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Provision

A provision is a liability of uncertain timing or amount


Double entry
Dr Expense
Cr Provision (Liability SFP)

If it is part of a cost of an asset (e.g. Decommissioning costs)


Dr Asset
Cr Provision (Liability SFP)

Discounting of provisions
Provisions should be discounted
Eg. A future liability of 1,000 in 2 years time (discount rate 10%)
1,000 x 1/1.10 x 1/1.10 = 826
Dr Expense 826
Cr Provision 826

Then the discount unwound


Year 1 826 x 10% = 83
Dr Interest 83
Cr Provision 83
Year 2 (826+83) x 10% = 91

Dr Interest 91
Cr Provision 91

A company sells goods with a warranty for the cost of repairs required in the first 2 months after purchase.
Past experience suggests:
88% of the goods sold will have no defects
7% will have minor defects
5% will have major defects
If minor defects were detected in all products sold, the cost of repairs will be $24,000;
If major defects were detected in all products sold, the cost would be $200,000.

What amount of provision should be made?


(88% x 0) + (7% x 24,000) + (5% x 200,000) = $11,680

Contingent Liabilities
These are simply a disclosure in the accounts
They occur when a potential liability is not probable but only possible
(Also occurs when not reliably measurable)

Contingent Assets
Here, it is not a potential liability, but a potential asset.
The principle of PRUDENCE is important here, it must be harder to show a potential asset in your accounts than it is a
potential liability.
This is achieved by changing the probability test.
For a potential (contingent) asset - it needs to be virtually certain (rather than just probable).

Probability test for Contingent Liabilities


Remote chance of paying out - Do nothing
Possible chance of paying out - Disclosure
Probable chance of paying out - Create a provision
Probability test for Contingent Assets
Remote chance of receiving - Do nothing
Possible chance of receiving - Do nothing
Probable chance of receiving - Disclosure
Virtually certain of receiving - create an asset in the accounts

Specific types of provision


Future operating losses
Provisions are not recognised for future operating losses (no obligation)
Onerous contracts
Recognised and measured as a provision (as there is a contract and so a legal obligation)
Restructuring

Restructuring - Create a provision when:


1. There is a detailed formal plan for the restructuring; and
2. There is 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 (this creates a constructive obligation)
Provide only for costs that are:
(a) necessarily entailed by the restructuring; and
(b) not associated with the ongoing activities of the entity

Possible Exam Scenarios


Warranties
Yes there is a legal obligation so provide. The amount is based on the class as a whole rather than individual claims. Use
expected values
Major Repairs
These are not provided for. Instead they are treated as replacement non current assets. See that chapter
Self Insurance
This is trying to provide for potential future fires etc. Clearly no provision as no obligation to pay until fire actually occurs
Environmental Contamination Clearance
Yes provide if legally required to do so or other parties would expect the company to do so as it is its known policy
Decommissioning Costs
All costs are provided for. The debit would be to the asset itself rather than the income statement
Restructuring
Provide if there is a detailed formal plan and all parties affected expect it to happen. Only include costs necessary caused by it
and nothing to do with the normal ongoing activities of the company (e.g. dont provide for training, marketing etc)
Reimbursements
This is when some or all of the costs will be paid for by a different party.
This asset can only be recognised if the reimbursement is virtually certain, and the expense can still be shown separately in
the income statement

Circumstance Provide?
Warranties/guarantees Accrue a provision (past event was the sale of defective goods)
Customer refunds Accrue if the established policy is to give refunds
Onerous (loss-making) contract Accrue a provision
Land contamination Accrue a provision if the company's policy is to clean up even if there is no legal require
to do so
Future operating losses No provision (no present obligation)
Firm offers staff training No provision (there is no obligation to provide the training)
Major overhaul or repairs No provision (no obligation)
Restructuring by sale of an operation/line of Accrue a provision only after a binding sale agreement
business
Restructuring by closure of business locations or Accrue a provision only after a detailed formal plan is adopted and announced
reorganisation publicly. A Board decision is not enough

Question 1 of 3
1. A company has a legal obligation to remove an asset after it has finished with it in 8 years time.
How is this dealt with in the accounts?
Dr Asset
Cr Provision

2. The provision will be at what value initially? A discounted amount

3. At 31 May 2016 Moo was being sued by a supplier over a disputed contract
Moo's solicitors advise that the supplier is likely to be successful and that damages of $100,000 will be awarded against them
How should this be dealt with in the accounts?

Dr Expense 100,000
Cr Provision 100,000
4. Do you provide for an obligated future cost? Yes
5. Do you provide for a refund if your policy is to give them out but you're not legally obliged to do so?
Yes this is an example of a constructive obligation Constructive basically means expected
6. Do you provide for next years losses if you're virtually certain they're going to happen?
No - theres no obligation - you don't have to stay in business!
7. Do you provide for next years losses under a contract?
Yes now there is an obligation
1. Q4a b - December 2011
(a) IAS 37 Provisions, contingent liabilities and contingent assets prescribes the accounting and disclosure for those items
named in its title.
Required:
Define provisions and contingent liabilities and briefly explain how IAS 37 improves consistency in financial reporting.
(6 marks)
(b) The following items have arisen during the preparation of Boroughs draft financial statements for the year ended 30
September 2011:
(i) On 1 October 2010, Borough commenced the extraction of crude oil from a new well on the seabed. The cost of a 10-year
licence to extract the oil was $50 million. At the end of the extraction, although not legally bound to do so, Borough intends to
make good the damage the extraction has caused to the seabed environment. This intention has been communicated to
parties external to Borough. The cost of this will be in two parts: a fixed amount of $20 million and a variable amount of 2
cents per barrel extracted. Both of these amounts are based on their present values as at 1 October 2010 (discounted at 8%)
of the estimated costs in 10 years time. In the year to 30 September 2011 Borough extracted 150 million barrels of oil.
(ii) Borough owns the whole of the equity share capital of its subsidiary Hamlet. Hamlets statement of financial position
includes a loan of $25 million that is repayable in five years time. $15 million of this loan is secured on Hamlets property and
the remaining $10 million is guaranteed by Borough in the event of a default by Hamlet. The economy in which Hamlet
operates is currently experiencing a deep recession, the effects of which are that the current value of its property is estimated
at $12 million and there are concerns over whether Hamlet can survive the recession and therefore repay the loan.
Required:
Describe, and quantify where possible, how items (i) and (ii) above should be treated in Boroughs statement of financial
position for the year ended 30 September 2011.
In the case of item (ii) only, distinguish between Boroughs entity and consolidated financial statements and refer to any
disclosure notes. Your answer should only refer to the treatment of the loan and should not consider any impairment of
Hamlets property or Boroughs investment in Hamlet.
Note: the treatment in the income statement is NOT required for any of the items.
The following mark allocation is provided as guidance for this requirement:
(i) 5 marks
(ii) 4 marks

Answer
(a) IAS 37 Provisions, contingent liabilities and contingent assets defines provisions as liabilities of uncertain timing or
amount that should be recognised where there is a present obligation (as a result of past events), it is probable (assumed to
be more than a 50% chance) that there will be an outflow of economic benefits (to settle the obligation) and the amounts can
be estimated reliably. The obligation may be legal or constructive.
A contingent liability has more uncertainty in that it is a possible obligation (assumed to be less than a 50% chance) whose
existence will be confirmed only by one or more future uncertain events that are not wholly within the control of the entity.
An existing obligation where the amount cannot be reliably measured is also treated as a contingent liability.
The Standard seeks to improve consistency in the reporting of provisions. In the past some entities created
general (rather than specific) provisions for liabilities that did not really exist (known as big bath provisions); equally many
entities did not recognise provisions where there was a present obligation. The latter often related to deferred liabilities such
as future environmental costs. The effect of such inconsistencies was that comparability was weakened and profit was
frequently manipulated.
(b) (i) Although the information in the question says the environmental provision is not a legal obligation, it implies that it is
a constructive obligation (Borough has created an expectation that it will pay the environmental costs) and therefore these
costs should be provided for. The obligation for the fixed element of the cost arose as soon as the extraction commenced,
whereas the variable element accrues in line with the extraction of oil. The present value of the environmental cost is shown
as a non-current liability (credit) with the debit added to the cost of the licence and (effectively) charged to income as part of
the annual amortisation charge.

(ii) From Boroughs perspective, as a separate entity, the guarantee for Hamlets loan is a contingent liability of $10 million.
As Hamlet is a separate entity, Borough has no liability for the secured amount of $15 million, not even for the potential
shortfall for the security of $3 million. The $10 million contingent liability would normally be described and disclosed in the
notes to Boroughs entity financial statements.
In Boroughs consolidated financial statements, the full liability of $25 million would be included in the statement
of financial position as part of the groups consolidated non-current liabilities there would be no contingent liability
disclosed.
The concerns over the potential survival of Hamlet due to the effects of the recession may change the disclosure in Boroughs
entity financial statements. If Borough deems it probable that Hamlet is not a going concern the $10 million loan, which was
previously a contingent liability, would become an actual liability and should be provided for on Boroughs entity statement of
financial position and disclosed as a current (not a non-current) liability.
2. MC4 - September 2016

Answer: A

3. Q5ii - June 2014


The following issue have arisen during the preparation of Skeptics draft financial statements for the year ended 31 March
2014:
Skeptic has two potential liabilities to assess. The first is an outstanding court case concerning a customer claiming damages
for losses due to faulty components supplied by Skeptic. The second is the provision required for product warranty claims
against 200,000 units of retail goods supplied with a one-year warranty.
Court cases Product warranty claims
10% chance of no damages awarded 70% of sales will have no claim
65% chance of damages of $ 4 million 20% sales will require a $ 25 repair
25% chance of damages of $ 6 million 10% of sales will require a $ 120 repair
Required:
Advise, and quantify where possible, how the above item should be treated in Skeptics financial statements for the year
ended 31 March 2014. 4 marks

Answer:
The two provisions must be calculated on different bases because IAS 37 Provisions, Contingent Liabilities and Contingent
Assets distinguishes between a single obligation (the court case) and a large population of items (the product warranty
claims).
For the court case the most probable single likely outcome is normally considered to be the best estimate of the liability, i.e.
$4 million. This is particularly the case as the possible outcomes are either side of this amount. The $4 million will be an
expense for the year ended 31 March 2014 and recognised as a provision.
The provision for the product warranty claims should be calculated on an expected value basis at $34 million (((75% x nil) +
(20% x $25) + (10% x $120)) x 200,000 units). This will also be an expense for the year ended 31 March 2014 and
recognised as a current liability (it is a one-year warranty scheme) in the statement of financial position as at 31 March 2014.
Examiners Report
(ii) This part was answered much better, with many of the candidates who did answer it gaining full marks.
Candidates were required to identify that a liability for an ongoing court case should be recognised as a provision at the most
likely outcome (the 65% probability) for $4 million. By contrast, the second liability was for outstanding product warranties
which required a provision based on expected values. The errors that occurred included taking an expected value approach to
the court case and concluding that the warranties were a contingent, rather than an actual, liability.

4. MC5 - December 2014

Answer: C
(i) is an onerous contract and (iii) the provision is still required if there is no intention to sell
5. Q5a - December 2013
Fundo entered into a 20-year operating lease for a property on 1 October 2000 which has a remaining life of eight years at 1
October 2012. The rental payments are $23 million per annum.
Prior to 1 October 2012, Fundo obtained permission from the owner of the property to make some internal alterations to the
property so that it can be used for a new manufacturing process which Fundo is undertaking. The cost of these alterations
was $7 million and they were completed on 1 October 2012 (the time taken to complete the alterations can be taken as being
negligible). A condition of being granted permission was that Fundo would have to restore the property to its original
condition before handing back the property at the end of the lease. The estimated restoration cost on 1 October 2012,
discounted at 8% per annum to its present value, is $5 million.
Required:
(a) Explain how the lease, the alterations to the leased property and the restoration costs should be treated in the financial
statements of Fundo for the year ended 30 September 2013. (4 marks)

Answer
(a) The alterations to the leased property do not affect the lease itself and this should continue to be treated as an operating
lease and charging profit or loss with the annual rental of $23 million.
The initial cost of the alterations should be capitalised and depreciated over the remaining life of the lease. In addition to this,
IAS 37 Provisions, Contingent Assets and Contingent Liabilities requires that the cost of restoring the property to its original
condition should be provided for on 1 October 2012 as this is when the obligation to incur the restoration cost arises (as the
time taken to do the alterations is negligible). The present value of the restoration costs, given as $5 million, should be added
to the initial cost of the alterations and depreciated over the remaining life of the lease. A corresponding provision should be
created and a finance cost of 8% per annum should be charged to profit or loss and accrued on this provision.
Examiners Report
This question concerned the accounting treatment of alterations to a property leased under an operating lease together with a
requirement to restore the property to its original condition at the end of the operating lease.
Part (a) asked candidates to explain how the items should be treated and part (b) asked for extracts from the financial
statements reflecting the treatment. As referred to earlier this question had a relatively high number of candidates that did
not attempt it. It is difficult to explain why this would be the case as the topics of an operating lease, capitalisation of non-
current assets and provisions for rectification/restoration costs have all been asked (several times) in past examinations.
For part (a) several candidates wrote down everything they had rote learned about the difference between operating and
finance leases. This gained no marks as it was not what the question asked. Those that had attempted to answer the question
asked made some fundamental errors; many said that the operating lease rentals should be capitalised, effectively treating it
as a finance lease when the question clearly said (in bold print) that it was an operating lease.
Another common misunderstanding was to write off the cost of the alterations (they should be capitalised), and, although
most said the restoration costs should be provided for, they either said they should be accrued over the 8-year remaining life
of the lease, or they should be expensed immediately. The correct answer is that they should be provided for in full
immediately and also capitalised by adding them to the capitalised alteration costs and then depreciated over the 8-year life.

6. MC6 - September 2016 Specimen

Answer: B
Extraction provision at 30 September 2014 is $25 million (250 x 10).
Dismantling provision at 1 October 2013 is $204 million (30,000 x 068).
This will increase by an 8% finance cost by 30 September 2014 = $22,032,000.
Total provision is $24,532,000.
7. MC16 - June 2015

Answer D
(iv) deferred tax relating to the revaluation of an asset must be provided for even if there is no
intention to sell the asset in accordance with IAS 12.s

8. MC17 - December 2014

Answer: B
Extraction provision at 30 September 2014 is $25 million (250 x 10).
Dismantling provision at 1 October 2013 is $204 million (30,000 x 068).
This will increase by an 8% finance cost by 30 September 2014 = $22,032,000.
Total provision is $24,532,000.