Chapter 30 - Provisions, Contingent Liabilities and Contingent Assets

Question 1

What standard sets out the accounting rules in relation to provisions, contingent liabilities and contingent assets?

Answer 1

IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

Question 2

How does IAS 37 define a provision?

Answer 2

A provision is defined by IAS 37 as “a liability of uncertain timing and amount”.

Question 3

In order to raise a provision, IAS 37 requires what 3 conditions are met?

Answer 3

1 - There is a present obligation from a past event.

2 - There is a probable outflow of economic resources.

3 - A reliable estimate can be made of the amount of the obligation.

Question 4

What is a legal obligation?

Answer 4

A legal obligation means that the entity must act in a certain way due to the existence of legislation or a legal requirement.

Question 5

What is a constructive obligation?

Answer 5

A constructive obligation arises because there is an expectation that the company will act in a certain way as a result of their past actions or published views.

Question 6

Explain what a contingent liability is?

Answer 6

The main difference between a provision and a contingent liability relates to the level of certainty:

• a provision involves a probable outflow but a contingent liability only involves a possible outflow.
• In accordance with IAS 37, no adjustment is made in the financial statements in relation a contingent liability but disclosure must be made in the notes to the financial statement.

Question 7

What is a contingent asset?

Answer 7

A contingent asset arises when the entity is expecting a future inflow of economic benefits and the level of certainty that the amount will be received is only probable.

Contingent assets are not recognized in the financial statements. (Relates to prudence concept).

Question 8

What is an onerous contract?

Answer 8

An onerous contract is where the unavoidable costs of meeting the contract are more than the expected benefits.

A provision is required at the lower of:

• any exit costs for the contract
• the net cost of fulfilling the contract

Question 9

What is a reimbursement?

Answer 9

When the entity can claim some of the costs under a provision from another party, this is known as a reimbursement.

Question 10

What are the rules set out in IAS 37 in relation to reimbursements?

Answer 10

• Do not recognize the reimbursement amount unless it is virtually certain to be received.
• The reimbursement is recognized as an asset separately. It is not netted off against the provision in the statement of financial position (SOFP).
• The reimbursement and the provision may be netted off against one another in the statement of profit or loss and other comprehensive income.

Question 11

When can restructuring provisions be made?

Answer 11

Restructuring provisions can only be made when:

• The entity has a detailed formal plan in place;
• Has informed the parties that will be affected by the restructuring.

Question 12

What costs can restructuring provisions include?

Answer 12

Restructuring provision costs can only include those costs:

• necessarily entailed by the restructuring; and
• not associated with the ongoing activities of the entity.

Question 13

When there are a number of possible outcomes for a single obligation, how do you determine the amount of the liability?

Answer 13

Where there are a number of possible outcomes for a single obligation, then the most likely outcome is the best estimate of the liability.

For example, if there’s a 10% chance a legal payment will be X, a 20% chance a legal payment will be Y, and a 70% chance a legal will be Z, then the company will make a provision for Z, as it is the most likely outcome,.

Question 14

A firm realises that due to a change in business environment/industry that it will be make a loss in the next period.

Can the firm make a provision for this loss?

Answer 14

IAS 37 does not permit the creation of provisions for future operating losses. A provision can only be created if certain criteria are met. One of these criteria is that there is a present obligation as a result of a past event.

There are a number of different ways that a company could avoid the forecast operating loss. No recognition or disclosure is required.

Question 15

Restructuring costs are those directly arising from the restructuring of the organisation and not with
the ongoing activity of the entity.

What costs are specifically excluded from a restructuring provision?

Answer 15

The costs specifically excluded from a restructuring provision are:

• retraining of continuing staff;
• relocation costs of continuing staff;
• marketing;
• investment in new systems and distribution networks.