IAS 37 Provisions, contingent liabilities and contingent assets Véronique Weets

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1 IAS 37 Provisions, contingent liabilities and contingent assets Véronique Weets

2 IAS 37 Provisions, contingent liabilities and contingent assets FACILITATOR VÉRONIQUE WEETS Dr. Véronique Weets is a Professor of International Accounting and a faculty member at two Belgian universities. In that role she is responsible a general IFRS course and a Financial Instruments course. At regular occasions she participates in Master Programs of UAMS, Programs of Vlerick and the Solvay Business School. Véronique Weets was also associated with the IFRS Technical desk of Deloitte in Belgium, where she was involved in client work on matters such as the transition to IFRS and the subsequent application of IFRS to listed companies. She was also responsible for client trainings as well as trainings of the professional staff. As from 2006 Véronique Weets created her own company in which she helps clients with the application of IFRS on a daily basis through trainings or consultancy. This means that she actively searches for the practical translation of this principle based framework of accounting in order to provide realistic solutions to the clients. Therefore, facilitation sessions provided by Véronique Weets always have a strong theoretical basis that is translated to practical applications that are relevant to the business environments of the delegates. In addition to this, Véronique Weets is also an author of a long list of technical accounting literature in English, French and Dutch. DISCLAIMER Whilst every effort is made to ensure that the contents of its case studies and other material handed out during or in connection with courses are accurate and up to date, we shall not be under any liability whatsoever for any inaccuracy or misleading information whether arising for negligence or otherwise and in particular we shall not be liable for any consequential damage or expense of any loss of profit or any liability to third parties incurred as a result of reliance on such inaccurate or misleading information. REFERENCES (OTHER THAN THE OFFICIAL PUBLICATIONS OF THE IASB) Deloitte, igaap 2005 IFRS Reporting in the UK, CCH KPMG, Insights into IFRS 2005/6 Edition, Thomson. PWC, Manual of Accounting IFRS for the UK 2007, CCH

3 IAS 37 Provisions, contingent liabilities and contingent assets OVERVIEW IAS 37 Provisions, contingent liabilities and contingent assets o Objective and scope o Definitions o Recognition o Measurement o Specific applications Future operating losses Onerous contracts Restructuring plans Other practical applications o IFRIC 1 Changes in existing decommissioning, restoration and similar liabilities o IFRIC 6 Liabilities arising from participating in a specific market waste electrical and electronic equipment o IFRIC 13 Customer loyalty programmes o Financial guarantee contracts o Emission rights Recent developments o ED amendments to IAS 37 o ED 2010/1 Measurement of liabilities in IAS 37

4 IAS 37 Provisions, contingent liabilities and contingent assets Véronique Weets 1 Overview IAS 37 Provisions, contingent liabilities and contingent assets Objective and scope Definitions Recognition Measurement Specific applications Future operating losses Onerous contracts Restructuring plans 2 1

5 Overview Other practical applications IFRIC 1 Changes in existing decommissioning, restoration and similar liabilities IFRIC 6 Liabilities arising from participating in a specific market waste electrical and electronic equipment IFRIC 13 Customer loyalty programmes Financial guarantee contracts Emission rights Recent developments ED Amendments to IAS 37 ED 2010/1 Measurement of liabilities in IAS 37 3 IAS 37 Provisions, contingent liabilities and contingent assets 4 2

6 Objective and scope Objective Ensure appropriate recognition criteria and measurent bases for provisions, contingent liabilities and contingent assets Ensure that sufficient information is disclosed to enable users to understand nature, timing and amount Scope Accounting for provisions, contingent liabilities and contingent assets, except those that result from Executory contracts (unless onerous) Contracts under which neither pary has performed any of its obligatins or both parties have partially performed their obligations Those dealt with in an other IFRS (IFRS 3, IAS 11, IAS 12, IAS 17, IAS 19, IFRS 4, IAS 18, IAS 32/39) 5 Definitions A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. A provision is a liability with uncertain timing and/or amount. 6 3

7 Definitions Recognize a provision when: There is a past event ( Obligating event ) that led to a present obligation There is a present obligation Legal obligation (contract, law, ) Constructive obligation entity has indicated acceptance of responsibility (e.g. by established pattern, published policies, specific statement) and as a result created valid expectation of discharge Economic outflow is probable More likely than not Reliable estimate can be made Rebuttable presumption 7 Definitions A contingent liability should be disclosed when There is a present obligation as a result of a past event: That probably requires an outflow of economic benefits, but the obligation cannot be measured That may, but will probably not, require an outflow of resources embodying economic benefits There is a possible obligation as a result of a past event, that may, but probably not, require an outflow of resources. 8 4

8 Definitions 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 occurrence of one or more uncertain future events not wholly within the control of the enterprise. Assets should be recognised when controlled, not when probable Only recognise when virtually certain Example: a reimbursement by an insurance company is recognised as an asset when receival is virtually certain No netting in balance sheet Netting in income statement is allowed 9 Measurement The provision should be measured at the best estimate of the expenditure required to settle the present obligation at the end of the reporting period 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 10 5

9 Measurement Consider Risks & uncertainties Prudence, but remain neutral and reliable Take into account in cash flows or in discount rate Legal & technological changes Time value of money if material Pre tax cash flows and pre tax discount rate Evidence provided by events that take place after the end of the reporting period Do not consider Gains from expected disposal 11 Measurement Discount rate should take into account Inflation, unless cash flows are expressed in current prices 1 R ( n ) R ( r ) 1 1 R ( i ) Unwinding of provision should be measured at nominal rate and included as borrowing cost Risks and uncertainties concerning amount, unless reflected in cash flows Tax effect Government bond rates are risk free and usually pre tax 12 6

10 Measurement Inability to estimate is rare Review & adjust for current best estimate Reverse when outflow is not longer probable Effect of expected reimbursement (e.g. insurance): Recognize only when virtually certain to be received Amount should not exceed provision amount Recognize reimbursement as separate asset May present provision expense net of reimbursement in the income statement 13 Specific applications Operating losses Do not recognize provisions for future operating losses Expected operating losses may indicate impairment i Test assets for impairment under IAS 36 Recognize onerous contract obligations as a provision An onerous contract is a contract where the unavoidable costs exceed the expected benefits to be received Specific assets might ihbe dedicated di dto a particular contract, in which case, before a separate provision for an onerous contract can be made, it is necessary to recognise any impairment loss for those assets in accordance with the rules set out in IAS

11 Special applications Restructuring plan Program planned & controlled by management that materially changes either: Scope of business Manner of conducting business Recognize provision when the recognition criteria are met 15 Specific applications Recognition of restructuring provision requires detailed formal plan including: Business or part involved Principal locations affected Location, function, # employees who will be compensated for termination Expenditures that will be undertaken When implemented AND

12 Specific applications A valid expectation to carry out this plan Announcement of main features Start of implementation Binding sale agreement when restructuring involves sale of an operation 17 Specific applications Restructuring costs: Include direct expenditures, which are both: Required as part of restructuring, & Not ongoing activities Do not include: Retraining or relocating continuing staff Marketing Investment in new systems & distribution networks Examples Remuneration of employees engaged in dismantling plant and disposing of surplus stocks Costs of making employees redundant Costs or terminating leases and other contracts, the termination of which results directly from the reorganisation 18 9

13 Contingent liabilities Possible obligation only confirmed by future events not within entity s control; or Present obligation not recognized because: Economic outflow is not probable; or Amount cannot be reliably measured Disclose unless possibility of outflow is remote 19 Contingent assets Possible assets: Due to past events Will be confirmed by future events not within entity s control Disclose when economic benefit inflow is probable 20 10

14 Other practical applications 21 IFRIC 1 Changes in existing decommissioning, restoration and similar liabilities 22 11

15 Special topics: Changes in ARO (IFRIC 1) IAS 37 requires the amount recognized as a provision to be the best estimate of the expenditure required to settle the obligation at the B/S date. Changes in this estimate are due to: Revision of estimated cash flows (e.g. estimated costs of decommissioning a power plant) Revisions to the current market based discount rate Increase in the liability that reflect the passage of time also referred to as the unwinding of the discount 23 Special topics: Changes in ARO (IFRIC 1) Changes in the estimated decommissioning costs and changes in discount rates: For entities ii using the cost model, dlchanges are capitalized as part of the cost of the item and depreciated prospectively over the remaining life Under the FV model, a change in the liability is not capitalized but alters the revaluation surplus or deficit on the item (change in surplus is adjusted to equity; change in deficit is recognized in net income) An increase in the liability that reflects the passage of time (accretion) also referred to as the unwinding of the discount is recognized in profit or loss as a finance cost as it occurs 24 12

16 IFRIC 6 Liabilities arising from participating in a specific market Waste electrical and electronic equipment 25 Background EU Directive on Waste Electrical and Electronic Equipment (WE&EE) : Historical waste (products sold < 13 August 2005) New waste (products sold > 13 August 2005) Waste from private households Waste from sources other than private households Cost of waste management for historical household equipment to be borne by producers that are in the market at the measurement period 26 13

17 Scope Recognition of liabilities in the financial statements of producers of electrical and electronic equipment for sales of historical lhousehold h equipment Outside scope : Measurement of such liabilities: IAS 37 New equipment (household and other) Historical equipment from sources other than households 27 Issue and consensus Issue: What is the obligating event? Manufacturing or sale of HHE? Participating i in the market ktduring measurement period? Incurrence of cost for waste management activities? Consensus : Participating in the market during measurement period Consequence : No obligation unless and until market share in measurement period Timing obligating event >< timing waste management / cost 28 14

18 IFRIC 13 Customer loyalty programmes 29 Scope and transitional provisions IFRIC 13 applies to customer loyalty award credits that An entity grants as part of a sales transaction; and Subject to meeting any further qualifying conditions, the customers can redeem in the future for free or discounted goods or services Entities shall apply the interpretation for annual periods beginning gon or after 1/7/2008 No transitional provisions 30 15

19 Accounting treatment Award credits supplied in the context of a customer loyalty programme should be accounted for as a separately identifiable component of the sales transaction in which they are granted (IAS 18.13). This requires: Allocation of some of the consideration received or receivable to the award credits and Deferral of the recognition of revenue until the award credits are redeemed 31 Measurement Allocation of the consideration to the award credits by reference to their fair value, i.e.: Based on the relative fair values of each component of the sale, or Equal to their fair value. Allocation by reference to the cost of the award credits is prohibited! 32 16

20 Practical application French construction and media company Bouygues adopts early IFRIC 13 "Customer loyalty programmes" and derecognizes a 166 million liability relating to its telecoms activities. Bouygues discloses that the effects of early adoption of IFRIC 13 are derecognition of a 166 million opening customer loyalty programme provision for After consequent adjustment to deferred tax, this results in a 109 million increase in opening equity in the comparative figures. There is no impact on revenue. The company tells us that it previously applied French GAAP and that the change results from the fair valuation of fidelity points awarded to the general public in its telecoms business. This is the first instance we have seen of early adoption of IFRIC 13 and shows that the new Interpretation can have a significant impact on provisions. The Interpretation is currently in process of approval by the European Union. 33 Financial guarantee contracts 34 17

21 Background Financial guarantee contracts contracts that require the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument 2005 Amendment to IAS 39 and IFRS 4 These contracts are within the scope of IAS 39, but if the issuer previously asserted explicitly hat it regards such contracts as insurance contracts, the issuer may elect to apply either IAS 39 or IFRS Treatment under IAS 39 Initial measurement at fair value Subsequent measurement At the higher of The amount determined in accordance with IAS 37 and The amount initially recognized less, when appropriate amortization recognized in accordance with IAS 18 If a credit guarantee meets neither the definition of a financialguaranteecontract contract in IAS39nor thedefinition of an insurance contract in IFRS 4, the issuer applies IAS 39, because such a contract is a derivative Example: a contract that requires payments if the credit rating of a debtor falls below a particular level 36 18

22 IFRIC 3 Emission rights (withdrawn) 37 IFRIC 3 Emission rights (withdrawn) Entities have three options Limit its emissions to its cap Reduce its emissions to below its cap and sell (or carry forward) the allowances that it does not require Produce emissions in excess of its cap, in which case it must buy additional allowances for the excess of its cap, in which case it must buy additional allowances for the excess emissions and/or incur a penalty

23 IFRIC 3 Emission rights (withdrawn) A cap and trade scheme gives rise to: An asset for allowances held Allowances, whether issued by government or purchased, are intangible assets Allowances that are issued for less than fair value shall be measured initially at their fair value! A government grant When allowances are issued for less than fair value, the difference between the amount paid and fair value is a government grant A liability for the obligation to deliver allowances equal to emissions that have been made. Measured at the best estimate: usually present market price 39 IFRIC 3 Emission rights (withdrawn) EC decided not to endorse (May 2005) Intangible measured at fair value through profit and loss? Apply hedge accounting model? Mismatch measurement and presentation IASB decided to withdraw (June 2005) and to have project on government grants including emission rights Currently: «Reconsideration of IFRIC 3 has been deferred pendingtheconclusion of work on other relevant projects» 40 20

24 CBN Boekhoudkundige verwerking van broeikasgasemissierechten/ Traitement comptable des quotas d émission de gaz à effet de serre 41 Gross method Recognise emission rights as intangible assets Measure at purchase price if purchased in market Measure at fair value if received at cost lower than fair value Difference in other income Can be deferred until emission Recognise a liability for the emission Measure at initial cost of the rights for rights held by the entity Measure at fair value on balance sheet date for rights to purchase 42 21

25 Net method Calculate at balance sheet date Number of rights needed Number of rights held Recognise difference as asset/liability Measured at fair value on balance sheet date though profit and loss statement 43 Recent Developments 44 22

26 ED Amendments to IAS ED Amendments to IAS 37 Scope Apply to all liabilities not within scope of another standard Except executory contracts, unless onerous Eliminate contingent liabilities Currently describes two different ideas Unrecognized present obligation Possible obligation (business risk) 46 23

27 ED Amendments to IAS 37 Present obligations are liabilities Non recognition inconsistent with Framework and other standards Business risks are not liabilities Recognition inconsistent with Framework 47 ED Amendments to IAS 37 Lawsuits Claim against company <> obligation Claim may be evidence that an obligation exists More guidance on identifying liabilities Distinguishing business risks from liabilities Need for evidence to support judgment that present obligation exists More guidance on measurement Expected value calculations 48 24

28 ED 2010/1 Measurement of liabilities in IAS ED 2010/1 Main provisions Account for uncertainty about the amount and timing of outflows by using the probability weighted average of the outflows for the range of possible outcomes. Elimination of probability criterion Measured at the amount that the entity would rationally pay at the measurement date to be relieved of the liability. estimate of the present value of the resources required to fulfill the liability based on expected outflows of resources, the time value of money, and the risk that the actual outflows might ultimately differ from the expected outflows

ED 2010/1 Main provisions Liability to pay cash to a counterparty

plus any associated costs, such as legal fees.

plant) at a future date amounts that the entity estimates it

29 ED 2010/1 Main provisions Liability to pay cash to a counterparty (for example to settle a legal dispute) expected cash payments plus any associated costs, such as legal fees. Liability is to undertake a service (for example, to decommission plant) at a future date amounts that the entity estimates it would pay a contractor at the future date to undertake the service on its behalf

30 Disclaimer Cethys takes every care in preparing course material to ensure that the content is accurate and up to date. This course material does not provide an exhaustive presentation of treatment of topics presented in accordance with IFRS. As such, when evaluating the underlying accounting treatment, the original IFRS Standards and Interpretations should be consulted, and an advice of a qualified IFRS expert should be obtained when deemed necessary. No responsibility for loss occasioned to any person acting or refraining from acting as a result of such material can be accepted by Cethys or Véronique Weets

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