Chapter 9 - Provisions, contingencies and events after the reporting period Flashcards
What international accounting standards are we concerned with in this chapter?
- IAS37 - Provisions, Contingent Liabilities, and Contingent Assets
- IAS10 - Events after the reporting period
Briefly outline what IAS37 establishes
IAS 37 - Provisions, Contingent Liabilities, and Contingent Assets outlines the principles for recognizing, measuring, and disclosing provisions, contingent liabilities, and contingent assets in financial statements. It aims to ensure that entities provide adequate transparency about obligations and potential future events that might affect their financial position
According to IAS37, what is the definition of a provision?
A provision is a liability of uncertain timing or amount
According to IAS37, when should a provision be recognised?
- An entity has a present obligation (legal or constructive) as a result of a past event
- It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation
- A reliable estimate can be made of the amount of the obligation
How do we determine if an entity has a ‘present obligation’ when deciding if a provision is to be made?
To establish whether an entity has a present obligation which arose from a past event, identification of an ‘obligating event’ is required. An obligating event occurs where the entity has no realistic alternative to settling the obligation created by the event.
There are two types of ‘obligations’:
- Legal obligations: derive from a contract (through explicit or implicit terms), legislation or other operation of law - e.g. A warranty provided at the time of sale to undertake necessary repairs for a specified period of time.
- Constructive obligation: is an obligation that derives from an entity’s actions where an established pattern of past practice has created a valid expectation on the part of those other parties that it will discharge those responsibilities - e.g. There is likely to be a constructive obligation where failure to do something would result in unacceptable damage to an entity’s reputation or future business.
What is considered a ‘probable outflow of resources’ when deciding if a provision is to be made?
A provision is recognised only where the obligation will lead to a probable outflow of resources. Probable is defined for these purposes as more likely than not to occur. In practical terms this means that there is a greater than 50% chance that an entity will have to transfer resource to another party
What is considered a ‘reliable estimate’ when deciding if a provision is to be made?
The amount provided should be the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. This is the amount that an entity would rationally pay to settle the obligation at the end of the reporting period or to transfer it to a third party at that time.
For a single obligation the most likely outcome is considered the best estimate of the liability.
Where there is a large population of items (eg a warranty provision), the obligation is estimated by weighting all possible outcomes by their associated probabilities, to arrive at the expected value.
Where the effect of the time value of money is material, the amount of the provision should be discounted to the present value of the expenditure required to settle the obligation.
Under IAS37, how should provisions be subsequently measure?
Provisions are inherently uncertain and IAS 37 requires that they should be reviewed at the end of each reporting period and adjusted to reflect the current best estimate.
If a transfer of economic benefit is no longer probable, the provision should be reversed
What specific applications of IAS37 with regards to provisions will we consider?
- Future operating losses
- Onerous contracts
- Restructuring costs
- Decommissioning costs
Under IAS37, can we recognise provisions against future operating losses? Why?
Provisions should not be recognised for future operating losses as they do not meet the definition of a liability:
- They do not result from a past event. Instead, they reflect possible future unfavorable financial outcomes.
- There is no present obligation because the losses are expected to occur in the future, and no commitment to pay exists yet.
- The losses are uncertain and not tied to any specific obligation.
What is an ‘onerous contract’?
An onerous contract is a contract in which the unavoidable costs of fulfilling the contract exceed the economic benefits expected to be received from it - the company expects to incur a net loss by continuing with the contract.
Unavoidable costs are the lower of the cost of fulfilling the contract (which includes the costs directly related to fulfilling the contract, such as material, labor, and other expenditures necessary to complete the contract) and any compensation or penalties arising from failure to fulfil it.
Economic benefits refer to the inflows or benefits the entity expects to receive from the contract.
Under IAS37, how should we account for onerous contracts with regards to making provisions?
Under IAS 37, when a contract becomes onerous, a company is required to recognize a provision for the unavoidable losses associated with fulfilling the contract.
Once a contract is identified as onerous, the provision should be measured as the lower of:
* The cost of fulfilling the contract (e.g., costs of materials, labor, and other expenses), or
* The compensation or penalties that would arise from terminating the contract (if it is possible to exit the contract).
The provision will appear as a liability (either current or non-current depending on when this is to occur) in the SOFP and an expense in the P&L. NOTE: the provision is based on the present value of these expected losses if they extend over more than one reporting period.
The provision must be reviewed at each reporting date and adjusted if there are changes in the estimate of unavoidable costs or economic benefits. If the contract is completed or the loss is no longer expected, the provision is reversed.
What are ‘restructuring costs’?
Restructuring costs can include the costs incurred from the sale or termination of a line of business, closure of business locations, the relocation of business activities or changes in management structure
Under IAS37, how should we account for restructuring costs with regards to making provisions?
IAS 37 treats a restructuring as creating a constructive obligation (and therefore as requiring
recognition as a provision) only when an entity has:
* a detailed formal plan and:
* has raised a valid expectation in those affected that it will carry out the restructuring by starting implementation or announcing its main features (e.g. redundancy notices to the staff involved).
Where an operation is to be sold, no obligation arises for the sale until the entity is committed to the sale, ie there is a binding sale agreement.
Any provision made should include only the direct expenditures (excludes indirect costs) arising from the restructuring, which are both:
* Necessarily entailed by the restructuring
* Not associated with ongoing activities.
The provision will appear as a liability (either current or non-current depending on when this is to occur) in the SOFP and an expense in the P&L.
What are ‘decommissioning costs’?
Decommissioning costs refer to the expenses that a company is required to incur to dismantle, remove, and restore an asset and its surrounding environment after the end of the asset’s useful life. These obligations can be legal or constructive
Under IAS37, how should we account for decommissioning costs with regards to making provisions?
A decommissioning provision must only be recognized if it meets the criteria of a provision.
The decommissioning provision should be measured at the present value of the estimated future decommissioning costs - since the actual decommissioning will happen in the future, the expected future costs must be discounted to their present value using an appropriate discount rate.
The present value of the decomissioning will be debited to the non-current asset and credited as a non-current liability in the SOFP
The provision will then be adjusted to “unwind the discount” each year so that when it comes to pay the decomissioning costs, the provision will equal the decomissioning costs that were originally estimated
According to IAS37, what is the definition of a contingent liability?
A contingent liability is either:
* A possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events 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 resources embodying economic benefits will be
required to settle the obligation;
or
– The amount of the obligation cannot be measured with sufficient reliability.
Under IAS37, should contingent liabilities be recognised in the financial statements?
Contingent liabilities should not be recognised in the financial statements, but will require disclosure (unless the likelihood of payment is considered to be remote).
A contingent liability will only be recognised as a provision when the likelihood of an outflow of resources changes from possible to probable (i.e., more likely than not) and the obligation can now be reliably measured (if measurement was initially uncertain).
Outline what disclosures are required for contingent liabilities under IAS37
For each class of contingent liability:
* A brief description of its nature
* An estimate of the financial effect (measured in the same way as a provision)
* An indication of the uncertainties
* The possibility of any reimbursement
See IAS handbook
Outline the main differences between provisions and contingent liabilities
The main difference between a contingent liability and a provision lies in the likelihood of an outflow of economic resources and whether the obligation can be reliably measured.
A provision is recognized in the financial statements because it represents a present obligation with a probable outflow of resources and the amount can be reliably estimated. A contingent liability, on the other hand, is not recognized in the financial statements because it either:
* Involves an uncertain obligation or depends on the outcome of a future event, or
* Has an outflow of resources that is only possible, not probable, or
* Cannot be reliably measured.
Outline the summary of relationship between provisions and contingent liabilities
According to IAS37, what is the definition of a contingent asset?
A contingent asset is a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity
Under IAS37, should contingent assets be recognised in the financial statements?
A contingent asset must not be recognised. Where an inflow of economic benefits is probable (more likely than not) the contingent asset must be disclosed. Where the inflow of economic benefits is merely possible (or remote) no disclosures should be made.
A contingent asset will only be recognised as a receivable when the realisation of the related economic benefits is virtually certain
Briefly outline what IAS10 establishes
IAS 10 - Events After the Reporting Period establishes the accounting and disclosure requirements for events that occur after the end of the reporting period but before the financial statements are authorized for issue
What two events are defined under IAS10?
- Adjusting events
- Non-adjusting events
Define adjusting events and describe their accounting treatment under IAS10. Give some common examples of adjusting events and the adjustments required
Adjusting events are events that provide additional evidence of conditions that existed at the end of the reporting period
Under IAS10 when an adjusting event occurs, it should be reflected in the financial statements by adjusting the amounts recognized and adequate disclosures made.
Examples of adjusting events:
* The settlement of a court case outstanding at the end of the reporting period - adjust the amount of the provision for the liability (if it was initially recognized) or recognize a provision for the liability (if it wasn’t recognized before)
* Bankruptcy of a customer - adjust the amount receivable (i.e. bad debt w/off)
* Sale of inventories at below cost - adjust the carrying amount of the inventories at the reporting period’s end to reflect their net realizable value
* Receipt of valuation report indicating the impairment of PPE - adjust the carrying value of the PPE to reflect its impaired value at the end of the reporting period
Define non-adjusting events and describe their accounting treatment under IAS10. Give some common examples of non-adjusting events
Non-adjusting events are events that are indicative of conditions that arose after the reporting period.
Under IAS10 when a non-adjusting event occurs, it does not need to be reflected in the financial statements but disclosed in a note to the financial statements.
Examples of adjusting events:
* Small fire or flood, since the reporting period end, that damages assets
* A fall in the market value of investments since the reporting period end
* Plans to discontinue operations announced after the reporting period end
* Major purchases of assets since the reporting period end
* Dividends on equity shares proposed or declared after the reporting period end
NOTE: if any of these events post year end affect the companies going concern status then they will automatically become adjusting events - non-adjusting events can become
adjusting events if their severity means the going concern assumption is no longer valid.
Outline the key differences between UK GAAP and IFRS for reporting events after the reporting period
