1. Connolly – International Financial Accounting and Reporting – 4 th Edition CHAPTER 14 PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS

2. Connolly – International Financial Accounting and Reporting – 4 th Edition 14.1 INTRODUCTION A number of problems have arisen in the past with respect to provisions  Inconsistency in accounting treatment (e.g. restructuring, warranties, environmental)  Earnings smoothing with ‘big bath’ provisions with no real substance  Intentions rather than firm obligations  Lack of detailed disclosure Therefore guidance essential

3. Connolly – International Financial Accounting and Reporting – 4 th Edition 14.2 RECOGNITION A provision should be recognised when: an entity has a present obligation (legal or constructive) as a result of a past event; it is probable that a transfer of economic benefits will be required to settle the obligation; and a reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision should be recognised

4. Connolly – International Financial Accounting and Reporting – 4 th Edition Present obligation A present obligation is one that exists at the reporting date as a result of a past event See Chapter 14, Examples 14.1 – 14.3 There are two types of present obligation – legal and constructive See Chapter 14, Examples 14.4 and 14.5

5. Connolly – International Financial Accounting and Reporting – 4 th Edition Present obligation – legal This is an obligation that derives from:  A contract (through explicit or implicit terms)  Legislation  Other operation of law

6. Connolly – International Financial Accounting and Reporting – 4 th Edition Present obligation – constructive This is an obligation that derives from an entity’s actions where:  By 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 and a the part of those other parties that it will discharge those responsibilities.

7. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 14.1: Self insurance An entity expects to pay €100,000 in damages based on previous experience. As there is no present obligation/obligating event until an accident occurs, no provision is recognised. Although it could be argued that there is a constructive obligation due to past experience.

8. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 14.2: Refurbishment costs (no legislative requirement) A furnace has a lining that needs to be replaced every five years for technical reasons. At the reporting date, the lining has been in use for three years. Is there a present obligation as a result of a past obligating event? – There is no present obligation. Conclusion No provision is recognised. The cost of replacing the lining is not recognised because, at the reporting date, no obligation to replace the lining exists independently of the company’s future actions – even the intention to incur the expenditure depends on the company deciding to continue operating the furnace or to replace the lining. Instead of a provision being recognised, the depreciation of the lining takes account of its consumption, i.e. it is depreciated over five years. The re-lining costs then incurred are capitalised with the consumption of each new lining shown by depreciation over the subsequent five years.

9. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 14.3: Refurbishment costs (legislative requirement) An airline is required by law to overhaul its aircraft once every three years. Is there a present obligation as a result of a past obligating event? – There is no present obligation. Conclusion No provision is recognised. The costs of overhauling aircraft are not recognised as a provision for the same reasons as the cost of replacing the lining is not recognised as a provision in the previous example. Even a legal requirement to overhaul does not make the costs of overhaul a liability, because no obligation exists to overhaul the aircraft independently of the entity’s future actions. The entity could avoid the future expenditure by its future actions, for example by selling the aircraft. Instead of a provision being recognised, the depreciation of the aircraft takes account of the future incidence of maintenance costs (i.e. an amount equivalent to the expected maintenance costs is depreciated over three years).

10. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 14.4: legal present obligation – provision for warranties A manufacturer gives warranties at the time of sale to purchasers of its product. Under the terms of the contract for sale the manufacturer undertakes to make good, by repair or replacement, manufacturing defects that become apparent within three years from the date of sale. On past experience, it is probable (i.e. more likely than not) that there will be some claims under the warranties. Is there a present obligation as a result of a past obligating event? – The obligating event is the sale of the product with a warranty, which gives rise to a legal obligation. Is there an outflow of resources embodying economic benefits in settlement? – Probable for the warranties as a whole. Conclusion – A provision is recognised for the best estimate of the costs of making good under the warranty products sold before the reporting date.

11. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 14.5: Constructive present obligation – refunds policy A retail store has a policy of refunding purchases by dissatisfied customers, even though it is under no legal obligation to do so. Its policy of making refunds is generally known. Is there a present obligation as a result of a past obligating event? – The obligating event is the sale of the product which gives rise to a constructive obligation because the conduct of the store has created a valid expectation on the part of its customers that the store will refund purchases. Is there an outflow of resources embodying economic benefits in settlement? – Probable that a proportion of goods are returned for refund. Conclusion – A provision is recognised for the best estimate of the costs of refunds.

12. Connolly – International Financial Accounting and Reporting – 4 th Edition Past event An event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation The event must cause an obligation now, not at a later date

13. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 14.6: Contaminated land (Legislation virtually certain to be enacted) An entity in the oil industry causes contamination but cleans up only when required to do so under the laws of the particular country in which it operates. One country in which it operates has had no legislation requiring cleaning up and the entity has been contaminating land in that country for several years. At 31 December 2012, it is virtually certain that a draft law requiring a clean-up of land already contaminated will be enacted shortly after the year end. Is there a present obligation as a result of a past obligating event? – The obligating event is the contamination of the land because of the virtual certainty of legislation requiring cleaning up. Is there a probable transfer of economic benefits? – Yes, probable. Conclusion A provision is recognised for the best estimate of the costs of the clean-up.

14. Connolly – International Financial Accounting and Reporting – 4 th Edition Restructuring i.e. practical application of present obligation and past event Sale or termination of a line of business Closure of business locations or relocation of business activities Changes in the management structure Fundamental reorganisations that have a material effect on the nature and focus of operations

15. Connolly – International Financial Accounting and Reporting – 4 th Edition Restructuring A restructuring provision should include only the correct expenditures arising from the restructuring i.e. those that are both:  Necessarily entailed by the restructuring; and  Not associated with the ongoing activities of the entity. Costs that cannot be included in a restructuring provision:  Retraining or relocating continuing staff  Marketing, or  Investment in new systems and distribution networks

16. Connolly – International Financial Accounting and Reporting – 4 th Edition Sale or termination of a line of business No obligation arises for the sale of an operation until the entity is committed to its sale e.g. there is a binding sale agreement at the reporting date (if virtually certain, disclose but do not adjust)

17. Connolly – International Financial Accounting and Reporting – 4 th Edition Closure of business locations or relocation of business activities Recognise a provision only when the entity has (at the reporting date):  A detailed formal plan for the restructuring  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 all those affected by it The formal plan should identify at least:  The business or part of the business concerned  The principal locations affected  The allocation, function, and approximate number of employees who will be terminated  The expenditures that would be undertaken  When the plan will be implemented See Chapter 14, Examples 14.7 and 14.8

18. Connolly – International Financial Accounting and Reporting – 4 th Edition Future operating losses Provisions should not be recognised for future operating losses Future operating losses do not meet the general definition of a liability and the general recognition criteria for provisions

19. Connolly – International Financial Accounting and Reporting – 4 th Edition Probable transfer of economic benefits Regarded as a probable if the event is more likely than not to occur i.e. the probability that the event will occur is greater than that the probability that it will not See Chapter 14, Examples 14.4 – 14.6

20. Connolly – International Financial Accounting and Reporting – 4 th Edition Reliable estimate of the obligation An estimate of the obligation, based upon a the range of possible outcomes is acceptable Where no reliable estimate can be made, the liability cannot be recognised and should be disclosed as a contingent liability See Chapter 14, Examples 14.7 – 14.9

21. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 14.7: Closure of a division (no communication) On 12 December 2012 the board of an entity decided to close down a division. Before the reporting date (31 December 2012) the decision was not communicated to any of those affected and no other steps were taken to implement the decision. Is there a present obligation as a result of a past obligating event? – There has been no obligating event and so there is no obligation (i.e. no communication). Conclusion – No provision should be recognised at 31 December 2012.

22. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 14.8: Closure of a division (with communication) On 12 December 2012, the board of an entity decided to close down a division making a particular product. On 20 December 2012 a detailed plan for closing down the division was agreed by the board. Letters were sent to customers warning them to seek an alternative source of supply and redundancy notices were sent to the staff of the division. Is there a present obligation as a result of a past obligating event? – The obligating event is the communication of the decision to the customers and employees, which gives rise to a constructive obligation from that date because it creates a valid expectation that the division will be closed. Is there an outflow of resources embodying economic benefits in settlement? – Probable. Conclusion – A provision is recognised at 31 December 2012 for the best estimate of the costs of closing the division.

23. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 14.9: Legal obligation Under new legislation, an entity is required to fit smoke filters to its factories by 30 June 2012. The entity has not yet fitted the smoke filters as at 31 December 2011. (a) At the reporting date of 31 December 2011 Is there a present obligation as a result of a past obligating event? There is no obligation as there is no obligation to fit the filters or pay the fines. Therefore no provision required. (b) At the reporting date of 31 Dcember 2012 Is there a present obligation as a result of a past obligating event? There is still no obligation for the costs of fitting smoke filters because no obligating event has occurred (i.e. the fitting of the filters). However, an obligation might arise to pay fines or penalties under the legislation because the obligating event has occurred (i.e. the non-compliant operation of the factory). Therefore, a provision should be recognised for the best estimate of any fines and penalties that are more likely than not to be imposed at 31 December 2012.

24. Connolly – International Financial Accounting and Reporting – 4 th Edition Changes in provisions Provisions should be reviewed at each reporting date date 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

25. Connolly – International Financial Accounting and Reporting – 4 th Edition Reimbursement Unless it is virtually certain that the reimbursement will be received, it should not be recognised. In the SFP, the reimbursement should be treated as a separate asset and not netted against the liability In the SPLOCI – P/L, any expenses relating to a provision can be netted against the related reimbursement See Chapter 14, Table 14.1

26. Connolly – International Financial Accounting and Reporting – 4 th Edition Onerous contracts This is a contract in which the unavoidable costs of meeting the applications under it exceed the economic benefits expected to be received from it The present obligation under onerous contracts should be recognised and measured as a provision

27. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 14.10: Onerous contract An entity operates profitably from a factory that it has leased under an operating lease. During December 2012 the entity relocates its operations to a new factory. The lease on the old factory continues for the next four years, it cannot be cancelled and the factory cannot be sub-let. Present obligation?Yes – signing of lease Probable outflow?Yes – costs exceed benefits Reliable estimate?Yes – future lease payments would be known ConclusionTherefore recognise a provision

28. Connolly – International Financial Accounting and Reporting – 4 th Edition Contingent liabilities A present obligation that arises from past events that is not recognised because either:  It is not probable (i.e. it is ‘only’ possible) 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 Contingent liabilities should not be recognised in the accounts but should be disclosed in the notes, unless the possibility of a transfer of economic benefits is remote

29. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 14.11: Court case After a wedding in 2011, 10 people died, possibly as a result of food poisoning from products sold by the entity. Legal proceedings are started seeking damages from the entity, but it disputes liability. Up to the date of authorisation of the financial statements for the year to 31 December 2011, the entity’s lawyers advise that it is probable that it will not be found liable. However, when the entity prepares the financial statements for the year to 31 December 2012, its lawyers advise that, owing to developments in the case, it is probable that it will be found liable. Requirement What is the required accounting treatment: (a) at 31 December 2011? (b) at 31 December 2012?

30. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 14.11: Court case Solution At 31 December 2011: 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. At 31 December 2012: 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.

31. Connolly – International Financial Accounting and Reporting – 4 th Edition Contingent liability in a business combination The general rule under IAS 37 is that a contingent liability is not recognised in the financial statements. The only exception to this is in a business combination (See IFRS 3 Business Combinations – Chapter 26). A contingent liability is recognised by the acquirer if it is a present obligation that arises from past events and its fair value can be measured reliably. The amount of the contingent liability is also taken into account in the calculation of goodwill or premium on acquisition.

32. Connolly – International Financial Accounting and Reporting – 4 th Edition Contingent asset A possible asset arising 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 No recognition of a contingent asset (unless certain) If economic inflow is probable, disclose:  Description of the nature of contingent asset  Estimate of the financial effect

33. Connolly – International Financial Accounting and Reporting – 4 th Edition 14.3 MEASUREMENT Best estimate of the expenditure required to settle the present obligation at the reporting date (See Chapter 14, Example 14.10) Estimates of outcome and the financial effect are determined by the judgement of management, supplemented by experience of similar transactions Risks and uncertainties should be taken into account in reaching the best estimate (See Chapter 14, Example 14.13) Where the effect of the time value of money is material, the amount of a provision should be the present value of the expenditures expected to be required to be settle the obligation (See Chapter 14, Example 14.14, Issue 5)

34. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 14.13: Risk and uncertainty Parker plc 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. Percentage of Goods SoldDefectsCost of Repairs € million 75%None- 20%Minor1.0 5%Major4.0 Requirement: Calculate the expected cost of repairs. Solution The cost is found using ‘expected values’ (75% x €nil) + (20% x €1.0m) + (5% x €4.0m) = €400,000.

35. Connolly – International Financial Accounting and Reporting – 4 th Edition 14.4 DISCLOSURE For each class of provision:  A brief description of the nature of the obligation, and the expected timing of any resulting transfers of economic benefits  An indication of the uncertainties about the amount or timing of those transfers of economic benefits  Carrying amount at beginning and end of period  Additional provisions made in the period  Amounts used during the period  Unused amounts reversed during the period  Increase during the period in the discounted amount arising from the passage of time and the effect of any change in the discount rate  The amount of any expected reimbursement  Comparative information is not required

36. Connolly – International Financial Accounting and Reporting – 4 th Edition 14.4 DISCLOSURE For each class of contingent liability:  Description of the nature of the contingent liability  Estimate of its financial effect  Indication of the uncertainties relating to the amount or timing of any outflow  Possibility of any reimbursement  No recognition of a contingent liability

37. Connolly – International Financial Accounting and Reporting – 4 th Edition 14.4 DISCLOSURE For each class of contingent asset:  If probable, a brief description of the nature and financial effect

38. Connolly – International Financial Accounting and Reporting – 4 th Edition Start Present obligation as a result of an obligating event? Probableoutflow? Reliableestimate? Provide Possibleobligation? Remote? Disclose contingent liability Do nothing Yes Yes Yes No No No (rare) Yes No No Yes Now try Example 14.14