7. Provisions (IAS 37) (FRS 102 s21)

Question 1

What are provisions?

Why are they stated differently?

Answer 1

Provisions are liabilities of a company. Provisions are shown separately from other liabilities because the amount of a provision can be measured only by using a substantial amount of estimation.

Question 2

In relation to provisions what is the aim of IAS 37? (2)

Answer 2

IAS 37 aims to ensure that:
1) Appropriate recognition criteria and measurement bases are applied to provisions.
2. Sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature timing and amount.

Question 3

What criteria must be satisfied for a provision to be created? (2)

Answer 3

1) The business has a present obligation to incur the expenditure (e.g., a legal obligation - such as sales made with a warranty guarantee, a legal claim against the business); and
2. It is probable (i.e., more than 50% likely) that the expenditure will be incurred.

Question 4

Why is professional judgement particularly important in determining whether a provision is needed?

Answer 4

There is a significant amount of judgement required in determining whether a provision is needed and the amount to be provided.

The accountant will often seek advice from other professional, such as lawyers when considering legal claims and production managers when considering warranties.

It is also an area in which ethics must be considered, as the level of judgement and uncertainty involved may mean that there is increased scope for the manipulation of the financial statements.

The accountant must ensure that a provision is created and accounted for in such a way that the financial statements show a true and fair view.

Question 5

What is stage 1 of the accounting treatment for a provision?

Answer 5

Stage 1: Create Provision

At the point at which a provision is created, an expense is recorded in the statement of profit or loss and a corresponding liability is recorded in the statement of financial position. The journal entry to record this is:

Debit - Expenses (P/L)
Credit - Current Liabilities

Question 6

What is stage 2 of the accounting treatment for a provision?

Answer 6

Stage 2: Incur Expenditure

When the expenditure for which the provision was created is incurred, it should be charged against the provision (thereby removing the provision from current liabilities). If the expenditure is greater than the amount provided, an additional charge will be required in the statement of profit or loss. The journal entry to record the use of a provision where the expenditure exceeds the amount provided for is:

Debit - Expenses (P/L)
Debit - Current Liabilities
Credit - Cash at bank

Question 7

What is stage 3 of the accounting treatment for a provision?

(If the actual expenditure was less than the amount provided for)

Answer 7

Stage 3: Remove excess provision

If the actual expenditure was less than the amount provided for, any excess provision remaining in the statement of financial position should be released to profit or loss by recording the journal entry:

Debit - Current liabilities
Credit - Expenses (P/L)

Question 8

How does an accountant decide how much a warranty provision should be for?

Answer 8

The accountant has to apply judgement in deciding how much the warranty provision should be for.

This will be based on various factors, such as the level of returns in prior periods, industry averages, any changes in the products sold in the year and the average cost of a warranty on repair in prior years.

Question 9

What is the accounting treatment for a warranty provision?

What if any warranty claims arise?

Answer 9

When a business first sets up a warranty provision, the full amount of the provision is debited to expenses and credited to current liabilities.

If any warranty claims arise during the year, the costs incurred are charged against the warranty provision:
Debit - Provisions
Credit - Cash/payables

Question 10

How can the warranty provision be adjusted from one year to the next?

Answer 10

1. Calculate the new warranty provision required.
2. Compare it with the existing balance on the warranty provision account (i.e., the balance b/d from the previous accounting period less any costs charged against the provision in the year).
3. Calculate increase or decrease required.
   - If a higher provision is required now
   - Debit Expenses (P/L)
   - Credit Provisions (FP)
   with the amount of the increase

If a lower provision is needed now than before:
Debit Provisions (FP)
Credit Expenses (P/L)
with the amount of the decrease.