Semester 1 Week 10 PP (Provisions, contingencies and post year end events)

Question 1

What types of provision are there?

Answer 1

Two types of provision:
Those that affect the value of an asset (e.g. depreciation, bad debt provisions).
Those that are stand alone provisions.

Question 2

What principles does provisions follow?

Answer 2

Provisions follow both the accruals and prudence principles.

They are liabilities of uncertain timing and uncertain amount.

Question 3

Greentree Ltd. are a chemical manufacturing company they have a 31 December year end.

On 5th October dangerous chemicals spilled into a nearby river.
Greentree is going to face a fine from the government as well as paying compensation claims to local businesses.
At the year end these amounts had not finalised.

Answer 3

Should Greentree set a trade payable?

No – not been invoiced.

Should they just ignore?

Would that give a true and fair view? .
They should create a provision.

A provision is a liability of uncertain timing or uncertain amount.
In the case of Greentree it would be an estimate of how much they expect to pay.

Question 4

Are the following obligations?
Kay Limited has the following issues:
1. Kay has an ageing vehicle fleet and plan to replace it in two years. The directors believe a provision should be put in place for this.
2. Kay is aware that one of its systems is not compliant with GDPR. They wish to create a provision in the expectation of fines.
3. Although not detailed to in the employee’s contracts, Kay has paid a Christmas bonus to its staff every year since 1971.

Answer 4

1. No – although it may make good business sense to replace this equipment, Kay is not obligated to do so by any third party.
2. No – there is not a current obligation. Kay can avoid these fines by updating its systems – it is in its control.
3. Yes – although not contractually obliged to do so, Kay’s previous actions have created a constructive obligation.

Question 5

Brae Limited has the following transactions. Would you say any of them are of uncertain timing or amount?
1. Received an invoice of £3,000 due in 30 days.
2. Two days before the year end received a material order worth £4,000. The invoice had not been received by the year end.
3. Have a rent accrual of £6,000.
4. Have a court action brought against them for an equal pay claim, Their lawyers estimate they will lose and have to pay £14,000 in compensation.

Answer 5

1. Standard invoice. Both the amount and payment terms are clear.
2. Although they might not be able to predict the exact day they will receive the invoice there is no real uncertainty over either the timing or the amount.
3. Again, they might not know exactly when they will receive the invoice but no real uncertainty.
4. Yes – uncertain the exact amount, or when the court case will settle.

Question 6

W hat is the journal entry for provision?

Answer 6

Journal entry is

Dr P/L expense
Cr SFP provision
Being creation of provision
The P&L expense would be what the “real” expense would be on the amount. For example warranty provisions would go against cost of sales.

Question 7

What sources of estimate are allowed in accounts?

Answer 7

Past experience/practice

Experts

Mathematical calculation

All these would be acceptable.

Question 8

Coulter Ltd. has had an employee injured whilst at work. An initial review by Coulter’s lawyers consider that they are at fault and will have to pay compensation of £40,000.

Prepare the journal required at Coulter’s year end.

Answer 8

Dr P/L admin expenses (compensation) 40,000
Cr Provision 40,000
Being provision for compensation

Question 9

What if there are perforable outcomes?

Answer 9

If there are several potential outcomes, two approaches can be taken:

If there is one overwhelmingly likely outcome that should be selected.
If there are a number of potential outcomes which are all possible then a weighted average approach should be taken.

Question 10

Mirfield Plc believe they have two provisions. Prepare the year end journal entry for each.

Misleading advertising:
The Advertising Standards Agency recently judged that one of Mirfield’s adverts was misleading, it appears as if a fine will be due.
The possibilities are from £0 (no fine) up to £750,000. Although Mirfield’s lawyers believe a fine of £50,000 is the most likely outcome.

Decommissioning:
One of Mirfield’s previous factories has now been shut down although the land requires to be decontaminated.
Mirfield estimate that there is a 20% chance this will cost £100,000 a 30% chance it will cost £150,000 a 35% chance it will cost £200,000 and a 15% chance it will cost £300,000.

Answer 10

Misleading advertising:
One likely outcome, therefore
Dr Admin expenses 50,000
Cr Provision for fine 50,000
Being provision for fine

Decommissioning:
A range of possible outcomes therefore a weighted average:
20% x 100,000 = 20,000
30% x 150,000 = 45,000
35% x 200,000 = 70,000
15% x 300,000 = 45,000
Weighted average = 180,000

Dr Admin expense (decommissioning) 180,000
Cr Provision for decommissioning 180,000
Being provision for decommissioning

Question 11

When do we use provisions?

Answer 11

A provision is used when a cost is actually incurred (crystallises to use the formal terminology).
Journal:
Dr Provision
Cr Bank/creditors
Being use of provision

Question 12

Wishart Plc. was involved in a legal case regarding a copyright dispute.
In line with this they created a provision of £60,000 for legal fees at the year end 31 March 20X3.
In June 20X3 the case was settled out of court. Total legal fees were £45,000.

Answer 12

Dr Provision 45,000
Cr Bank 45,000
Being payment of legal fees

Dr Provision 15,000
Cr P/L legal fees 15,000
Being write back of unused provision

Question 13

Partridge Plc. has a chemical plant in Dundee. As part of the original planning permission Partridge committed that when the plant came to the end of its useful life they would decontaminate the site and return it to its original condition.
Partridge estimate that the plant will end its useful life in 10 years when it will cost £8,000,000 to decommission. The underlying interest rate is 4%.
Prepare the journal to account for this provision.

Answer 13

Remember:
To work out the present value of something you discount it as follows

Amount/ 1+ interest rate^number of years

Required provision =

£8,000,000/1.04^10

= 5,404,513 (to nearest pound)

Dr admin expenses (decommissioning) 5,404,513
Cr decommissioning provision 5,404,513
Being creation of provision

Question 14

What guidance is advised for restructuring situations?

Answer 14

To have a provision for restructuring it has to be a “fundamental change in the business’s operations”, for example:
Tesco withdrawing from China
RBS selling its insurance arm
Standard Life removing a level of management.
The provision can only be for direct expenses of restructuring (continuing operations not allowed).
The company must have committed to the restructuring and announced it to those affected by the year end.

Question 15

What guidance is advised for Future operating losses and Onerous contracts?

Answer 15

Future operating losses:
Specifically prohibited by the standard from making a provision for future operating losses.
Onerous contracts:
An onerous contract is a contract a company is committed to but they no longer want to be in.
Can create a provision for this but only if it leads to a loss (not if it just leads to a smaller profit than anticipated).

Question 16

Onerous Contract Example:

Rochdale Ltd. has two contracts which may be onerous. Describe the appropriate treatment.
Liverpool Warehouse:
Rochdale is still committed to 12 years of a lease on a warehouse in Liverpool paying £2,300 a month. Due to a restructuring the warehouse is no longer required but they can sub-lease it at £2,500 a month.

Barley:
Rochdale has committed to buying 400 tonnes of barley per month at £105 per tonne. This was acquired for Rochdale’s whisky distilling operation.
Rochdale’s distillery was sold this year, but the contract still has a number of months to run. Rochdale has no alternative use for the barley. The open market price of Barley is £90 a tonne.

Answer 16

Liverpool Warehouse:
Although the warehouse is no longer required they make a profit from it. There is no loss therefore no need for a provision.
Barley:
As Rochdale no longer need it their only option is to sell it at a loss of £105-£90 = £15 a tonne.
A provision of 400 x £15 = £6,000 a month for each remaining month of the contract is therefore required.

Question 17

What is a contingent liability?

Answer 17

A contingent liability is either a
Possible liability
OR
A present liability where an estimate cannot be made (note this is EXTREMELY rare). It would extremely rare that an estimate cannot be made. This would mean that there was no precedent, no expert, and no calculation that could be made.
For example an employee is injured at work and breaks her leg due to a company’s negligence. Although we might not be able to provide an exact figure there is a long history of case law which would be able to.

Question 18

How are contingent liabilities treated?

Answer 18

Contingent liabilities are disclosed as notes to the accounts. There is no DR/CR entry and no impact on the statement of financial position or P&L.
No disclosure needs to be made if the possibility is considered remote.

Question 19

The directors of Jude Ltd. have approached you for advice on how the following matters should be treated:
1. Jude has guaranteed the bank borrowings of its subsidiary. The subsidiary is currently in good financial condition.
2. One of Jude’s delivery trucks crashed into a parked car. The directors estimate a payout of £15,000 will be required.
3. After watching a movie one of the directors is concerned about the impact of a satellite falling on Jude’s main building.

Answer 19

1. No provision is required as the subsidiary is in good health. Although currently in good financial health, the possibility of a payout is not remote so a contingent liability is required.
2. This would be a standard provision – there is a current obligation and an amount that be eliminated.
3. Although a possible obligation I think we can safely assume the possibility of a satellite dropping is remote!

Question 20

Which of these could be material post year end?
Purchase or sale of fixed assets
Change in exchange rates
Change in tax rates

Answer 20

Possible that all of them (or none of them) could be.
For example for a company with large foreign currency holdings, a large change in exchange rates could have a big impact.

Dividends declared post year end are always considered significant regardless of size.

Question 21

What are contingent assets?

Answer 21

A contingent asset is an asset a business is likely to receive.
Should never be recognised in P/L or statement of financial position. But may be recognised as a disclosure note if receipt is probable not just possible.