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1 Provisions, contingent assets and contingent liabilities – IAS 37 Week 5 MN20018.

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Presentation on theme: "1 Provisions, contingent assets and contingent liabilities – IAS 37 Week 5 MN20018."— Presentation transcript:

1 1 Provisions, contingent assets and contingent liabilities – IAS 37 Week 5 MN20018

2 2 Off Balance Sheet Financing – Substance over Form Substance Has a transaction occurred Giving rise to a new asset or liability Giving rise to a change in an existing asset or liability Rights Access to benefits Evidenced by exposure to risks Likelihood of risks arising

3 3 Substance over form Typical examples: Consignment stocks Sale and repurchase agreements Debt factoring

4 4 Consignment stocks Legal title retained by consignor Consider economic risks and benefits Likelihood of stock being returned Past experience Contractual penalty clauses

5 5 Sale and repurchase agreements Vendor retains control of the asset Asset remains in use Substance not that of normal sale Retain on balance sheet of vendor

6 6 Sale and repurchase agreements Substance is that of finance arrangement Money borrowed on security of asset Repurchase amount will include interest Separate out the interest element Report interest in Income Statement Report as a liability in the balance sheet

7 7 Debt factoring Factoring may be: Without recourse Or With recourse Sale of debts without recourse Any bad debts are suffered by factor Treat cash received from factor as settlement of debts

8 8 Provisions & Contingencies Provisions Affect income statement & balance sheet Contingencies No affect Can be disclosed as note May not even be disclosed at all Provisions Liability of uncertain timing or amount Increase in provision recognised in IS as expense Liability created Provisions are by nature uncertain so Timing and amount has to be estimated

9 9 Recognition Used to be able to use provisions to manipulate accounts Eg loss making business creating provision to cause large loss in 1 year Gradually reduce provision in subsequent years to offset losses/show profits IAS 37 prevents this Company should have present obligation arising from past event Must be probable an outflow of resources embodying economic benefits will be required to clear the obligation Probable = more likely than not to occur Group of small obligations can be lumped together as a class of obligations Should be reliable estimate of amount of obligation

10 10 Non-recognition Provision not recognised unless Obligatory event exists – present obligation from past event Settlement of obligation is legally enforceable Eg obligation to make good environmental damage Constructive obligation – event creates valid expectation in 3rd party Eg a retail store that has a long-standing policy of allowing customers to return merchandise within, say, a 30-day period Or decommissioning nuclear power stations

11 11 Measurement & Review Measurement of provision = Best estimate of expenditure required Amount should be estimate before tax If large number of events – expected value based on range of outcomes & probabilities Should take account of risks & uncertainties but not use excessive prudence & overstate provisions Reviewing provision At every balance sheet date & adjust to reflect best current estimate If provision is long-term & time value of money is material - should be stated at present value

12 12 Specific applications - 1 Future operating losses Cannot create provision for this – no obligating event & no present obligation Specifically outlawed by IAS 37 Onerous contracts Unavoidable costs of meting contract are > than expected economic benefits Provision should be recognised Lowest cost of exiting contract Ie cost of carrying out contract or Cost of penalty for failure to complete contract

13 13 Specific applications - 2 Restructuring costs Incurred when company Sells/closes line of business Closes business location in a country/region of another country Changes management structure substantially Carries out fundamental reorganisation materially affecting nature/focus of operations Provision for restructuring costs only allowed if recognition criteria apply i.e. Detailed & formal plan of restructuring exists outlining expected number/location of employees to be compensated, expenditures to be undertaken & timing of them Should have raised expectation in individuals affected that reorganisation will occur

14 14 Contingent liabilities Possible obligations that arise from past events & whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events that are not wholly within the companys control Or present an obligation arising out of past events that is not recognised as a provision because Not probable outflow of resources needed to settle obligation Obligation cannot be measured satisfactorily

15 15 Contingent liabilities So contingent liability is Possible obligation not yet confirmed Present obligation that does not meet all criteria for recognition as a provision Therefore not recognised as liability If CL is not remote - possibility disclose as note If CL is remote - do not disclose

16 16 Contingent Asset Arises from past events but its existence confirmed by occurrence/non- occurrence of uncertain future events not in the companys control. Eg compensation from a law suit Do not recognise as an asset When realisation of income/asset become virtually certain then recognise

17 17 Disclosures Reconciliation for each class of provision: Opening balance Additions Used (amounts charged against the provision) Released (reversed) Unwinding of the discount Closing balance A prior year reconciliation is not required For each class of provision, a brief description of: Nature Timing Uncertainties Assumptions Reimbursement

18 18 Post balance sheet events – IAS 10 Events which could be favourable or unfavourable that occur after the balance sheet date but before accounts are authorised 2 types of events… Adjusting event: An event after the balance sheet date that provides further evidence of conditions that existed at the balance sheet including an event that indicates that the going concern assumption in relation to the whole or part of the enterprise is not appropriate. Non-adjusting event: An event after the balance sheet date that is indicative of a condition that arose after the balance sheet date.

19 19 Treatment Adjust financial statements for adjusting events Do not adjust for non-adjusting events If an entity declares dividends after the balance sheet date, the entity shall not recognise those dividends as a liability at the balance sheet date That is a non-adjusting event

20 20 Going Concern Issues Arising After Balance Sheet Date An entity shall not prepare its financial statements on a going concern basis if management determines after the balance sheet date either that it intends to liquidate the entity or to cease trading, or that it has no realistic alternative but to do so

21 21 Disclosure Non-adjusting events should be disclosed if they are of such importance that non-disclosure would affect the ability of users to make proper evaluations and decisions Required disclosure is the nature of the event and an estimate of its financial effect or a statement that a reasonable estimate of the effect cannot be made

22 22 Disclosure A company should update disclosures that relate to conditions that existed at the balance sheet date to reflect any new information that it receives after the balance sheet date about those conditions. Companies must disclose the date when the financial statements were authorised for issue and who gave that authorisation If the enterprise's owners or others have the power to amend the financial statements after issuance the enterprise must disclose that fact

23 23 IAS 24 - Related party disclosures Objective of IAS 24 To ensure that an entity's financial statements contain the disclosures necessary to draw attention to the possibility that its financial position and profit or loss may have been affected by the existence of related parties and by transactions and outstanding balances with such parties

24 24 Who Are Related Parties? Parties are considered to be related if one party has the ability to control the other party or to exercise significant influence or joint control over the other party in making financial and operating decisions

25 25 Related Entity A party is related to an entity if: (a) directly, or indirectly through one or more intermediaries, the party: (i) controls, is controlled by, or is under common control with, the entity (this includes parents, subsidiaries and fellow subsidiaries) (ii) has an interest in the entity that gives it significant influence over the entity or (iii) has joint control over the entity (b) the party is an associate of the entity (c) the party is a joint venture in which the entity is a venturer

26 26 Related Entity A party is related to an entity if: (d) the party is a member of the key management personnel of the entity or its parent (e) the party is a close member of the family of any individual referred to in (a) or (d) (f) the party is an entity that is controlled, jointly controlled or significantly influenced by or for which significant voting power in such entity resides with, directly or indirectly, any individual referred to in (d) or (e) or (g) the party is a post-employment benefit plan for the benefit of employees of the entity, or of any entity that is a related party of the entity

27 27 Not related Examples where a party is not related: two enterprises simply because they have a director or key manager in common two venturers who share joint control over a joint venture providers of finance, trade unions, public utilities, government departments and agencies in the course of their normal dealings with an enterprise a single customer, supplier, franchiser, distributor, or general agent with whom an enterprise transacts a significant volume of business merely by virtue of the resulting economic dependence

28 28 Related Party Transactions A related party transaction is a transfer of resources services or obligations between related parties regardless of whether a price is charged

29 29 Disclosure The amount of the transactions. The amount of outstanding balances, including terms and conditions and guarantees Provisions for doubtful debts related to the amount of outstanding balances Expense recognised during the period in respect of bad or doubtful debts due from related parties

30 30 Types of transactions that would be disclosed if they are with a related party Purchases or sales of goods Purchases or sales of property and other assets Rendering or receiving of services Leases Transfers of research and development Transfers under licence agreements Transfers under finance arrangements (including loans and equity contributions in cash or in kind) Provision of guarantees or collateral Settlement of liabilities on behalf of the entity or by the entity on behalf of another party

31 31 IAS 32 – Financial Instruments – Disclosure & Presentation Objective of the standard Objective to enhance financial statement users' understanding of the significance of financial instruments to an entity's financial position, performance, and cash flows Does so by Clarifying the classification of a financial instrument issued by an enterprise as a liability or as equity Prescribing the accounting for treasury shares (a company's own repurchased shares) Prescribing strict conditions under which assets and liabilities may be offset in the balance sheet Requiring a broad range of disclosures about financial instruments, including information as to their fair values

32 32 No-one here just us shares We will deal with SHARES only When a company issues a financial instrument it should classify as Financial Liability (sometimes asset) Equity Equity Instruments Ordinary shares Some preference shares Share warrants (right to purchase shares in future at fixed price) Financial Liabilities Trade payables Bank loans Bonds (loan stock/debentures) Some preference shares

33 33 and preference shares Preferences shares Entitle shareholder to a dividend before ordinary shareholders Usually fixed amount Redeemable Irredeemable

34 34 Equity or financial liability? Or both (compound financial instrument) Key factor – extent to which company obliged to make future repayments Required to redeem share = future obligation redeemable element = financial liability dividends = financial liability or deduction of equity Cumulative shares dividend element = financial liability Irredeemable non-cumulative = Equity Convertible bonds have 2 elements Financial liability + equity – therefore compound financial instrument

35 35 Compound instruments illustration Convertible debentures 1 January 20X0 1,000 £100 5% issued at par 1 January 20X5 Convert into 50 ordinary shares per £100 OR redeem at par Interest rate on similar debentures is 6%

36 36 Compound instruments illustration Value of debt Present value of redemption payment £74,726 Present value of interest (5 years)£21,062 Value of debt£95,788 Value of equity proceeds£ 4,212 Par value £100,000

37 37 Interest, dividends, gains & losses All 4 relating to a financial liability should be recognised as an expense (in IS) Dividends to equity shareholders debit directly to equity Transaction costs of equity transactions = debit to equity net of tax benefit Note divis recognised in Fin Statements as deduction from equity only If dividend paid before BS date since previous BS date

38 38 Distributable Profit Profits not distributed until profit/gain realised If company makes a loss should be allowed to pay divis if has sufficient accumulated profits Capital from shareholders is not distributable Reserves Capital reserves not distributable (revaluation reserve/share premium) Revenue reserves are distributable

39 39 Share issues Increase cash/bank/assets by cash raised less issue costs Share capital increased by nominal value of shares Share premium increased by cash raised – par value – issue costs Bonus issue In bonus issue Company converts some reserves to share capital Issues new shares to existing share holders in proportion to existing shareholdings If there is share premium it can be reduced If not (or insufficient) use reserves

40 40 Own share buy back - 1 Can repurchase own shares and cancel them But creditors must be protected Therefore: transfer from accumulated profit to capital reserves…. Purchase cost of shares DRCR Par value share capitalBank Share premium Accumulated profit Capital maintenance DRCR Accumulated profitCapital reserves

41 41 Own share buy back - 2 As purchase price probably > par value Dr excess top share premium, but restricted to lowest of 3 amounts share premium originally received when shares issued current balance on share premium actual premium on redemption Transfer to capital reserve = par value of shares purchased + cancelled If repurchase financed by new issue of preference shares treated as equity Transfer to capital reserve reduced by mount of new shares issued

42 42 Redeemable shares As company under obligation to buy back in future Obligation = financial liability

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