IAS 37 (Provisions & Contingencies)

Question 1

Why is an accounting standard on provisions necessary?

Answer 1

Until the standard was developed there were various problems with provisions:

• Several items could be aggregated into one large provision that was reporting as an exceptional item
• Inadequate disclosure meant that in some cases it was difficult to ascertain the significance of the provision and any movements in the year
• Provisions were often recognised as a result of an intention to make expenditure, rather than obligation to do so. A common example was on the appointment of a new management team, they would set up large provisions for reorganisations, then years later would ‘discover’ not all those provisions were necessary, so they would write back those provisions, thus enhancing profits. So the profits under the new management would look impressive, when in reality they had been created by the release of provisions, charged in an earlier period.

Question 2

What is a provision?

Answer 2

A liability of uncertain timing or amount.

Question 3

What is a liability?

Answer 3

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 benefits.

Question 4

How should provisions be recognised?

Answer 4

1) An entity should have a present obligation (legal or constructive) as a result of past event(s).
2) A reliable estimate can be made of the obligation
3) It’s probable that an outflow of resources will be required to settle the obligation

Question 5

What are the 3 conditions of a provision, and what happens if they’re not all met?

Answer 5

If these conditions are not met, NO provision shall be recognised, and shall hit the SOPL not SOFP.

1) An entity should have a present obligation (legal or constructive) as a result of past event(s).
2) A reliable estimate can be made of the obligation
3) It’s probable that an outflow of resources will be required to settle the obligation

Question 6

What’s the 1st condition of a provision?

Answer 6

A present obligation as a result of a past event

Question 7

A provision needs to have a present obligation as a result of past events, but what can these obligations be?

Answer 7

• Legal/contractual
  Or
• Constructive; where the company establishes a valid expectation through a course of past practice, regardless of whether there is a legal requirement to perform the task or not.

Question 8

What is a constructive obligation in terms of provisions?

Answer 8

Constructive; where the company establishes a valid expectation through a course of past practice, regardless of whether there is a legal requirement to perform the task or not.

Question 9

If there is an intention to make a payment, can a provision be provided?

Answer 9

No, a payment is not enough on its own to justify a provision. There must be an actual obligation.

Question 10

What are the two obligations which either have to be present to satisfy the 1st part of the conditions for provisions?

Answer 10

1) Legal / contractual

2) Constructive

Question 11

True or false, if there is a future obligation to repair a part of a building under a lease, a provision must be provided in the accounts?

Answer 11

False. IAS 37 does not permit this approach, because there is no obligation to incur this cost at the reporting date, this is a future obligation.

Question 12

Fill in the blank. An entity has a ….. obligation (legal of constructive) as a result of a ….. event.

Answer 12

A present obligation as a result of a past event.

Question 13

A retail store has a policy of refunding purchases by dissatisfied customers, even though it is under no legal obligation to do so. It’s policy of making refunds is generally know. Should a provision be made at YE?

Answer 13

A provision is required.

• There is a constructive obligation.
• It is probably some refunds will be made.
• These can be measured using expected values.
• The policy creates a valid expectation.

Question 14

What is the 2nd condition of a provision?

Answer 14

A reliable estimate can be made.

Question 15

If a provision relates to one event, how should it be measured?

Answer 15

Using the most likely outcome.

Question 16

If a provision is made up of numerous events, how should it be measured?

Answer 16

Using the expected values.

Question 17

An entity has to rectify a serious fault. The most likely outcome after the first attempt will cost £400,000, but there is a small chance a further attempt will be necessary, increasing the total cost to £500,000. What amount of provision should be recognised?

Answer 17

£400,000. This is because the best estimate of the liability is its most likely outcome, not the worst-case scenario.

Question 18

What is the 3rd condition of a provision?

Answer 18

There is a probably outflow of economic resources.

Question 19

If there is a possible liability, should a provision be provided in the accounts?

Answer 19

No, the company should record a contingent liability instead.

Question 20

What’s the difference between a provision and contingent liability?

Answer 20

Provisions are probable, contingent liabilities are possible.

Question 21

How should contingent liabilities be disclosed at YE?

Answer 21

As a note to the accounts. No entries are made into the financial statements.

Question 22

What is the normal accounting entry for a provision?

Answer 22

Dr Profit or Loss        x
Cr Provisions (SFP)   x

This is very similar to accrued expense.
The provision is a non-current liability in the SFP.

Question 23

When accounting for provisions, if the time value of money is material, what should happen to the provision?

Answer 23

The provision should be discounted to present value.

Question 24

An entity believes it’s going to incur operating costs in the future, should a provision be provided?

Answer 24

No provisions may be made for future operating losses or repairs because they arise in the future and can be avoided and therefore no obligation exists.

Question 25

What is the accounting treatment for provision for warranties?

Answer 25

Provisions for warranties are required at the time of sale rather than the time of the repair. The provisions must be reviewed at each YE to see if the provision needs to be adjusted, possibly due to increase in costs as a result of technological advancements.

Question 26

Warranty was sold at £100 during the year. At year end a repair for £250 was required. What amount should be included as a provision within the statement of financial position?

Answer 26

£100. A provision for warranties are required at the time of sale rather than the time of repair/replacement.

Question 27

An environmental provision is required for future environmental costs. How should the cost be treated at YE?

Answer 27

The cost should be discounted to present value at a pre-tax market rate, this is to take the time value of money into consideration.

Question 28

A restructuring is a programme that is planned and controlled by management. When should provisions for restructuring be accounted for?

Answer 28

An obligation to restructure a business exists if:
- There is an approved detailed plan
- Employees affected are aware of the plan
If the obligation exists, a provision should be recognised for the direct costs of the restructuring, and not any costs of the ongoing business.

Question 29

True or false, a provision should be recognised for the direct costs of restructuring and any costs of the ongoing business.

Answer 29

False. A provision should be recognised for the direct costs of the restructuring, and NOT any costs of the ongoing business.

Question 30

How should contingent generally be recognised in the accounts?

Answer 30

Contingent assets should not generally be recognised, but if the possibility of inflows of economic benefits is probable, they should be disclosed.

Question 31

Can you think of any liabilities where the amount or timing of the liability is unknown?

Answer 31

Tax liability - at YE a company knows that it has an obligation to pay corporation tax on the profits it has made during the year. However, as the tax calculation may be quite complicated and invoiced negotiation with the tax authorities the exact amount of the tax liability is unknown.

Unsettled court cast - during the year a company may be sued. If they are guilty they have an obligation to pay damages. However, the exact amount and timing of the payment will not be known until the court case is settled in the next accounting period.

Warranties - if a company has offered a warranty to repair the goods they have sold in the future if they break down then this gives rise to an obligation. The amount of the liability is unknown at the year end as they do not yet know how many products will breakdown and the cost of the repair.

Refunds - if a company offers a no question asked refund to their customers then they will have an obligation to refund their customers. Similarly to warranties the amount of the liability is unknown at the YE as they do not yet know how many customers will request refunds.

Question 32

True or false, provisions should be recognised when there is a probable economic outflow?

Answer 32

True. Provisions are recognised when there is probable economic outflow. If the economic outflow is only possible then provisions will not be recognised but disclosed in the accounts.

Question 33

True or false, provisions can only be recognised if the exact amount of the obligation is known?

Answer 33

False. Provisions are liabilities of uncertain timing or amount so it is unlikely that the exact obligation would be known. A reliable best estimate is used where the amount is unknown.

Question 34

True or false, Directors have a choice whether to make a provision or not?

Answer 34

False. Directors do not have a choice of whether to recognise a provision or not, if an event meets the recognition criteria of a provision it must be recognised.

Question 35

True or false, future operating losses should be provided for?

Answer 35

False. IAS 37 specifically excludes future operating losses as no obligation has yet arisen.

Question 36

What is the initial double entry to recognise a provision?

Answer 36

Dr Expense (SOPL)
Cr Provisions (Liability in SOFP)

Once the provision has been established the double entry to show the expense in the statement of profit of loss and the liability in the statement of financial position is above.

Question 37

If a provision is fully settled, what would the double entry be?

Answer 37

Dr Provisions (SOFP)
Cr Bank (SOPL)

Here we’re reversing out the original Cr Provision with a Dr, and then Credited the bank as we will be paying out cash as a provision is a liability.

Question 38

What is the double entry to decrease a provision?

Answer 38

Dr Provision (SOFL)
Cr Expense (SOPL)

To decrease a provision the double entry is reversed