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5 Example: Transfer of economic benefits

5 Example: Transfer of economic benefits

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one specific item. However, when considering the population as a whole the probability of some transfer

of economic benefits is quite likely to be much higher. If there is a greater than 50% probability of some

transfer of economic benefits then a provision should be made for the expected amount.



2.5.1 Measurement of provisions

Important



The amount recognised as a provision should be the best estimate of the expenditure required to settle the

present obligation at the year end.

The estimates will be determined by the judgement of the entity's management supplemented by the

experience of similar transactions.

Allowance is made for uncertainty. Where the provision being measured involves a large population of

items, the obligation is estimated by weighting all possible outcomes by their discounted probabilities,

ie expected value.



Question



Warranty



Parker Co sells goods with a warranty under which customers are covered for the cost of repairs of any

manufacturing defect that becomes apparent within the first six months of purchase. The company's past

experience and future expectations indicate the following pattern of likely repairs.

% of goods sold



Defects



75

20

5



None

Minor

Major



Cost of repairs

$m



1.0

4.0



What is the expected cost of repairs?



Answer

The cost is found using 'expected values' (75% × $nil) + (20% × $1.0m) + (5% × $4.0m) = $400,000.

Where the effect of the time value of money is material, the amount of a provision should be the present

value of the expenditure required to settle the obligation. An appropriate discount rate should be used.

The discount rate should be a pre-tax rate that reflects current market assessments of the time value of

money. The discount rate(s) should not reflect risks for which future cash flow estimates have been

adjusted.



2.5.2 Future events

Future events which are reasonably expected to occur (eg new legislation, changes in technology) may

affect the amount required to settle the entity's obligation and should be taken into account.



2.5.3 Expected disposal of assets

Gains from the expected disposal of assets should not be taken into account in measuring a provision.



2.5.4 Reimbursements

Some or all of the expenditure needed to settle a provision may be expected to be recovered from a third

party. If so, the reimbursement should be recognised only when it is virtually certain that

reimbursement will be received if the entity settles the obligation.



Part B Accounting standards  5: Provisions, contingencies and events after the reporting period



143







The reimbursement should be treated as a separate asset, and the amount recognised should not

be greater than the provision itself.







The provision and the amount recognised for reimbursement may be netted off in profit or loss for

the year.



2.5.5 Changes in provisions

Provisions should be renewed at each year end and adjusted to reflect the current best estimate. If it is no

longer probable that a transfer of economic benefits will be required to settle the obligation, the provision

should be reversed.



2.5.6 Use of provisions

A provision should be used only for expenditures for which the provision was originally recognised.

Setting expenditures against a provision that was originally recognised for another purpose would conceal

the impact of two different events.



2.5.7 Future operating losses

Provisions should not be recognised for future operating losses. They do not meet the definition of a

liability and the general recognition criteria set out in the standard.



2.5.8 Onerous contracts

If an entity has a contract that is onerous, the present obligation under the contract should be recognised

and measured as a provision. An example might be vacant leasehold property.



Key term



An onerous contract is a contract entered into with another party under which the unavoidable costs of

fulfilling the terms of the contract exceed any revenues expected to be received from the goods or services

supplied or purchased directly or indirectly under the contract and where the entity would have to

compensate the other party if it did not fulfil the terms of the contract.



2.6 Examples of possible provisions

It is easier to see what IAS 37 is driving at if you look at examples of those items which are possible

provisions under this standard. Some of these we have already touched on.



144



(a)



Warranties. These are argued to be genuine provisions as on past experience it is probable, ie

more likely than not, that some claims will emerge. The provision must be estimated, however, on

the basis of the class as a whole and not on individual claims. There is a clear legal obligation in

this case.



(b)



Major repairs. In the past it has been quite popular for companies to provide for expenditure on a

major overhaul to be accrued gradually over the intervening years between overhauls. Under

IAS 37 this will no longer be possible as IAS 37 would argue that this is a mere intention to carry

out repairs, not an obligation. The entity can always sell the asset in the meantime. The only

solution is to treat major assets such as aircraft, ships, furnaces and so on as a series of smaller

assets where each part is depreciated over shorter lives. Thus, any major overhaul may be argued

to be replacement and therefore capital rather than revenue expenditure.



(c)



Self insurance. A number of companies have created a provision for self insurance based on the

expected cost of making good fire damage and so on instead of paying premiums to an insurance

company. Under IAS 37 this provision would no longer be justifiable as the entity has no obligation

until a fire or accident occurs. No obligation exists until that time.



(d)



Environmental contamination. If the company has an environment policy such that other parties

would expect the company to clean up any contamination or if the company has broken current

environmental legislation then a provision for environmental damage must be made.



5: Provisions, contingencies and events after the reporting period  Part B Accounting standards



(e)



Decommissioning or abandonment costs. When an oil company initially purchases an oilfield it is

put under a legal obligation to decommission the site at the end of its life. Prior to IAS 37 most oil

companies up the provision gradually over the field so that no one year would be unduly burdened

with the cost.

IAS 37, however, insists that a legal obligation exists on the initial expenditure on the field and

therefore a liability exists immediately. This would appear to result in a large charge to profit or

loss in the first year of operation of the field. However, the IAS takes the view that the cost of

purchasing the field in the first place is not only the cost of the field itself but also the costs of

putting it right again. Thus all the costs of abandonment may be capitalised.



(f)



Restructuring. This is considered in detail below.



2.6.1 Provisions for restructuring

One of the main purposes of IAS 37 was to target abuses of provisions for restructuring. Accordingly,

IAS 37 lays down strict criteria to determine when such a provision can be made.



Key term



IAS 37 defines a restructuring as:

A programme that is planned and is controlled by management and materially changes either:







The scope of a business undertaken by an entity, or

The manner in which that business is conducted.



The IAS gives the following examples of events that may fall under the definition of restructuring.





The sale or termination of a line of business







The closure of business locations in a country or region or the relocation of business activities

from one country region to another







Changes in management structure, for example, the elimination of a layer of management







Fundamental reorganisations that have a material effect on the nature and focus of the entity's

operations



The question is whether or not an entity has an obligation – legal or constructive – at the year end.



Important







An entity must have a detailed formal plan for the restructuring.







It must have raised a valid expectation in those affected that it will carry out the restructuring by

starting to implement that plan or announcing its main features to those affected by it.



A mere management decision is not normally sufficient. Management decisions may sometimes trigger

off recognition, but only if earlier events such as negotiations with employee representatives and other

interested parties have been concluded subject only to management approval.

Where the restructuring involves the sale of an operation then IAS 37 states that no obligation arises until

the entity has entered into a binding sale agreement. This is because until this has occurred the entity will

be able to change its mind and withdraw from the sale even if its intentions have been announced publicly.



2.6.2 Costs to be included within a restructuring provision

The IAS states that a restructuring provision should include only the direct expenditures arising from the

restructuring.







Necessarily entailed by the restructuring

Not associated with the ongoing activities of the entity



The following costs should specifically not be included within a restructuring provision.









Retraining or relocating continuing staff

Marketing

Investment in new systems and distribution networks

Part B Accounting standards  5: Provisions, contingencies and events after the reporting period



145



2.6.3 Disclosure

Disclosures for provisions fall into two parts:



Disclosure of details of the change in carrying value of a provision from the beginning to the end

of the year





Disclosure of the background to the making of the provision and the uncertainties affecting its

outcome



2.7 Contingent liabilities

FAST FORWARD



An entity should not recognise a contingent asset or liability, but they should be disclosed.

Now you understand provisions it will be easier to understand contingent assets and liabilities.



Key term



IAS 37 defines a contingent liability as:





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

entity's control, or







A present obligation that arises from past events but is not recognised because:





It is not probable that a transfer of economic benefits will be required to settle the

obligation, or







The amount of the obligation cannot be measured with sufficient reliability.



As a rule of thumb, probable means more than 50% likely. If an obligation is probable, it is not a

contingent liability – instead, a provision is needed.



2.7.1 Treatment of contingent liabilities

Contingent liabilities should not be recognised in financial statements but they should be disclosed. The

required disclosures are:











A brief description of the nature of the contingent liability

An estimate of its financial effect

An indication of the uncertainties that exist

The possibility of any reimbursement



2.8 Contingent assets

Key term



IAS 37 defines a contingent asset as:





A possible asset that arises from past events and whose existence will be confirmed by the

occurrence of one or more uncertain future events not wholly within the entity's control.



A contingent asset must not be recognised. Only when the realisation of the related economic benefits is

virtually certain should recognition take place. At that point, the asset is no longer a contingent asset!



2.8.1 Disclosure: contingent liabilities

A brief description must be provided of all material contingent liabilities unless they are likely to be

remote. In addition, provide:







146



An estimate of their financial effect

Details of any uncertainties



5: Provisions, contingencies and events after the reporting period  Part B Accounting standards



2.8.2 Disclosure: contingent assets

Contingent assets must only be disclosed in the notes if they are probable. In that case a brief description

of the contingent asset should be provided along with an estimate of its likely financial effect.



2.8.3 'Let out'

IAS 37 permits reporting entities to avoid disclosure requirements relating to provisions, contingent

liabilities and contingent assets if they would be expected to seriously prejudice the position of the entity

in dispute with other parties. However, this should only be employed in extremely rare cases. Details of

the general nature of the provision/contingencies must still be provided, together with an explanation of

why it has not been disclosed.

You must practise the questions below to get the hang of IAS 37. But first, study the flow chart, taken

from IAS 37, which is a good summary of its requirements.



Exam focus

point



If you learn this flow chart you should be able to deal with most tasks you are likely to meet on exam.



Question



Recognise or not 1?



Warren Co gives warranties at the time of sale to purchasers of its products. Under the terms of the

warranty the manufacturer undertakes to make good, by repair or replacement, manufacturing defects that

become apparent within a period of three years from the year end. Should a provision be recognised?



Answer

Warren Co cannot avoid the cost of repairing or replacing all items of product that manifest

manufacturing defects in respect of which warranties are given before the end of the reporting period, and

a provision for the cost of this should therefore be made.



Part B Accounting standards  5: Provisions, contingencies and events after the reporting period



147



Warren Co is obliged to repair or replace items that fail within the entire warranty period. Therefore, in

respect of this year's sales, the obligation provided for at the year end should be the cost of making good

items for which defects have been notified but not yet processed, plus an estimate of costs in respect of

the other items sold for which there is sufficient evidence that manufacturing defects will manifest

themselves during their remaining periods of warranty cover.



Question



Recognise or not 2?



After a wedding in 20X8 ten people died, possibly as a result of food poisoning from products sold by

Callow Co. Legal proceedings are started seeking damages from Callow but it disputes liability. Up to the

date of approval of the financial statements for the year to 31 December 20X8, Callow's lawyers advise

that it is probable that it will not be found liable. However, when Callow prepares the financial statements

for the year to 31 December 20X9 its lawyers advise that, owing to developments in the case, it is

probable that it will be found liable.

What is the required accounting treatment:

(a)

(b)



At 31 December 20X8?

At 31 December 20X9?



Answer

(a)



At 31 December 20X8

On the basis of the evidence available when the financial statements were approved, there is no

obligation as a result of past events. No provision is recognised. The matter is disclosed as a

contingent liability unless the probability of any transfer is regarded as remote.



(b)



At 31 December 20X9

On the basis of the evidence available, there is a present obligation. A transfer of economic benefits

in settlement is probable.

A provision is recognised for the best estimate of the amount needed to settle the present

obligation.



2.9 Section summary





The objective of IAS 37 is to ensure that appropriate recognition criteria and measurement bases

are applied to provisions and contingencies and that sufficient information is disclosed.







The IAS seeks to ensure that provisions are only recognised when a measurable obligation exists.

It includes detailed rules that can be used to ascertain when an obligation exists and how to

measure the obligation.







The standard attempts to eliminate the 'profit smoothing' which has gone on before it was issued.



3 Proposed amendments

FAST FORWARD



148



6/12



An Exposure Draft issued in 2005 proposed amendments to IAS 37. These were supplemented by a

further Exposure Draft in January 2010. A full replacement of IAS 37 is expected.

(a)



The standard would be re-named 'Liabilities' and be extended to include all liabilities not covered

by other standards.



(b)



The terms 'contingent liability' and 'contingent asset' would be removed, and unconditional and

conditional obligations introduced.



(c)



Expected values would be used.



5: Provisions, contingencies and events after the reporting period  Part B Accounting standards



The most obvious change is that the term 'provision' is no longer used; instead it is proposed that the

term 'liability' is used.



Key term



A liability is a liability other than a financial liability as defined in IAS 32 Financial instruments:

Presentation.



3.1 Scope and terminology

IAS 37 defines a provision as a liability of uncertain timing or amount. The ED does not use the term

provision, but proposes the use of the term 'liability' as defined above. This includes items previously

described as provisions, but also all other liabilities not covered by other Accounting Standards.



3.2 Contingent liabilities

3.2.1 IAS 37 treatment

IAS 37 defines a contingent liability as a possible obligation or a present obligation that is not

recognised. A contingent liability could be a present obligation that is not recognised either because it is

not probable that an outflow of resources will be required to settle the obligation or because the amount of

the obligation cannot be measured with sufficient reliability. The standard does not permit contingent

liabilities to be recognised but requires them to be disclosed, unless the possibility of any outflow of

economic resources in settlement of the contingent liability is remote.



3.2.2 The proposals

The ED proposes changing the treatment as follows:

(a)



The term 'contingent liability' will be eliminated.



(b)



The term 'contingency' will be used to refer to uncertainty about the amount that will be required

to settle a liability rather than uncertainty about whether a liability exists. The 2010 Exposure Draft

clarified that liabilities will be (initially and subsequently) measured at the amount an entity would

rationally pay to be relieved of the present obligation.



(c)



The ED specifies that a liability for which the settlement amount is contingent on one or more

uncertain future events is recognised independently of the probability that the uncertain future

event(s) will occur (or fail to occur).



The purpose of these amendments is twofold.

(a)



To clarify that only present obligations (rather than possible obligations) of an entity give rise to

liabilities and that liabilities arise from unconditional obligations



(b)



To require uncertainty about future events that affect the amount that will be required to settle a

liability to be reflected in the measurement of the liability



3.3 Contingent assets

3.3.1 IAS 37 treatment

IAS 37 defines a contingent asset as a possible asset. It does not permit contingent assets to be

recognised, but requires them to be disclosed if an inflow of economic benefits is probable.



3.3.2 The proposals

The ED proposes changing the treatment as follows:

(a)



The term 'contingent asset' would be eliminated.



(b)



The term 'contingency' would be used to refer to uncertainty about the amount of the future

economic benefits embodied in an asset, rather than uncertainty about whether an asset exists.

Part B Accounting standards  5: Provisions, contingencies and events after the reporting period



149



The purpose of this amendment is to clarify that only resources currently controlled by the entity as a

result of a past transaction or event (rather than possible assets) give rise to assets, and that assets arise

from unconditional rights.



3.4 Constructive obligations

3.4.1 IAS 37 treatment

IAS 37 defines a constructive obligation as an obligation that derives from an entity's actions when the

entity has (a) indicated to other parties that it will accept particular responsibilities and (b) as a result has

created a valid expectation on the part of those other parties that it will discharge those responsibilities.



3.4.2 The proposals

(a)



The definition of a constructive obligation will be amended to clarify that the actions of an entity

must result in other parties having a valid expectation that they can reasonably rely on the entity

to discharge its responsibilities.



(b)



Additional guidance will be provided to help determine whether an entity has incurred a

constructive obligation.



3.5 Probability recognition criterion

The ED proposes omitting the probability recognition criterion (currently in IAS 37) from the standard

because, in all cases, an unconditional obligation satisfies the criterion. Therefore, items that satisfy the

definition of a liability are recognised unless they cannot be measured reliably.



3.5.1 Rationale for proposed treatment

The Basis for Conclusions on the ED emphasises that the probability recognition criterion is used in the

IASB's Framework to determine whether it is probable that settlement of an item that has previously been

determined to be a liability will require an outflow of economic benefits from the entity. In other words, the

Framework requires an entity to determine whether a liability exists before considering whether that

liability should be recognised. The Basis notes that in many cases, although there may be uncertainty

about the amount and timing of the resources that will be required to settle a liability, there is little or no

uncertainty that settlement will require some outflow of resources.



3.5.2 Example: Product warranty

In the case of a product warranty, the question is not whether it is probable that the entity will be required

to repair or replace the product. Rather, the question is whether the entity's unconditional obligation to

provide warranty coverage for the duration of the warranty (ie to stand ready to honour warranty claims)

will probably result in an outflow of economic benefits.



3.6 Measurement

The obligation is measured as the amount the entity would rationally pay to settle the obligation at the

reporting date or to transfer it to a third party. This is the lower of:









The present value of the resources required to fulfil an obligation

The amount that an entity would have to pay to cancel the obligation and

The amount that the entity would have to pay to transfer the obligation to a third party



Expected values would be used, whether measuring a single obligation or a population of items.

For future services (eg decommissioning), outflows are based on contractor prices. The exception is for

onerous contracts, where the amount to be used is the amount the entity, rather than the contractor,

would pay.



150



5: Provisions, contingencies and events after the reporting period  Part B Accounting standards



3.7 Reimbursement

IAS 37 states that when expenditure required to settle a provision is expected to be reimbursed by another

party, the reimbursement should be recognised when it is virtually certain that the reimbursement will be

received. Consistently with the revised analysis of a contingent asset, the ED proposes that if an entity has

an unconditional right to receive reimbursement, that right should be recognised as an asset if it can

be measured reliably.



3.8 Onerous contracts

The ED provides additional recognition guidance relating to onerous contracts. The amount to be used is

the amount the entity, rather than the contractor, would pay.



3.9 Restructuring provisions

3.9.1 IAS 37 treatment

IAS 37 states that an entity that (a) has a detailed formal plan for restructuring and (b) has raised a valid

expectation in those affected that it will carry out the restructuring has a constructive obligation.

Therefore, it recognises a liability for the direct expenditures arising from the restructuring.



3.9.2 The proposals

The ED proposes the following changes.

(a)



The application guidance will be revised to specify that a liability for a cost associated with a

restructuring is recognised only when the definition of a liability has been satisfied for that cost.

Accordingly, a cost associated with a restructuring is recognised as a liability on the same basis as

if that cost arose independently of a restructuring.



(b)



More specific guidance will be given for costs associated with a restructuring.



3.10 Example of change from IAS 37

An entity is being sued for damages of £15 million. Legal proceedings have started, but the entity disputes

liability. The entity estimates that it has a 20 per cent chance of losing the case. Under IAS 37, the entity

would disclose a contingent liability of £15 million in the notes to the accounts. Under the new proposals,

the entity has an unconditional obligation to stand ready to pay the damages if awarded. In this case, it

would recognise a liability of £3 million.



3.10.1 Example: Present obligation

Shortly before 31 December 20X0, a patient dies in a hospital as a result of a mistake made during an

operation. The hospital is aware that a mistake occurred. In these circumstances, the hospital's past

experiences and lawyer's advice indicate that it is highly likely that the patient's relatives will start legal

proceedings and, if the matter comes to court, that the hospital will be found guilty of negligence.

At the time that the financial statements are authorised for issue in early 20X1, the hospital has not

received notice of legal proceedings against it.

Explain the accounting treatment required, in terms of recognition or otherwise and measurement.



Solution

There is a present obligation as a result of a past event, this being the operation in which negligence

occurred. Accordingly, a liability is recognised.

Measurement of the liability reflects the likelihood that the hospital will be required to pay compensation

because of the mistake, and the amount and timing of that compensation.



Part B Accounting standards  5: Provisions, contingencies and events after the reporting period



151



Chapter Roundup





IAS 10 should be familiar from your earlier studies, but it still could come up in part of a question.







Under IAS 37, a provision should be recognised:









When an entity has a present obligation, legal or constructive

It is probable that a transfer of economic benefits will be required to settle it

A reliable estimate can be made of its amount







An entity should not recognise a contingent asset or liability, but they should be disclosed.







An Exposure Draft issued in 2005 proposed amendments to IAS 37. These were supplemented by a

further Exposure Draft in January 2010. A full replacement of IAS 37 is expected.

(a)



The standard would be re-named 'Liabilities' and be extended to include all liabilities not covered

by other standards.



(b)



The terms 'contingent liability' and 'contingent asset' would be removed, and unconditional and

conditional obligations introduced.



(c)



Expected values would be used.



Quick Quiz



152



1



According to IAS 37 when, and only when, can a provision be recognised?



2



A provision can be made for future operating losses. True or false?



3



When should a contingent liability be recognised?



5: Provisions, contingencies and events after the reporting period  Part B Accounting standards



Answers to Quick Quiz

1











2



False



3



Never. However, they should be disclosed in a note to the accounts.



Present obligation

Probable transfer of economic benefits

Reliable estimate of value



Now try the question below from the Practice Question Bank



Number



Level



Marks



Time



Q8



Examination



25



49 mins



Part B Accounting standards  5: Provisions, contingencies and events after the reporting period



153



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