
franchise agreement (since it is an onerous contract).
 Restructuring
Examples of events that may qualify as restructuring:

Sale or termination of a line of business

Closure of business locations in a region or relocation of
business activities from one location to another
Changes in management structure, such as elimination
of a layer of management
Fundamental re-organisation of the entity such that it
has a material and a significant impact on its operations.
 A constructive obligation arise when:
An entity

A) Has a detailed formal plan for restructuring , outlining at least

i) The business or the part of the business being restructured
ii) The principal locations affected by the restructure
iii) The location, function and approximate number of employees who will be compensated for
terminating their employment.
iv) When the plan will be implemented
v) The expenditures that will be undertaken.

B) Has raised valid expectations in the minds of those affected that the entity will carry out
restructuring by starting to implement that plan or announcing its main features to those affected by
it.

Although many fundamental structural changes to an entitys operations would be significant enough
to warrant disclosure in footnotes to the financial statements, not all of these changes qualify as
restructuring that necessitates recognition, because they do not meet the criteria for recognizing a
provision.
 Restructuring provision
A restructuring provision should include only direct expenditures
arising from the restructuring, which are those that are necessarily
entailed by the restructuring and not associated with the on going
activities of the entity.

The standard has specifically excluded certain types of expenditures as

expenditure arising from restructuring:

- Costs of retraining or relocating continuing staff.

- Marketing
-Investment in new systems and distribution networks.
 Example
XYZ Inc. is getting ready to move its factory from its existing location to a new
industrial free zone specially created by the government for manufacturers.
To avail itself of the preferential licensing offered by the local governmental
authorities as a reward for moving into the free trade zone and the savings in
costs that would ensue (since there are no duties or taxes in the free trade
zone), XYZ Inc. has to move into the new location before the end of the year.

The lease on its present location is noncancelable and is for another two years
from year-end. The obligation under the lease is the annual rent of $100,000.
Required

Advise XYZ Inc. what amount, if any, it needs to provide at year-end toward
this lease obligation.
 Solution
The lease agreement is an executory onerous contract
because after moving to the new location, XYZ Inc. would
derive no economic benefits from the existing factory building
but would still need to pay rent under the agreement since
the lease is noncancelable. Thus the unavoidable costs exceed
the benefits expected under the lease contract.

Based on the annual lease obligation under the lease

agreement, the total amount needed to be provided at year-
end is the present value of the total commitment under the
lease = PV of [$100,000 2 (years)].
 Practical Insights
A decision taken by the board of directors of an entity
contemplating embarking on a restructuring program but not
communicated to the parties affected by the decision (such
that it creates a valid expectation in their minds that the
restructuring decision will in reality be implemented) would
not by itself give rise to a constructive obligation.

Thus communication of the decision of the board of directors

to parties affected is a prerequisite if an entity wants to make
a provision for restructuring on the basis of a constructive
obligation.
 Example
The board of directors of ABC Inc. at their meeting held on December 15, 2015, decided
to close down the entity's international branches and shift its international operations and
consolidate them with its domestic operations. A detailed formal plan for winding up the
international operations was also formalized and agreed by the board of directors in that
meeting. Letters were sent out to customers, suppliers, and workers soon thereafter.
Meetings were called to discuss the features of the formal plan to wind up international
operations, and representatives of all interested parties were presenting those meetings.

Required
Do the actions of the board of directors create a constructive obligation that needs a
provision for restructuring?
 Disclosure of provision
For each class of provision, an entity should disclose:
i) carrying amount at the beginning and end of the year
ii) additional provisions made in the period, including increases to existing
provisions.
iii) Amount utilized during the period.
iv) The increase during the period in the discounted amount arising from the
passage of time and the effect of any change in the discount rate.

An entity should also disclose, for each class of provision:

A brief description of the nature of the obligation and the expected timing of any
resulting outflows of economic benefits
An indication about the uncertainties about the amount and timing of those
outflows ( and where necessary, major assumptions made concerning future events).
The amount of any expected reimbursement, stating the amount of any asset that
has been recognized for that expected reimbursement.
 Contingent Liabilities
Contingent Liabilities -is a possible obligation arising from past events, the outcome
of which will be confirmed only on the occurrence or nonoccurrence of one or more
uncertain future events.

A contingent liability is also a present obligation that is not recognized, either because
it is not probable that an outflow of resource will be required to settle an obligation
or the amount of the obligation cannot be measured with sufficient reliability.

Once recognized as a contingent liability, an entity should continually assess the

probability of the outflow of the future benefits relating to that contingent liability.

If the probability of the outflow of the future economic benefits changes to more
likely than not, then the contingent liability may develop into an actual liability and
would need to be recognized as a provision.
 Disclosure of Contingent Liability
For each class of contingent liability an entity should disclose at the end of
the reporting period a brief description of the nature of the contingent
liability and where practicable
-an estimate of its financial effect
-an indication of the uncertainties relating to the amount or timing of any
outflow.
- the possibility of any reimbursement

Contingent liabilities are not recognised in the financial statements but must be
disclosed in the notes to the financial statements
 Example
Excellent Inc. has been sued for the following 3 alleged infringement of law:
1. Unauthorized use of a trademark, the claim is for $100 million, Legal council opinion is
that the chances of this lawsuit are remote.

2. Non payment of the end of service severance pay and gratuity to 5000 employees who
were terminated without entity giving any reason, the class action lawsuit is claiming $3
million. Legal council opinion is that it is probable that the entity would have to pay the
displaced employees but the best estimate of the amount that would be payable if the
plaintiff succeeds against the entity is $2million.

3.Unlawful environmental damage for dumping waste in the river near its factory,
environmentalists are claiming unspecified damages as cleanup costs. Legal council opinion
is that there is no current law that would compel the entity to pay for such damages. There
may be a case of constructive obligation, but the amount of damages cannot be estimated
with any reliability.

Required:
What should be the provision that Excellent Inc. recognized and the contingent liabilities
that it should disclose in each of the lawsuits, based on the assessments of its legal council?
 Review
Review the FSC financial report for 2014 accounting policy on
Contingent liabilities and discuss how FSC has complied with the
requirement of IAS37 their disclosure

To download: click on below link.

http://www.fsc.com.fj/reports/AnnualReport2014.pdf
 Contingent Assets
Contingent Assets-are possible assets that arise from a past event and whose
existence is confirmed only by the occurrence or nonoccurrence of one or more
uncertain future events not wholly within the control of the entity.

Disclosure:
Where inflow of economic benefits is probable, an entity should disclose a brief
description of the nature of the contingent assets at the balance sheet date and
where practicable , an estimate of the financial estimate.
 Readings
Week 4 Reading 1-The Impact of Recognition
Versus Disclosure on Financial Information A
Preparers Perspective.

Week 4 Reading 2 - Management Roles and

Sustainability Information- Exploring.
 Tutorial Questions
1. Waste from an entitys production process contaminated the groundwater at the entitys plant.

In a lawsuit brought against the entity, members of the local community seek compensation for
damages to their health as a result of the contamination.

The entity acknowledges its wrongdoing and the court is deciding

on the extent of the compensation to be awarded to the members of the local community.

It is uncertain when the ruling will take place but the entitys lawyers
expect it will take place in about two years and they estimate that the
compensation awarded by the court will be in the range $1 million $30 million.

Required:
How should the entity treat this events in its financial statements
 Question 2
2. 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 the basis of experience, it is probable that there will be some claims under the
warranties.

Required:

How should the entity treat this events in its financial statements
 Question 3
3. In a lawsuit brought against an entity, a group of people are collectively seeking
compensation for damages to their health as a result of contamination to the
nearby land believed to be caused by waste from that entitys production process.

It is doubtful whether the entity is the source of the contamination because many
entities operate in the same area producing similar waste and the source of the leak
is unclear.

The entity denies any wrongdoing since it has taken precautions to

avoid such leaks and so it is vigorously defending the case.
However, the entity cannot be certain that it has not caused the leak and the true offender will become
known only after extensive testing.

The entitys lawyers expect a court ruling in about two years. If the entity loses the case, compensation is
likely to be in the range $1 million30 million.

Required:

How should the entity treat this events in its financial statements
 Question 4
4. An entity has made a written pledge to contribute a substantial sum of money
toward the construction of a new performing arts centre in its community.

Executives of the entity appeared in a press conference to announce the pledge.

With the entitys consent, the charitable organisation that is building the arts
centre has cited the entitys pledge in its materials soliciting additional pledges for
construction. Under local law, pledges to charitable organisations are not legally
enforceable.

Required:

How should the entity treat this events in its financial statements
 Question 5
Waste from an entitys production process contaminated the groundwater at the
entitys plant.

The entity is not required by law to restore the contaminated environment and
there is no court case.

However, before the end of the current reporting period the entity made a public
announcement that it would restore the contaminated environment within the
next 12 months.
Required:

How should the entity treat this events in its financial statements.
 Question 6
6. An entity is taking legal action against its competitor for patent infringement
relating to a patent that had been granted to the entity on one of its products.

The outcome of the case is uncertain. However, it is probable that the court
will order the competitor to pay damages to the entity.

Required:

How should the entity treat this events in its financial statements.