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Revise lecture 16 1 • Provisions, contingent liabilities and assets (IAS 37) 2 Provisions The problem • Until the issue of IAS 37 provisions, contingent liabilities and contingent assets, there was no accounting standard covering the general topic of provisions. This led to various problems. 3 Provisions • Provisions were often recognised as a result of an intention to make expenditure, rather than an obligation to do so. • Several items could be aggregated into one large provision that was reported as an exceptional item (the ‘big bath’). • Inadequate disclosure meant that in some cases it was difficult to ascertain the significance of the provisions and any movement in the year. 4 Provisions A common example was on the appointment of a new management team to a business. • On appointment the new management would set up large provisions for re-organisations (depressing profits), saying they were needed as a result of the actions of the previous management. Such depressed profits could therefore be blamed on that previous management team. 5 Provisions • One or more years later the new management would ‘discover’ that not all those provisions were necessary. • So they would be written back (enhancing profits), probably without any disclosure. • So the profits under new management would look impressive, when in reality they had been created by the release of provisions charged in an earlier period. 6 Objective of IAS 37 The objective of IAS 37 provisions, contingent liabilities and contingent assets is to ensure that: • Appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets • Sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount 7 Provisions What is a provision? • A provision is a liability of uncertain timing or amount • A liability is 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. 8 Recognition of a provision A provision should be recognised when: 1. An entity has a present obligation (legal or constructive) as a result of a past event 2. It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation 3. A reliable estimate can be made of the amount of the obligation • If any of these conditions is not met, no provision may be recognised 9 Obligations A provision may be necessary as a result of: • A legal or • A constructive obligation 10 Obligations Legal obligations A legal obligation is an obligation that derives from: 1. A contract 2. Legislation 3. Other operation of law 11 Obligations Constructive obligation A constructive obligation is an obligation that derives from an entity’s actions where: • By an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities 12 • Measuring provisions 13 Measuring provisions The amount recognised as a provision should be: • A realistic-estimate • A prudent estimate of the expenditure needed to settle the obligation existing at the reporting date • Discounted whenever the effect of this is material 14 Methods of measuring uncertainties Methods of measuring uncertainties include: • Weighting the cost of all probable outcomes according to their probabilities (expected values) • Considering a range of possible outcomes 15 Question 1 – Expected values • An entity sells goods with a warranty covering customers for the cost of repairs of any defect that are discovered within the first 2 months after purchase. • Past experience suggests that 88% of the goods sold will have no defects, 7% will have minor defects and 5% will have major defects. If minor defects were detected in all products sold, the cost of repairs would be Rs24000, if major defects were detected in all products sold, the cost would be Rs200,000. ts16 Question 1 – Expected values Required: What amount of provision should be made? 17 Question 1 – Expected values Answer: 18 Question 2 – Best estimate An entity has to rectify a serious fault in an item of plant that it has constructed for a customer. The most likely outcome is that the repair will succeed at the first attempt at a cost of Rs400,000, but there is a significant chance that a further attempt will be necessary, increasing the total cost to RS500,000. What amount of provision should be recognised? 19 Question 2 - Answer • A provision for Rs500,000 is recognised. • This is because although the best estimate of the liability may be its most likely outcome, other possible outcomes must be considered. • The ‘significance chance’ makes Rs500,000 the best estimate. • Note that where there is a range of other possible outcomes which are either mostly higher or mostly lower than the most likely outcome, the best estimate will be a higher or lower amount. 20 • Warranty provisions 21 Warranty provisions Introduction A warranty is often given in manufacturing and retailing businesses. It is either an: 1. Express (legal) or 2. Implied (constructive) Obligation to make good or replace faulty products. 22 Warranty provisions A provision is required at the time of the sale rather than the time of the repair/replacement as the making of the sale is the past event which gives rise to an obligation. 23 Warranty provisions This requires the seller to analyse past experience so that they can estimate: • How many claims will be made. If manufacturing techniques improve, there may be fewer claims in the future than there have been in the past. • How much each repair will cost. As technology becomes more complex, each repair may cost more. 24 Warranty provisions The provision set up at the time of sale: • Is the number of repairs expected in the future times at the expected cost of each repair. • Should be reviewed at the end of each accounting period in the light of further experience. 25 • Guarantees 26 Guarantees • In some instances (particularly in groups) one company will make a guarantee to another to pay off a loan, etc. if the other company is unable to do so. • This guarantee should be provided for if it is probable that the payment will have to be made. • It may otherwise require disclosure as a contingent liability. 27 Question 3 - Guarantees During 2005, X guarantees borrowings of Y. At the time of the guarantee, Y’s financial position was good. • How should this be treated in financial statement? 28 Question 3 - Answer 1. Present obligation? • Yes. The guarantee has given rise to a legal obligation 2. Transfer of benefits probable? • No. 3. Reliable estimate? • Yes Conclusion: Do not recognise a provision as not all conditions are met. 29