Chapter 17. Provisions, Contingencies & Events after the Reporting Period

Transcription

1 Provisions, Contingencies and Events after the Reporting Period Reference: Contents: IAS 37 Provisions, Contingent Liabilities and Contingent Assets IAS 10 Events After the Reporting Period IFRIC 1 Changes in Decommissioning, Restoration and Similar Liabilities Page 1. Introduction Definitions (provided in IAS 37) Liabilities, provisions and contingent liabilities 3.1 Recognition: liabilities and provisions Present obligations Past events Example 1: obligating events Example 2: obligating events Probable outflow of future economic benefits Reliable estimate 3.2 Recognition: contingent liabilities 3.3 Measurement: liabilities, provisions and contingent liabilities Best estimates and expected values Example 3: best estimate using expected values Risks and uncertainties Future cash flows and discounting Example 4: discounting liabilities to present values; journals Example 5: calculating present (discounted) values and related journals Future events Example 6: future events Gains on disposals of assets Example 7: gains on disposals of assets Reimbursements Example 8: reimbursements Example 9: reimbursements Changes in provisions Example 10: change in a decommissioning provision Reduction of provisions 3.4 Other specific issues Contracts Example 11: onerous contracts Restructuring provisions Example 12: restructuring costs 4. Assets: contingent assets 4.1 Recognition 4.2 Measurement 5. Disclosure: provisions, contingent liabilities and contingent assets 5.1 Provisions Example 13: disclosure: decommissioning provision (change in estimate) 5.2 Contingent liabilities 5.3 Contingent assets 5.4 Exemptions from disclosure requirements

2 Contents continued Page 6. Events after the reporting period 6.1 Overview 6.2 Adjusting events after the reporting period Example 14: event after the reporting period 6.3 Non-adjusting events after the reporting period Example 15: event after the reporting period 6.4 Dividends 6.5 Exceptions: no longer a going concern Example 16: events after the reporting period - various Disclosure: events after the reporting period Summary

3 1. Introduction This chapter covers two standards: IAS 37 and IAS 10. The standard, IAS 37, covers certain types of liabilities and assets whereas IAS 10 deals with events that occur after the reporting period but before the financial statements are authorised for issue. In IAS 37, the focus is on liabilities and assets that are subject to some type of uncertainty. Both liabilities and assets are defined in the Framework and it would be beneficial for you to refresh your memory of these two definitions before continuing. The discussion of the standard on provisions and contingencies (IAS 37) will be covered in three separate stages: first we will investigate the recognition of liabilities; then the recognition of assets and then the disclosure of liabilities and assets. It is important that you get to know the definitions used in IAS Definitions (provided in IAS 37) Provision: A liability of uncertain timing or amount. Liability (framework) a present obligation (legal or constructive); of the entity; as a result of a past event; the settlement of which is expected to result in an outflow of future economic benefits. Obligating event: An event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation. Legal obligation: An obligation that derives from a contract (through its explicit or implicit terms); legislation; or other operation of law. Constructive obligation: 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, AND as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities. Contingent liability: There are two types of contingent liabilities defined (slightly modified wording). A possible obligation from past events; whose existence will be confirmed only by the: occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity (e.g. a possible negative court ruling) OR A present obligation from past events that is not recognised because (the recognition criteria are not met): it is not probable that an outflow of economic benefits will be needed to settle the obligation; or the amount of the obligation cannot be measured with sufficient reliability. 542

4 Contingent asset: A possible asset 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 control of the entity (e.g. a possible positive court ruling). Onerous contract: (slightly modified wording) A contract where: the unavoidable costs of meeting the terms of the contract exceed the benefits to be derived from the contract. Restructuring: a programme that is planned and controlled by management and materially changes either: the scope of the business undertaken by the entity; or the manner in which the business is conducted. 3. Liabilities, provisions and contingent liabilities (IAS &.36.52) 3.1 Recognition: liabilities and provisions (IAS ) A provision is simply a liability where either (or both) the amount or the timing is uncertain. Provisions and liabilities are both recognised in the statement of financial position but are disclosed separately from one another. It needs to be remembered that before an element may be recognised (provided for), both the definition of the element and the recognition criteria need to be met. Whereas contingent liabilities are never recognised, pure liabilities and provisions are recognised if they: meet the definition of a liability; and meet the recognition criteria: a reliable estimate of the liability must be possible; and the outflow of future economic benefits must be probable. The most fundamental part of the definition is that there must be an obligation. Deciding whether or not there actually is an obligation is frequently difficult, and is an exercise that requires much professional judgement. There is a thin line separating pure liabilities, provisions and contingent liabilities Present obligations (IAS ) In very rare instances, it may be difficult to determine if there is a present obligation or even if there is a past event. In these instances, the entity must decide if it is: more likely that a present obligation did exist at year-end, in which case a provision is recognised; or more likely that a present obligation did not exist at year-end, in which case a contingent liability is disclosed (unless the possible outflow of future economic benefits is remote). In making this decision, the entity uses its professional judgement, other expert opinions (e.g. legal opinion) and events after the reporting period. An example of such a situation is when a court case is in progress at year-end, where there is no indication as to whether an entity has an obligation or even whether the deed that the entity is being accused of actually occurred (i.e. whether there is a past event at all). 543

5 3.1.2 Past events (IAS ) For an event to lead to a present obligation there must be an obligating event. An obligating event is one that leaves the entity with no realistic alternative but to settle the liability. There are two types of obligations possible: a legal obligation, and a constructive obligation. The past event must: exist independent of the entity s future actions. This is known as the walk-away test, i.e. if the company closed down today, would the obligation still exist? always includes another party (the third party) besides the entity. The standard does, however, state that the this other party does not need to be known, i.e. it could be the public at large. This means that a decision made at a board meeting would not lead to a present obligation because this event does not involve a third party and is not separate from the entity s future actions (its future actions could be changed if the board later decides to change its mind). Example 1: obligating events Consider the following issues that were discussed during a directors meeting on 24 December 20X3: A: A decision was made by the directors to pay a bonus to an employee. B: A decision was made by the directors to purchase a new machine in 3 years time. C: Legislation recently passed means that one of the plants has to be dismantled in a years time. D: Future losses are expected from a branch in Botswana. Explain whether or not any of the above result in present obligations as at 31 December 20X3. Solution to example 1: obligating events A and B: The entity is neither legally nor constructively obligated to: pay the bonus (A); or purchase the asset (B). Both these future payments may still be avoided by the future actions of the entity, and therefore do not meet the definition of an obligating event. These decisions may currently still be revoked. Only if these decisions are communicated to the relevant third parties in such a way that there is no realistic alternative but to make these payments, would an obligation arise. C: The new legislation means that future costs to dismantle a plant are unavoidable. This therefore represents an obligating event at year-end. D: The future losses expected from the branch in Botswana is not an obligation at year-end because they are also avoidable (the branch could be sold or shut-down before any losses are incurred). The expected losses may, however, indicate that certain assets may need to be tested for impairment (see the chapter on impairment of assets for more information in this regard). IAS states that provisions shall not be recognised for future operating losses. Example 2: obligating events Damij Ltd owned a road tanker that overturned in December 20X3 during a bad rain storm. The tanker spilled its contents, thus contaminating a local river. Damij Ltd has never before contaminated a river. Damij Ltd has no legal obligation to clean the river, has no published policies as to its views on the rehabilitation of the environment and has not made any public statement that it will clean the river. It intends to clean-up the river and has been able to calculate a reliable estimate of the cost thereof. Explain whether or not Damij Ltd should recognise a liability or a provision in its statement of financial position as at 31 December 20X3. 544

6 Solution to example 2: obligating events The event is the accident, and since it happened before year-end it is a past event. There is, however, no present obligation since: there is no law that requires the company to rehabilitate the river, and there is no constructive obligation to rehabilitate the river since neither: - a public statement has been made and nor - is there an established pattern of past practice since this was its first such accident. Although Damij Ltd intends to clean-up the river and even has a reliable estimate of the costs thereof, no liability or provision should be recognised because an obligating event is one that results in the entity having no realistic alternative but to settle the obligation: Damij Ltd can still change its intention Probable outflow of future economic benefits (IAS ) In deciding whether an outflow of future economic benefits is probable, one must be sure that the outflow is more likely to occur than not to occur, in which case a provision should be recognised. If it is more likely that the outflow will not occur, then a contingent liability should be disclosed (unless the possible outflow is remote) Reliable estimate (IAS ) It should be remembered that uncertainty and estimates are a normal part of the recognition and measurement process. Although a provision is a liability of uncertain amount, this does not mean that the liability cannot be reliably measured. If the estimated amount of an obligation involves a normal degree of uncertainty, and it is possible to make a reliable estimate thereof, it is recognised as a pure liability. For example, the telephone bill payable at year-end must be estimated if the actual invoice has not yet been received. This level of uncertainty is not material enough to classify the obligation as a provision and therefore it is recognised as a pure liability. If the estimated amount of an obligation involves a larger degree of uncertainty than normal, but yet a reliable estimate is still possible, the liability is still recognised but is termed a provision. Provisions should be disclosed separately from pure liabilities. A typical example of a provision is the estimated amount of damages payable pursuant to a court case where the court case has already ruled against the entity but has yet to establish an amount. If an amount is so uncertain that the estimate is not reliable, then the you have a contingent liability. You could not recognise it as a liability since one of the recognition criteria being able to reliably measure an amount is not met. A typical example of a contingent liability would be where the entity is being sued but it is either not yet possible to estimate whether the courts will probably rule against the entity (i.e. the outflow of future economic benefits is not yet probable) or it is not yet possible to estimate the amount that the courts will force the entity to pay (i.e. a reliable estimate is not yet possible). 3.2 Recognition: contingent liabilities (IAS ) Contingent liabilities are never recognised as liabilities, meaning that the contingent liability will never be journalised. Contingent liabilities are, however, disclosed in the notes to the financial statements where it is considered relevant to the user. There are two different types of contingent liabilities: one that is a liability that may not be recognised because one or both of the recognition criteria are not met (let s call this type 1); and the other that is almost a liability, but falls short of the definition in that there is only a possible obligation, (as opposed to a present obligation) (let s call this type 2). In this latter type, the existence of the obligation will only be confirmed by the occurrence of some future event/s that is not wholly within the control of the entity. 545

7 Therefore, only the first type of contingent liability is technically a liability because it meets the definition, but in the case of both types, no liability is recognised although disclosure thereof may be required. 3.3 Measurement: liabilities, provisions and contingent liabilities (IAS ) As with the recognition of all types of liabilities, there is judgement involved in the measurement thereof. The same principles are used whether measuring liabilities, provisions or contingent liabilities. Although a contingent liability is not recognised, it should be measured and disclosed where it is material and a reliable estimate is possible. Provisions should be measured at the best estimate of the expenditure required to settle the present obligation at the end of the reporting period (i.e. the amount that the entity would rationally pay to settle the obligation or transfer it to a third party at the end of the reporting period). A number of factors need to be carefully considered when measuring provisions and contingent liabilities: best estimates and expected values; risks and uncertainties; future cash flows and discounting to present values (if effects of discounting are considered to be material); future events; gains on disposals of assets; reimbursements; changes in provisions; and reduction in provisions Best estimates and expected values (IAS ) The best estimate of the amount of an obligation is the amount that an entity would rationally pay to settle the liability. It is frequently difficult to determine the amount of the obligation or the timing of the settlement of the obligation. When making these estimates, management should consider: previous experience; similar transactions; possibly expert advice; and events after the reporting period. Previous experience may indicate a range of possible outcomes, for which it may be possible to estimate a probability. This is referred to as the calculation of expected values using the theory of probabilities. The application of this theory is best explained by way of example. Example 3: best estimate using expected values A company offers goods for sale with a 6-month warranty, where goods sold that are found to be faulty within 6 months after purchase may be returned for a full refund. Not all goods will be faulty and similarly, not all customers bother to return faulty goods. The company s past experience suggests that the following are the possible outcomes and the probability thereof: Outcomes Probability Estimated cost Goods will not be returned 70% 0 Goods will be returned 30% % Calculate the expected cost of the provision and journalise it. 546

8 Solution to example 3: best estimate using expected values The provision, measured as the expected value of the future cost of fulfilling the warranty obligation, is calculated as follows: expected value = 70% x C0 + 30% x C = C Debit Credit Warranty costs (E) Provision for warranty costs (L) Provision for warranty costs Risks and uncertainties (IAS ) When determining the best estimate of a provision, the risks and uncertainties surrounding the events and circumstances must be taken into account. This may be done by using judgement, or by use of risk adjustments to either: the amounts of the provision; or the discount rate used (if the provision is present valued). One must be careful not to duplicate a risk adjustment and thereby overstate liabilities or understate assets Future cash flows and discounting (IAS ) The possibility that the settlement of an obligation may occur far into the future has an effect on the value of the obligation in current day terms. The effect that the passage of time has on the value of money is often referred to as the time value of money. Imagine being asked whether you would prefer to receive C100 today or C100 in 10 year s time. For many reasons, (including the fact that you could utilise the C100 immediately), you would choose to receive it immediately. This is because the value of C100 received in the future is less to you than the value of C100 received today. In other words, today s value (the present value) of a future cash flow is less than the actual (absolute/ future) amount of the cash flow. This is essentially the present value effect or the effect of the time value of money. If the difference between the actual (future) amount of the cash flow and the present value thereof is material, then the liability should be recorded at its present value. The present value is calculated using a pre-tax discount rate based on the current market assessment of the time value of money and the risks specific to the liability. As the period between the present and the date of the future cash flow gets shorter, so the difference between the present value and the actual (future) value of the cash flow gets smaller. Therefore, each year the present value of the future outflow must be recalculated with the result that the provision (the present value) will gradually be increased until the actual settlement date is reached, when the provision will finally equal the actual liability. When the settlement is due, the actual amount due and the present value thereof must logically be equal. The increase in the liability each year will be debited to finance charges (notional). Example 4: discounting liabilities to present values and the related journals At the beginning of year 1, an event occurs that results in an obligation to pay C at the end of year 3. The present values of this amount have been calculated as follows: C At the beginning of year 1: At the end of year 1: At the end of year 2: At the end of year 3: Show the related journal entries for each of the three years. 547

9 Solution to example 4: discounting liabilities to present values and the related journals Debit Credit Year 1 beginning Expense/ Asset Liability Initial recognition of the obligation: beginning of year 1 Year 1 end Finance charges (E) Liability Increase in liability as a result of time value of money: Year 2 end Finance charges (E) Liability Increase in liability as a result of time value of money: Year 3 end Finance charges (E) Liability Increase in liability as a result of time value of money: Liability Bank Payment of liability at the end of year 3 Example 5: calculating the present (discounted) values and the related journals A factory plant is bought on 1 January 20X1 for C cash including costs of installation. The entity is obliged to decommission the plant after a period of 3 years. Future decommissioning costs are expected to be C The company uses a discount rate of 10%. Draw up a present value table showing the present value of the future costs on January 20X1 and at the end of each year together with the annual movements. First calculate the present value/ discount factors (or use a financial calculator). Journalise all related entries. Solution to example 5: calculating the present (discounted) values and the journals Present value table: Date Discount factor (rounded): 10% Calculation of liability balance (present value) Liability balance Finance charges Calculation of finance charges: can be calculated either way Liability Movement in balance x 10% liability balance 1 Jan X x Dec X x x 10% Dec X x x 10% Dec X x x 10% Total

10 Number of years until the cash settlement Calculation of discount factor Discount factor (rounded): 10% 0 years (i.e. it s due) Actual = year 1/(1+10%) years 0.909/(1+10%) years 0.826/(1+10%) Notice that as it gets closer to the date on which the is to be paid, the discount factor increases. The gradual increase in the discount factor over the passage of time is referred to as the unwinding of discount. This causes the liability to gradually increase from its original present value of to on 31 December 20X3. The increase in the liability results in the recognition of finance charges each year. Notice that the total finance charges of when added to the present value of the liability of (on date of initial recognition) is , the future value (actual amount paid). Debit Credit 1 January 20X1 Plant: cost (A) Bank Purchase of plant for cash Plant (decommissioning) (A) Decommissioning liability Initial recognition of the decommissioning obligation 31 December 20X1 Finance charges (E) Decommissioning liability Increase in liability as a result of unwinding of the discount Depreciation (E) Plant: accumulated depreciation Depreciation of plant ( ) / 3 years 31 December 20X2 Finance charges (E) Decommissioning liability Increase in liability as a result of unwinding of the discount Depreciation (E) Plant: accumulated depreciation Depreciation of plant ( ) / 3 years 31 December 20X3 Finance charges (E) Decommissioning liability Increase in liability as a result of unwinding of the discount Depreciation (E) Accumulated depreciation Depreciation of plant ( ) / 3 years Decommissioning liability Bank Payment in respect of decommissioning Please notice that a total of is expensed over the 3 years: depreciation of ( for 3 years) and the finance charges of This is the total cost of using and decommissioning the asset: (cost of asset excluding cost of decommissioning) and (cost of decommissioning). Also notice how the cost (present value) of the decommissioning of the plant is debited to the plant s cost account (IAS 16.16). 549

11 3.3.4 Future events (IAS ) When calculating the amount of the liability or provision, expected future events should be taken into account when there is sufficient objective evidence available suggesting that the future event will occur. An example would be possible new legislation that is virtually certain to be enacted that may lead to a provision for environmental restoration (clean-up). Example 6: future events A company owns a number of nuclear plants. The company is presently obliged to dismantle one of these nuclear plants in 3 years time. The last nuclear plant dismantled by the company cost C to dismantle, but the company expects to dismantle this nuclear plant, if using the same technology, at a slightly reduced cost of C due to the increased experience. There is, however, a chance that completely new technology may be available at the time of dismantling, which could lead to a further C cost saving. Discuss the measurement of the provision. Solution to example 6: future events A provision should reflect expected future events where there is sufficient objective evidence that these will occur. Since the company has had experience in dismantling plants, it is argued that the expected cost savings through this experience is reasonably expected to occur. The cost savings expected as a result of the possible introduction of completely new technology, being outside of the control of the company, should not be taken into account, unless of course the company has sufficient objective evidence that this technology will be available. The provision should be measured at C Gains on disposals of assets (IAS ) When an obligation involves the sale of an entity s assets (e.g. during the restructuring of a business) and the sale thereof is expected to result in a gain, this gain should not be included in the calculation of the provision since this would reduce the provision, which would not be considered prudent. Example 7: gains on disposals of assets New legislation means that Undoo Ltd must dismantle its nuclear plant in a year s time. The dismantling is estimated to cost C but Undoo Ltd also expects to earn income from the sale of scrap metal of C The effects of discounting are expected to be immaterial. Process the required journal entry to raise the provision Solution to example 7: gains on disposals of assets Debit Credit Nuclear plant (A) Provision for dismantling costs Expected costs of dismantling (i.e. the C expected income is not offset against the expected costs) 550

12 3.3.6 Reimbursements (IAS ) Reimbursements occur when, for example, a retailer offers a guarantee to its customer, but where the manufacturer in turn offers the retailer a counter-guarantee. Expected reimbursements from the manufacturer (or other supplier) should: be disclosed as a separate asset; only be recognised if it is virtually certain that the reimbursement will be received; be measured at not more than the amount of the related provision. In the instance where the retailer does not offer a guarantee for faulty goods, but the manufacturer does, faulty goods would be returned to the retailer who would then send the goods back to the manufacturer who would then replace the goods. In this case, the retailer should not make a provision for any guarantee since no guarantee was offered by the retailer: the retailer has no obligation, but is merely acting as a conduit between the customer and manufacturer. However, a retailer may offer its customers a guarantee that is either partially or fully covered by the manufacturer. In this case, since the retailer offers the guarantee, the retailer should make a provision for the total expected costs of fulfilling the guarantee despite the fact that the retailer may then return the goods to the manufacturer for a full or partial refund (reimbursement of costs). This reimbursement should be recognised as a separate asset and should not be set off against the provision for the total expected costs of fulfilling the guarantee since the actual sequence of events would then be obscured to the user of the financial statements. Although the resultant asset and liability should not be set off against each other, the income and expense may be. Example 8: reimbursements A retailer company sells goods to its customers that are guaranteed. State whether the retailer must raise a provision for the cost of meeting future guarantee obligations: A. The retailer company provides the guarantee. B. The manufacturer provides the guarantee. The retailer is not liable in any way. C. The manufacturer provides the guarantee but the retailer company provides a guarantee irrespective of whether the manufacturer honours his guarantee. D. The manufacturer and retailer company provide a joint guarantee, whereby they share the costs of providing the guarantee: they jointly and severally accept responsibility for the guarantee. E. The manufacturer and retailer company provide a joint guarantee, whereby they share the costs of fulfilling the guarantee: the retailer is not liable for amounts that the manufacturer may fail to pay. Solution to example 8: reimbursements A. The retailer has the obligation and must therefore raise the provision. B. The manufacturer has the obligation. The retailer has no obligation. No provision should be raised. C. The retailer must raise a provision for the full cost of the provision and must recognise a separate reimbursement asset to the extent that it is virtually certain to receive the reimbursement. D. The portion of the costs that the retailer is expected to pay is recognised as a provision, whereas the portion of the costs that the manufacturer is expected to pay is disclosed as a contingent liability in case the manufacturer does not honour his obligations (IAS 37.29). E. The portion of the costs that the retailer is expected to pay is recognised as a provision. A contingent liability is not recognised for the portion of the costs that the manufacturer is expected to pay since the retailer has no obligation to pay this amount in the event that the manufacturer does not honour his obligations. 551

13 Example 9: reimbursements A retailer company estimates that it will cost C to fulfil its obligation in respect of the guarantees offered to its customers. The manufacturer, however, offers a guarantee to the retailer company. Show all related journal entries assuming that A: the entire C is virtually certain of being received from the manufacturer. B: an amount of C is virtually certain of being received from the manufacturer. Solution to example 9A: reimbursements Debit Credit Cost of fulfilling guarantees (E) Provision for guarantees (L) Provision for the cost of fulfilling guarantees Guarantee reimbursement (A) Guarantee reimbursement income (I) Provision for guarantee reimbursements Comment: The asset and liability should be separately disclosed and should not be set-off against each other (therefore both asset and liability will appear in the statement of financial position) whereas the income and expense may be set-off against each other and, in this case, would cancel each other out (will not appear in the statement of comprehensive income at all). Solution to example 9B: reimbursements The journal entries will be the same because the reimbursement asset is not allowed to be measured at more than the provision Changes in provisions (IAS ) The measurement of a provision is estimated based on circumstances in existence at the time of making the provision. As circumstances change, the amount of the provision must be reassessed and increased or decreased as considered necessary. Therefore, the balance of the provision should be assessed at the end of every year. Example 10: change in a decommissioning provision The same information as that provided in example 5 applies to the purchase of a factory plant: Cash purchase price (1 January 20X1) : Future decommissioning (the outflow expected on 31 December 20X3, : as assessed on 1 January 20X1) Discount rate : 10% Depreciation straight-line to nil residual values : 3 years During 20X2, it was established that, due to unforeseen prices increases, the expected future cost of decommissioning will be C Draw up a present value table showing the revised present value of the future costs on January 20X1 and the end of each subsequent year together with the annual movement. First calculate the present value/ discount factors (or use a financial calculator). Show all related entries in t-account format. 552

14 Solution to example 10: change in a decommissioning provision W1: Present value table: based on the old estimate Date Discount factor (rounded): 10% Calculation of liability balance Finance charges Liability balance Calculation of finance charges: can be calculated either way (present value) Liability balance x 10% Movement in liability balance 1 Jan X x Dec X x x 10% Dec X x x 10% Dec X x x 10% Total The following ledger accounts reflect the entries that have been processed to 31 December 20X1: Plant decommissioning: cost(asset) Provision for decommissioning (liability) 1/1/20X /1/20X1 (1) /1/20X1 (1) /12/20X1 (3) Balance Balance Plant decommissioning asset: accum. deprec. (2) 31/12/20X Balance Depreciation Finance charges 31/12/20X1 (2) /12/20X1 (3) (1) recording of original decommissioning obligation (2) recording of depreciation of the decommissioning asset: / 3 years (3) recording of the finance charges and gradual increase in the liability balance through the unwinding of the discount. Notice that the balance of the liability account is on 31 December 20X1, which agrees with the present value table based on the old estimate (W1). W2: Present value table: based on the new estimate determined as at 31 December 20X2 Date Discount factor (rounded): 10% Calculation of liability balance (present value) Finance charges Liability balance Calculation of finance charges: can be calculated either way Liability balance x 10% Movement in liability balance 1 Jan X1 W1 W Dec X1 W x 10% Dec X x Dec X x x 10% Dec X x x 10% Total It can be seen from the new present value table (W2) above that: At 1 January 20X2: the liability balance should be and not an increase of is therefore required to increase this liability (and its related asset: plant); In 20X2: the depreciation will be based on the revised carrying amount of the asset: (cost of asset: cost of future decommissioning: adjustment depreciation in 20X1: ) / 2 years remaining x 1 year = ; In 20X2: finance costs will be based on the revised table (W2): (not per W1). 553

15 The following entries must therefore be processed in the ledger (see these processed on the next page): (4) Adjustment to the asset and liability account: = (5) depreciation: (in 20X2 and 20X3) (6) finance costs: in 20X2 and in 20X3. Plant decommissioning: cost(asset) Provision for decommissioning (liability) 01/01/20X /1/20X1 (1) /01/20X1 (1) /12/20X1 (3) Balance /01/20X2 (4) /01/20X2 (4) /12/20X2 (6) /12/20X3 (6) Plant decommissioning asset: accum. deprec. (2) 31/12/20X /12/20X2 (5) /12/20X3 (5) Depreciation Finance charges 31/12/20X1 (2) /12/20X1 (3) /12/20X2 (5) /12/20X2 (6) /12/20X3 (5) /12/20X3 (6) Reduction of provisions (IAS ) A provision is made for future costs. When these costs are eventually paid for, the provision is reduced. Care must be taken to reduce the provision by only those costs, now paid for, that were originally provided for. 3.4 Other specific issues Contracts (IAS ) Costs that have been contractually committed to but not yet incurred in the current year should not be recognised as a liability since these are considered to be future costs. One exception to this rule is an onerous contract. An onerous contract is one where the costs to fulfil the terms of the contract are greater than the benefits that will be derived from it (i.e. will make a loss). In this case, the unavoidable costs should be provided for. The unavoidable costs (per IAS 37) are the lower of: the cost of fulfilling the contract; and the compensation or penalties that would be incurred if the contract were to be cancelled. Example 11: onerous contracts Silliun Ltd entered into a contract to perform certain services. The total contract price is C The estimated costs of fulfilling these contractual obligations have been recently reassessed to be C No work has yet been done. A penalty of C is payable if the contract is to be cancelled. Process the required journal entry. 554

16 Solution to example 11: onerous contract Debit Credit Contract cost Provision for onerous contract (L) Minimum cost related to an onerous contract: the cost to exit is whereas the expected loss is ( ) Restructuring provisions (IAS ) Restructuring is defined in IAS 37 as: a programme that is planned and 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. Restructuring occurs when, for example, a line of business is sold (e.g. a shoe manufacturer sells a factory producing takkies) or there is a change in the management structure. In both cases, there will be a variety of costs involved: for example, retrenchment packages will probably need to be paid out and in the case of the sale of the factory, there may be costs incurred in the removal of certain machinery. The same definition and recognition criteria must be met before making a provision for the costs of restructuring although IAS 37 provides further criteria to assist in determining whether the definition and recognition criteria have been met. These extra criteria are: there must be a detailed formal plan that identifies at least the following: the business or part of the business affected; the principal locations affected; the location, function and approximate number of employees who will be compensated for terminating their services; the expenditure that will be undertaken; when the plan will be implemented; AND the entity must have raised valid expectations in those affected before the end of the reporting period that it will carry out restructuring, by either having: started to implement the plan; or announced its main features to those affected by it. Costs of restructuring a business entity should be provided for on condition that the costs provided for are only those costs that are directly associated with the restructuring, being: those that are necessary; AND not associated with the ongoing activities of the entity (i.e. future operating costs are not part of the provision, for example: retraining and relocation costs for continuing staff, investment in new systems, marketing etcetera). Where the restructuring involves a sale of an operation, no obligation arises until there is a binding sale agreement. Example 12: restructuring costs A few days before year-end, Dropout Ltd announced its intention to close its shoe factory within 6 months of year-end. There is a detailed formal plan that lists, amongst other things, the expected costs of closure: retrenchment packages: C retraining the staff members who will be relocated to other factories: C loss on sale of factory assets: C Process the required journal entry. 555

17 Solution to example 12: restructuring costs Debit Credit Restructuring costs (E) Provision for restructuring costs (L) Provision for restructuring costs Note: The cost of retraining staff is a future operating cost and must therefore not be provided for. The loss on sale of factory assets simply indicates a possible need to impair the relevant assets at year-end. 4. Assets: contingent assets (IAS ) 4.1 Recognition For an asset to be recognised, both the definition and the recognition criteria need to be met. Contingent assets, which are only possible assets depending on future events, will, however, never be recognised since the definition and recognition criteria will not be met. Where the flow of economic benefits from a contingent asset is: virtually certain, the asset is no longer considered to be a contingent asset but a normal asset and is recognised (unless a reliable estimate is not possible); probable, a contingent asset would be disclosed (if material); and possible or remote, then the contingent asset is simply ignored. This is based on the concept of prudence. 4.2 Measurement Although contingent assets are not recognised, the asset/s may need to be disclosed, in which case its value will still need to be measured. The measurement principles for a contingent asset are the same as that for a contingent liability. For example, if the inflow is expected far into the future, the present value thereof should be calculated and if this present value is materially different from the absolute value of the inflow, then the present value should be used instead. 5. Disclosure: provisions, contingent liabilities and assets (IAS ) 5.1 Provisions Provisions should be disclosed as a separate line item in the statement of financial position. For each class of provision, disclose the following in the notes to the financial statements: a brief description of the nature of the obligation; the expected timing of the outflows; the uncertainties relating to either or both the amount and timing of the outflows; major assumptions made concerning future events (e.g. future interest rates; the assumption that a future law will be enacted with the result that a related provision was raised; future changes in prices and other costs); the expected amount of any reimbursements including the amount of the reimbursement asset recognised (if recognised at all); a reconciliation between the opening carrying amount and the closing carrying amount of the provision (for the current period only) indicating each movement separately: additional provisions made plus increases made to existing provisions; increases in a provision based on increasing present values caused by the normal passage of time and from any changes to the estimated discount rate; amounts used during the year (debited against the provision); and unused amounts reversed during the year. 556

18 The interpretation on changes in decommissioning, restoration and similar liabilities (IFRIC 1) requires that a change in such a provision be recorded in accordance with IAS 8: Accounting policies, estimates and errors. This would apply to all similar provisions. The disclosure requirements for a change in accounting estimate (per IAS 8) are as follows: the nature and amount of the change in estimate must be disclosed, where the amounts to be disclosed are as follows: - the effect on the current period; and - the effect on future periods. Example 13: disclosure of a decommissioning provision (including a change in estimate) The same information as that provided in example 10 applies to the purchase of a factory plant: Cash purchase price (1 January 20X1) : Future decommissioning (the outflow expected on 31 December 20X3, : as assessed on 1 January 20X1) Discount rate : 10% Depreciation straight-line to nil residual values : 3 years During 20X2, it was established that, due to unforeseen prices increases, the expected future cost of decommissioning will be C Disclose the decommissioning asset and liability in the statement of financial position and related notes for the year ended 31 December 20X2. Solution to example 13: disclosure of a change in decommissioning provision Company name Statement of financial position (extracts) As at 31 December 20X2 Note 20X2 20X1 ASSETS C C Non-current assets Property, plant and equipment LIABILITIES AND EQUITY Non-current liabilities Provisions Company name Notes to the financial statements (extracts) For the year ended 31 December 20X2 6. Provision for decommissioning 20X2 C 20X1 C Opening carrying amount Provision for decommissioning raised Increase in provision increased future cost Increase in present value unwinding of discount: finance charges (per note 8) Closing carrying amount Decommissioning of the plant is expected to occur on 31 December 20X3 and is expected to result in cash outflows of (20X1 estimate: ). The amount of the outflows is uncertain due to changing prices. The timing of the outflow is uncertain due to the changing asset usage, which may result in a longer or shorter useful life. Major assumptions include that the interest rates will remain at 10% and that the asset has a useful life of 3 years. 557

19 Company name Notes to the financial statements continued (extracts) For the year ended 31 December 20X2 20X2 C 20X1 C 7. Property, plant and equipment Factory plant: Net carrying amount: 1 January Gross carrying amount: 1 January Accumulated depreciation: 1 January ( ) 0 Acquisition ( ) Depreciation (see profit before tax note) ( ) ( ) Increase in present value of future decommissioning costs Net carrying amount: 31 December Gross carrying amount: 31 December Accumulated depreciation: 31 December ( ) ( ) 8. Profit before tax Profit before tax is stated after accounting for the following disclosable (income)/ expense items: Finance charges Depreciation Change in estimate The expected cash outflow on 31 December 20X3 in respect of the decommissioning of plant was changed. The effect of the change is as follows: increase/(decrease) Current year profits (before tax) C1&C2 ( ) (W1: W2: ) Future profits (before tax) (W1: W2: ) C1&C2 ( ) Workings: Working 1. Change in estimated finance costs For detailed calculations, see the present value table in example 10 based on the old estimate (supporting the was column) and the present value table in example 10 based on the new estimate (supporting the is column). Change in estimated finance costs Was Is Difference Adjustments (a) (b) (b) (a) Initial liability ( ) Finance costs: 31/12/20X1 (30 000) Carrying amount: 31/12/20X1 ( ) ( ) Adjustment (see ex. 10 for workings) ( ) Extra liability ( ) Finance costs: 20X2 (33 000) (55 000) Extra expense Carrying amount: 31/12/20X2 ( ) ( ) ( ) Finance costs: future (36 300) (60 500) (24 200) Extra expense Carrying amount: future ( ) ( ) ( ) total change 558

20 Working 2. Change in estimated depreciation Change in estimated depreciation Was (a) Is (b) Difference (b) (a) adjustments Cost ( ) Depreciation 20X / 3 yrs ( ) Carrying amount: 31/12/20X Adjustment (see ex. 10 for workings) Extra asset Carrying amount: 1/1/20X Remaining useful life (years) 2 years 2 years Depreciation: 20X2 ( ) ( ) ( ) Extra deprec. Carrying amount: 31/12/20X dr asset cr liab Depreciation: future ( ) ( ) ( ) Extra deprec. Carrying amount: final total change 5.2 Contingent liabilities Where a contingent liability is to be disclosed, the following information should be provided (per class of contingent liability): a brief description of the nature of the contingent liability; an estimate of its financial effect; the uncertainties relating to either or both the amount and timing of the outflows; and the possibility of any reimbursement. 5.3 Contingent assets Where the contingent asset is to be disclosed, the following information should be provided: a brief description of the nature of the contingent asset; and an estimate of its financial effect. 5.4 Exemptions from disclosure requirements There are two instances where disclosure of provisions, contingent liabilities and contingent assets are not required: where disclosure thereof is not practicable, in which case this fact should be stated; and where the information required would be seriously prejudicial to the entity in a dispute with a third party. If this is the case, then the general nature of the dispute together with the fact that disclosure has not been made and the reason for non-disclosure should be disclosed. 6. Events after the reporting period (IAS 10) 6.1 Overview Although one might assume that events that occur after the current year-end should not be taken into account in the current year s financial statements, this is not always the case! Events after the reporting period are defined in IAS 10 as: those events, favourable or unfavourable, that occur between the end of the reporting period and the date when the financial statements are authorised for issue. There are two types of events after the reporting period: adjusting; and non-adjusting. 559