ias 37 provisions,contingen t liabilities,and contingent assets

IAS 37 PROVISIONS,CONTINGENT LIABILITIES,AND CONTINGENT

ASSETS

1Compiled by Yagnesh Desai FCA, CPA (USA)

ALSO

2Compiled by Yagnesh Desai FCA, CPA

(USA)

APPLICABILITY• APPLIED TO

• All Types of Provisions, Contingent Liabilities and Contingent Assets.

• NOT APPLIED TO -• Executory contracts( Other

than Onerous Contracts)• And covered by others

standards• IAS 11, IAS 12, IAS 17)

(However, onerous leases are covered by IAS 37.)

• Employee benefits (IAS 19) • IAS 39 Financial Instruments• IFRS 4 Insurance Contracts


(USA)

`

Liability


(USA)

Both From Past Events

Con

tinge

nt

Liab

ilitie

s


(USA)

Contingent asset.

Compiled by Yagnesh Desai FCA, CPA (USA)

6

•A possible asset arising from past events and whose existence contingent on occurrence or nonoccurrence of one or more uncertain future events

•that are not completely within the control of the entity.


7

• Executory Contracts• 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 Contracts • 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.


(USA)

Those liabilities that are of uncertain timing or amount are “provisions,”


(USA)

Probable that Outflow of Sources would

Occur – More Likely Than NOT


(USA)

START

Presentation obligation as a result of an obligating event?

Possible Obligation?

No

No (rare)

NoNo

RemoteProbable Outflow?

Reliable Estimate?

Provide Disclose Contingent

Liability

Do Nothing

Yes

Yes

YesYes Yes

No

11

Compiled by Yagnesh Desai FCA, CPA (USA)`


12

Accruals Provisions

Reported as part of trade and other payables

Reported Separately

Definition of Provision Re -

• A provision falls within the definition of a liability with the added feature that there is uncertainty over the amount to be paid or the timing of the payment.

• 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 benefit”.


(USA)

PROVISION


(USA)


(USA)

However, if amounts are expected to be reimbursed by another party, these should be taken into consideration in arriving at the amount of the provision`


(USA)

Discounting

Once the cash flow associated with an obligation have been estimated , it is then necessary to consider whether or not the time value of money has a material effect on the sums to be paid.

The standard requires that where the effect of the time value is material the amount of a provision should be the present value of the expenditure expected to be required to settle the obligation.[IAS 37 Para 45].

Therefore, for the majority of provisions that will reverse in the short-term, for example, within the next and perhaps in the following financial year, the effects of discounting may be immaterial and are not then required to be made.


(USA)

Discounting – Contd.• The present value of a provision should be

determined based on a pre-tax discount rate that reflects current market assessment of the time value of money.

• Once the company has established the amount for which provision is to be made it necessary to consider how this provision should be adjusted each year.


(USA)

Case Study 1• Facts

Excellent Inc. is an oil entity that is exploring oil off the shores of Excess oil 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 the past, other oil entities have had to settle with the environmentalists, paying huge amounts in out-of-court settlements. The legal counsel 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 Excess oil 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 stated that it is very conscious of its responsibilities toward the environment and will make good any losses that may result from its exploration. This policy has been widely publicized, and the chief executive officer has acknowledged this policy in official meetings when members of the public raised questions to him on this issue.RequiredDoes the above give rise to an obligating event that requires Excellent Inc. to make a provision for the cost of making good the oil spill?


(USA)

Solution• (a) Present obligation as a result of a past obligating event. The

obligating event is the oil spill. Because there is no legislation in place yet that would make cleanup 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, with its advertised policy and public statements, has created an expectation in the minds of the public at large that it will honor its environmental obligations.

(b) An outflow of resources embodying economic benefits in settlement. Probable.

(c) Conclusion. A provision should be recognized for the best estimate of the cost to clean up the oil spill.


(USA)

Unwinding the discount

• Due to the passage of time should be included as an element of borrowing costs in the income statement . [IAS 37 Para 60]. The unwinding of the discount is illustrated in the simplified example below.


(USA)

Example:• Entity A has litigation pending. Legal advice is

that entity A will lose the case and costs of C1, 200 in two years time are estimated . The liability is recognized on a discounted basis. The appropriate discount rate 4.5% and, for the purpose of this example, it is assumed that the discount rate does not change.

How should management calculate the amount of borrowing costs recognized on the unwinding of a discount?

Management should initially recognized a provision for C1,099, being the present value of C1,200 discounted at 4.5% for two years.


(USA)

Discount Factor at 4.5%

NPV Cash flows Borrowing Cost

0.9157 1,099

Year 1 0.9569 1,148 49

Year 2 1.0000 1,200 1,200 52


(USA)

• At the end of the year 1, the provision will increase to C1, 148 as management discounts the cash outflow of C1,200 for one year instead of two. The increment of C49 should be recognized as a borrowing cost in the income statement . Similarly in Year 2, the provision will increase by C52 to equal the amount due.

The situation is more complicated if the discount rate changes over the period- this is dealt with in paragraph 21.152 onwards.


(USA)

Post Balance Sheet events – IAS 10

• Events after the balance sheet date’, requires that a material events after the balance sheet date should be reflected in the prior year’s financial statements only where it is an adjusting event. An adjusting events is an event that occurs after the balance sheet date that provides additional evidence of conditions that existed at the balance sheet date. [IAS 10 Para 3, 8]


(USA)

• NO Provision for non – adjusting post- balance sheet events.

• The non-adjusting list includes:• Announcing, or commencing the

implementation of, a major restructuring .• Announcing a plan to discontinue an operation.• Classification of assets as held for sale in

accordance with IFRS 5,’ Non- current assets held for sale and discontinued operations.’


(USA)

Gains on Expected Disposal

• Gains on the expected disposal of asset are not taken into account in measuring a restructuring provision, even if the sale of assets is envisaged as part of the restructuring. [IAS 37 Para 83]. This is illustrated in following example


(USA)

Example- Question

• An entity is closing an operation and by the year end a formal plan will have been approved by management and announce. The closure will involve redundancies, but there will be a related gain when the factory is sold. The factory has been valued professionally at above its carrying value and is expected to be sold after the year end but before the financial statements are approved. Can the provisions for redundancies be reduce by the profit on sale of the factory , assuming it is sold before the financial statements are approved?


(USA)

Solution• No, it cannot. Paragraph 51 of IAS 37states that

gains from the expected disposal of assets should not be taken into account in measuring a provisions. Paragraph 52 of IAS 37 states that“ Gains on the expected disposal of assets are not taken into account in measuring a provision , even if the expected disposal is closely linked to the event giving rise to the provisions. Instead, an entity recognises gains on expected disposals of assets at the time specified by the standard dealing with the asset concerned”


(USA)

Case Study 2Facts

• 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 entity’s 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 cost of rectifying a “normal defect” in a car is $10,000. The cost of rectifying a “significant defect” in a car is $30,000.

• RequiredCompute the amount of “provision for warranty” needed at year-end.


(USA)

Solution

The expected value of the provision for warranty needed at year-end is: (60% × 0) + (25% × $10,000) + (15% × $30,000) = $7,000.


(USA)

Changes in Provisions and Use of Provisions

• Shall be reviewed at each balance sheet date, and accordingly adjust to reflect the current best estimate.

• When it is no longer probable that 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.


(USA)

Future Operating LossesNOT 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 obligations arising from past obligating events and could be avoided by a future action of the entity.

An expectation of future losses may however, lead one to believe that certain assets of the operations may be impaired; in this case, an entity should test assets for impairment under IAS 36.


(USA)

Onerous Contracts• Although executory contracts are

outside the general purview of IAS 37, it is required to recognize a provision under an executory contract that is “onerous.” An onerous contract that is covered under IAS 37 is an executory contract where the unavoidable costs exceed the benefits expected.


(USA)

Onerous Contracts

• An onerous contract is an agreement • That an entity cannot get out of legally

even though it has signed another parallel agreement under which it is able to undertake the same activities at a better price.

• As it is locked into the existing agreement, it would need to incur costs under both contracts but derive economic benefits from only one of them. MINIMUM LOCK IN.


(USA)

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 decided 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 lump-sum amount to the franchiser under the non cancelable franchise agreement for a period of two more years. Thus the entity would need to make a provision for the commitment under the franchise agreement (since it is an onerous contract).


(USA)


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.

• RequiredAdvise XYZ Inc. what amount, if any, it needs to provide at year-end toward this lease obligation.


(USA)

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)].


(USA)

Restructuring Rules in IAS 37

• IAS 37 applies to provision for restructuring, including discontinued operations.


(USA)

Restructuring• Provisions under IAS 37 are obligation to transfer

resources embodying economic benefits as a result of past transaction or events (that is, liabilities) that are uncertain as to their timing or amount.

For restructurings IAS 37 sets down detailed rules that indicate when an obligation event has occurred and when an obligation to restructure arises. The impact of these rule means that it is still possible in certain defined circumstances to make restructuring provisions under IAS 37.


(USA)

Definition – WHAT IS RE-STRUCTURING

• “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”


(USA)

• Some of the Examples By The Standard : The Sale or termination of a line of business. The Closure of business location in a country or

region or the relocation of business activities from one country or region to another.

Changes in management structure, for example, eliminating a layer of management.

Fundamental reorganization that have a material effects on the nature and focus of the entity’s operations.[IAS 37 Para 70]


(USA)

Applying the recognition criteria• It is only acceptable to make a provision for

restructuring when an obligation event has arisen. Without the existence of an obligation event no Provision can exist.

• For restructuring programme, it is unlikely that a liability will arise from legal obligation as the obligation is more likely to be constructive in nature. It is often more difficult to discern when a constructive obligation originates, so the standard introduces specific conditions that have to exist before a constructive restructuring obligation can exist. The evidence needed is:--


(USA)

EVIDENCES

• Example of the type of evidence needed to demonstrate that the entity has started to implement a restructuring plan.

• This includes: 1) Dismantling plant. 2) Selling assets. 3) Public announcement of the plan’s main

features.44


Restructuring – When to Provide ?

• Although many fundamental structural changes to an entity’s 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 (as opposed to disclosure), because they do not meet the criteria for recognizing a provision. Recognition of the provision is required because a constructive obligation may arise from the decision to restructure. In other words, a constructive obligation may not arise in all cases. A constructive obligation arises when, and only when, an entity…………………


(USA)

Restructuring – When to Provide ?•Has a detailed formal plan for the restructuring outlining at least the business or part of the business being restructured; the principal locations affected by the restructuring; the location, function, and approximate number of employees who will be compensated for terminating their employment; when the plan will be implemented and the expenditures that will be undertaken; and

• 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.


(USA)

IMPLEMENTING FORMAL PLAN• A detailed formal plan for the restructuring, which

identifies at least: The business or part of a business concerned. The principal location affected. The location, function, and approximate number of

employees who will be compensated for terminating their services.

The expenditure that will be undertaken. When the plan will be implemented.


(USA)

Costs of restructuring• IAS 37 specifies that a restructuring provision

should include only the direct expectation arising from the restructuring, which are those that are both:

1)Necessarily entailed by the restructuring: and2)Not associated with the ongoing activities of

the entity.[IAS 37 Para 80]


(USA)

• It is not possible to make provision where only a management or board decision to restructure has been taken BEFORE the balance sheet date, as this does not in itself gives rise to a constructive obligation. [IAS 37 Para 75].

• Even if the management or board complete the detailed plan and announce the restructuring after the entity’s year end, but BEFORE its financial statements are approved by the board, provision for the restructuring should NOT be made. This is because it does not represent an adjusting event after the balance sheet date as there is no commitment to restructure at the year end from which the entity cannot withdraw.


(USA)

• The entity could, for instance, change its plans completely in the new year. Consequently, the ‘obligation event’ does not take place until after the year end and should be reported as a non – adjusting event after the balance sheet date if the restructuring is of such importance that its non – disclosure would affect the ability of the user of the financial statements to make proper evolutions and decisions. [IAS 37 Para 75]


(USA)

Third Party Expectation• To be constructive obligation, a public announcement

has to be made in such a way and in sufficient detail (that is, setting out the main feature of the pan) that it raises valid expectations in customers, suppliers, employees (or their representative) and others that the entity will carry out the restructuring. [IAS 37 Para 73]. Practically, this means that in order to provide for restructuring at the balance sheet date the entity must have started to implement its restructuring plan AND it must have announced the main features of the restructuring plan to those affected by it in sufficiently specific manner to raise a valid expectation in them that the entity will carry out the restructuring. [IAS 37 Para 75]. This is illustrated In the following example.


(USA)

Example:• Entity A’s management has prepared a plan for a

reorganization of its operations. The board has approved the plan, which involves the closure of ten of entity A’s fifty retail outlets. Management will conduct further analysis before deciding which outlets to close.

• Management has announced its intentions publicly and believes that this has given rise to an obligation that should be recognized as a liability. Should a provision for restructuring costs be recognized?


(USA)

• No, a provision for restructuring should be recognized. A constructive obligation arises only when an entity has both a detailed formal plan for restructuring and makes an announcement of the plan to those affected by it. The plan to date does not provide sufficient detail that would permit recognition of a constructive obligation.


(USA)

• Starting to implement the plan means that something must have happened that makes those affected expect that the plan will be carried out. Examples include dismantling plant, selling assets or making a detailed public announcement. Where only an announcement has been made, it must be to a level of detail that raises a valid expectation in customers, suppliers, employees or trade unions, that the entity will carry out the restructuring and will not be able to change its mind.


(USA)

Costs of restructuring• IAS 37 specifies that a restructuring provision

should include only the direct expectation arising from the restructuring, which are those that are both:

1)Necessarily entailed by the restructuring: and2)Not associated with the ongoing activities of

the entity.[IAS 37 Para 80]


(USA)

• Expenditure ALLOWED in a restructuring provision :• 1) Expenditure necessarily entailed by the restructuring

and not associated with the ongoing activities of the business.

• 2) Costs of making employees redundant (although the treatment of redundancy cost is governed by IAS , 19, ‘ Employee benefits,’ being the more specific standard.

• 3)Costs of terminating lease and other contracts, the termination of which results directly from the recognition.

• 4)Costs representing contractual obligation that would either continue after the restructuring with no economic benefit to the entity, for example, where the company is not permitted to cancel the lease and is unable to use the property in its continuing operations.


(USA)

RESTRUCTURING – WHATS NOT COST ?

• Retraining continuing staff, marketing, or investment in new systems and distribution networks should not be included in the restructuring provision.

• Also, the restructuring provision does not include future operating losses - except Onerous Contracts

• Provision for restructuring should include only those commitments for future expenditure that relate to past operation( that is past events), not expenditure commitments that relates to future operations. In order to recognized a provision, it is a not sufficient to demonstrate that a commitments for a future expenditure exists at the balance date, it is also necessary for that expenditure commitments to relate to past operation not future operations


(USA)

Post Balance Sheet Events – Restructuring

• Post balance sheet events are dealt with in IAS 10,’Events after the balance sheet date’, requires that a material events after the balance sheet date should be reflected in the prior year’s financial statements only where it is an adjusting event. An adjusting events is an event that occurs after the balance sheet date that provides additional evidence of conditions that existed at the balance sheet date. [IAS 10 Para 3, 8]


(USA)

• Provision should not be made in the current year for non – adjusting post- balance sheet events. IAS 10 describes the type of events that are adjusting events and those that are non- adjusting events. [IAS 10 Para 9, 22]. The non-adjusting list includes:

• Announcing, or commencing the implementation of, a major restructuring .

• Announcing a plan to discontinue an operation.• Classification of assets as held for sale in

accordance with IFRS 5,’ Non- current assets held for sale and discontinued operations.’


(USA)

Case Study 4• Facts• The board of directors of ABC Inc. at their meeting held on

December 15, 20X1, 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.

• RequiredDo the actions of the board of directors create a constructive obligation that needs a provision for restructuring?


(USA)

Solution• The conditions prescribed by IAS 37 are

• There should be detailed formal plan of restructuring;• Which should have raised valid expectations in the minds of those affected that the entity would carry out the restructuring by announcing the main features of its plans to restructure.

The board of directors did discuss and formalize a formal plan of winding up the international operations. This plan was communicated to the parties affected and created a valid expectation in their minds that ABC Inc. will go ahead with its plans to wind up international operations. Thus there is a constructive obligation that needs to be provided at year-end


(USA)

Disclosures• For each class of provision, an entity should disclose

• The carrying amount at the beginning and the end of the period• Additional provisions made in the period, including increases to existing provisions• Amounts utilized during the period• Unused amounts reversed during the period• 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


(USA)

• 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

• In extremely rare circumstances, when disclosure of any or all this information is considered to be seriously prejudicial to the position of the entity in a dispute with other parties on the subject matter of the provision, an entity need not disclose the information but should disclose the general nature of the dispute, together with the fact that, and reason why, the information has not been disclosed.


(USA)

• Once recognized as a contingent liability, an entity should continually assess the probability of the outflow of the future economic 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.


(USA)

Disclosures• Unless the possibility of any outflow is remote, for each class of

contingent liability an entity should disclose at the balance sheet date 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; and• The possibility of any reimbursement.Where any of the information required above is not disclosed because it is not practicable to do so, the fact should be disclosed.

• In extremely rare circumstances, when disclosure of any or all the above information is considered to be seriously prejudicial to the position of the entity in a dispute with other parties on the subject matter of the contingent liability, an entity need not disclose the information but should disclose the general nature of the dispute, together with the fact that, and reason why, the information has not been disclosed.


(USA)


Amazon Inc. has been sued for following three alleged infringements of law:(1) Unauthorized use of a trademark; the claim is for $100 million(2) Nonpayment of end-of-service severance pay and gratuity to 5,000 employees who were terminated without Amazon Inc. giving any reason; the class action lawsuit is claiming $3 million(3) Unlawful environmental damage for dumping waste in the river near its factory; environmentalists are claiming unspecified damages as cleanup costs Legal counsel is of the opinion that not all the legal cases are tenable in law and has communicated to Amazon Inc. this assessment of the three lawsuits:

Lawsuit 1: The chances of this lawsuit are remote.


(USA)

Lawsuit 2: It is probable that Amazon Inc. 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 $2 million.

Lawsuit 3: There is no current law that would compel the entity to pay for such damages. There may be a case for constructive obligation, but the amount of damages cannot be estimated with any reliability.

Required• What should be the provision that Amazon Inc. should

recognize or the contingent liability that it should disclose in each of the lawsuits, based on the assessments of its legal counsel?


(USA)

Solution• Lawsuit 1: Because the probability of an outflow of economic

benefits is remote, no provision or disclosure is required.• Lawsuit 2: Because it is probable (“more likely than not”) that

Amazon Inc. would ultimately have to pay the dues to the displaced employees and the best estimate of the settlement is $2 million (as against the claim of $3 million), Amazon Inc. would have to make a provision for $2 million.

• Lawsuit 3: There is no legal obligation, but there is a constructive obligation. However, an estimate of the obligation with reasonable reliability is not possible. Hence this qualifies for disclosure as a contingent liability because it cannot be recognized as a provision (as it does not meet all the prescribed conditions for recognition of a provision).


(USA)

CONTINGENT ASSETS (Possible 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.


(USA)

Case Study 6• Facts• A Singapore-based shipping company lost an entire shipload of cargo

valued at $5 million on a voyage to Australia. It is, however, covered by an insurance policy. According to the report of the surveyor the amount is collectible, subject to the deductible clause (i.e., 10% of the claim) in the insurance policy. Before year-end, the shipping company received a letter from the insurance company that a check was in the mail for 90% of the claim. The international freight forwarding company that entrusted the shipping company with the delivery of the cargo overseas has filed a lawsuit for $5 million, claiming the value of the cargo that was lost on high seas, and also consequential damages of $2 million resulting from the delay. According to the legal counsel of the shipping company, it is probable that the shipping company would have to pay the $5 million, but it is a remote possibility that it would have to pay the additional $2 million claimed by the international freight forwarding company, since this loss was specifically excluded in the freight forwarding contract.

• RequiredWhat provision or disclosure would the shipping company need to make at year-end?


(USA)

Solution• The shipping company would need to recognize a

contingent asset of $4.5 million (the amount that is virtually certain of collection). Also it would need to make a provision for $5 million toward the claim of the international freight forwarding company. Because the probability of the claim of $2 million is remote, no provision or disclosure would be needed for that.


(USA)

MULTIPLE-CHOICE QUESTIONS1. When can a “provision” be recognized in accordance with IAS 37?

(a) When there is a legal obligation arising from a past (obligating) event, the probability of the outflow of resources is more than remote (but less than probable), and a reliable estimate can be made of the amount of the obligation.(b) When there is a constructive obligation as a result of a past (obligating) event, the outflow of resources is probable, and a reliable estimate can be made of the amount of the obligation.(c) When there is a possible obligation arising from a past event, the outflow of resources is probable, and an approximate amount can be set aside toward the obligation.(d) When management decides that it is essential that a provision be made for unforeseen circumstances and keeping in mind this year the profits were enough but next year there may be losses.

• Answer: (b)


(USA)

MULTIPLE-CHOICE QUESTIONS• 2. Amazon Inc. has been served a legal notice on December 15, 20X1, by the

local environmental protection agency (EPA) to fit smoke detectors in its factory on or before June 30, 20X2 (before June 30 of the following year). The cost of fitting smoke detectors in its factory is estimated at $250,000. How should Amazon Inc. treat this in its financial statements for the year ended December 31, 20X1?(a) Recognize a provision for $250,000 in the financial statements for the year ended December 31, 20X1.(b) Recognize a provision for $125,000 in the financial statements for the year ended December 31, 20X1, because the other 50% of the estimated amount will be recognized next year in the financial statement for the year ended December 31, 20X2.(c) Because Amazon Inc. can avoid the future expenditure by changing the method of operations and thus there is no present obligation for the future expenditure, no provision is required at December 31, 20X1, but as there is a possible obligation, this warrants disclosure in footnotes to the financial statements for the year ended December 31, 20X1.(d) Ignore this for the purposes of the financial statements for the year ended December 31, 20X1, and neither disclose nor provide the estimated amount of $250,000.

• Answer: (c)73


MULTIPLE-CHOICE QUESTIONS• 3. A competitor has sued an entity for unauthorized use of its

patented technology. The amount that the entity may be required to pay to the competitor if the competitor succeeds in the lawsuit is determinable with reliability, and according to the legal counsel it is less than probable (but more than remote) that an outflow of the resources would be needed to meet the obligation. The entity that was sued should at yearend:(a) Recognize a provision for this possible obligation.(b) Make a disclosure of the possible obligation in footnotes to the financial statements. (c) Make no provision or disclosure and wait until the lawsuit is finally decided and then expense the amount paid on settlement, if any.(d) Set aside, as an appropriation, a contingency reserve, an amount based on the best estimate of the possible liability.

• Answer: (b)74


MULTIPLE-CHOICE QUESTIONS4. A factory owned by XYZ Inc. was destroyed by fire. XYZ Inc. lodged an insurance claim for the value of the factory building, plant, and an amount equal to one year’s net profit. During the year there were a number of meetings with the representatives of the insurance company. Finally, before year-end, it was decided that XYZ Inc. would receive compensation for 90% of its claim. XYZ Inc. received a letter that the settlement check for that amount had been mailed, but it was not received before year-end. How should XYZ Inc. treat this in its financial statements?(a) Disclose the contingent asset in the footnotes.(b) Wait until next year when the settlement check is actually received and not recognize or disclose this receivable at all since at year-end it is a contingent asset.(c) Because the settlement of the claim was conveyed by a letter from the insurance company that also stated that the settlement check was in the mail for 90% of the claim, record 90% of the claim as a receivable as it is virtually certain that the contingent asset will be received.(d) Because the settlement of the claim was conveyed by a letter from the insurance company that also stated that the settlement check was in the mail for 90% of the claim, record 100% of the claim as a receivable at year-end as it is virtually certain that the contingent asset will be received, and adjust the 10% next year when the settlement check is actually received.

• Answer: (c)75


ILLUSTRATION 1 PROVISIONS AND CONTINGENCIES

• An entity entered into a ten year lease of a building. The annual rent under the lease agreement is CU36,000. The entity has decided to relocate its head office with five years still to run on the original lease. The entity is permitted to sublet the building and the believes that, although market rentals have decreased. it should be able to sublet the building for the full five years. The expected rental is CU24,000 per annum.

• A provision should be recognised for the excess costs under the lease contract above the expected benefits to be received. The obligating event was the signing of the lease agreement and CU36,000 is required to be paid in each of the remaining five years.

• A provisions for the following amount should be recognisedCU

Annual outflow 36,000Annual expected inflow 24,000Excess annual outflow expected 12,000

A provision of CU60,000( CU 12,000x 5 years ) should be recognised.Note: all other costs and the time value of money have been ignored. 76


ILLUSTRATION 2PROVISIONS AND CONTINGENCIES

• A business sells goods which carry a one-year repair warranty. If minor repairs were to be required on all goods sold in 2007, the repair cost would be CU100,000. if major repairs were needed on all goods sold at the cost would be CU500,000.

• It is estimated that 80% of goods sold in 2007 will have no defects, 15% will have minor defects and 5% will have major defects.

• The provision for repairs required at 31 December 2007 is : CU

80% of the goods will require no repairs -15% will require minor repairs 15% X CU100,000 150005% will require major repairs 5% X CU500,000 25000Best estimate of provision required 40000


(USA)

ILLUSTRATION 3PROVISIONS AND CONTINGENCIES

• An entity has received a claim for damaged goods from a customers. The entity’s legal advisors believe that it is probable that a settlement will need to be made of CU10,000 in favour of the customers. However in their opinion it is also probable that a counterclaim be the entity against their supplier for contributory negligence would successfully recover the damages.

• A provisions should be made for CU10,000 as the outflow of economic benefits is probable. The counterclaim asset is not recognised since it is only probable that it will be received . It can only be recognised when it is virtually certain to be received. It should be disclosed as a contingent asset.


(USA)

Topic Requirements of IFRS Requirements of Indian

GAAP

Governing

Literature

IAS 37 “Provisions,

Contingent Liabilities and

Contingent Assets”

AS 29 ‘‘Provisions,

Contingent Liabilities and

Contingent Assets”

Recognition

on the basis of

constructive

obligation

IAS 37 deals with

'constructive obligation' in

the context of creation of a

provision. The effect of

recognising provision on the

basis of constructive

obligation is that, in some

cases, provision will be

required to be recognised at

an early stage, e.g., in case

of a restructuring, a

In AS 29, the underlying

philosophy is that merely

On the basis of a detailed

Formal plan and

Announcement thereof, it

would not be appropriate

to recognise a provision

since a liability cannot be

considered to be

crystalised at this stage.

Further, the judgment79Compiled by Yagnesh Desai FCA, CPA

(USA)

constructive obligation arises

when an enterprise has a

detailed formal plan for the

restructuring and the

enterprise has raised a valid

expectation in those affected

that it will carry out the

restructuring by starting to

implement that plan or

announcing its main features

to those affected by it.

whether the

Management has

raised valid

Expectations in those

affected may be a

matter of considerable

argument. In view of

the above, AS 29 does

not specifically deal

with 'constructive

obligation'.

AS 29, however,

requires a provision to

be created in respect

of obligations arising

from normal business

practice, custom and a

desire to maintain 80Compiled by Yagnesh Desai FCA, CPA

(USA)

Good business

relations or act In an

Equitable manner. In

Such cases, general

criteria for recognition

Of provision are

required to be applied.

Note : It may be

Mentioned here that

the treatment

prescribed in AS 29 is

also in consonance

with the legal position

in India.


(USA)

Discounting Where the effect of time

value of money is material,

the amount of provision is

the present value of the

expenditure expected to be

required to settle the

obligation. The discount rate

is a pre-tax rate that reflects

the current market

assessment of the time

value of money and risks

specific to the liability. The

discount rate does not reflect

risk for which future cash

flow estimates have been

adjusted.

AS 29 requires that

The amount of a

provision should not

be discounted to its

present value since

Financial statements

in India are prepared

generally on historical

cost basis and not on

present value basis.

However a limited

revision is being

proposed to bring it in

line with IAS 39

insofar as this aspect

is concerned.


(USA)

Contingent

Assets

Contingent assets are

disclosed in the financial

statements where an inflow

of economic benefits is

probable.

Unlike IAS 37, as a

Measure of prudence,

AS 29 does not

require contingent

assets to be disclosed

in the financial

statements. They are

Usually disclosed as

part of the report of

the approving

authority (e.g. Board

Of Directors report).

Onerous

Contracts

If an entity has a contract

that is onerous, the present

obligation under the contract

should be recognised and

measured as a provision ( an

Same as IFRS.

However, AS 29 does

not permit discounting

the amount of provision

required in respect of83


onerous contract is a

contract in which the

Unavoidable costs of meeting

The obligations under the

Contract exceed the econo-

mic benefits expected to be

received under it. The

Unavoidable costs under a

contract reflect the least net

cost of exiting from the

contract, which is the lower

of the cost of fulfilling it and

any compensation or

penalties arising from failure

to fulfil it.)

onerous contracts.


(USA)

Changes in

Existing

Decommission

ing,

Restoration

and Similar

Liabilities

In accordance with IFRIC

1, provisions are adjusted

for changes in the

measurement of an

existing decommissioning,

restoration and similar

liability that result from

changes in the estimated

timing or amount of the

outflow of resources

Embodying economic

Benefits required to settle

the obligation, or a change

in the discount rate.

There is no guidance

on this issue.


(USA)

Thank You86


ias 37 provisions,contingen t liabilities,and contingent assets

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