Provisions, Contingent Liabilities and Contingent Assets Chapter 5 Provisions, Contingent Liabilities and Contingent Assets ACTG 6580

Objectives Describe the background to IAS 37 Identify items included within the scope of the standard Outline the concept of a provision and how it differs from other liabilities Outline the concept of a contingent liability and how it differs from a provision

Objectives Identify recognition and measurement criteria for provisions Outline the concept of a contingent asset Describe the disclosure requirements of IAS 37 Describe expected future developments

Introduction to IAS 37 IAS 37 addresses the recognition, measurement and presentation of: Provisions (excluding those covered by another IAS) Contingent assets and liabilities Restructuring provisions Onerous contracts

Definition of a Provision The Conceptual Framework defines a liability as: a present obligation arising from a past event that is expected to result in an outflow of economic resources A provision is a subset of liabilities, defined in IAS 37 as a liability of uncertain timing or amount A present obligation exists only where the entity has no reasonable alternative but to settle the obligation

Present Obligation A present obligation may be: Legal – arising from a contract Equitable – arising from normal business practice or custom Constructive – arising from established pattern of past practice A present obligation exists only where the entity has no realistic alternative but to make the sacrifice of economic benefits to settle the obligation

Distinguishing Provisions From Other Liabilities Key distinguishing factor is the uncertainty relating to either the timing or the amount Typical provisions : Warranty Restructuring Onerous contracts Employee benefits are not provisions under IAS 37

Contingent Liabilities Contingent liabilities are either: (a) A possible obligation whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly in control of the entity eg. a guarantee on a loan for another entity OR…

Contingent Liabilities (b) A present obligation that fails the recognition criteria because: it is not probable an outflow of resources will be required to settle the obligation or the amount cannot be measured reliably eg. a lawsuit where amount of damages is uncertain Contingent liabilities are not recognized in the financial statements but must be disclosed in the notes to the financial statements

Recognition Criteria For Provisions Three criteria: Present obligation as a result of a past event Probable outflow of resources to settle Amount of obligation can be reliably estimated

Decision Tree

Measurement of Provisions “Best estimate” of provision amount recognized Requires professional judgements Is calculated using ‘expected value’ estimation Measured before tax Estimates should be discounted to present value where material

Contingencies Loss Contingency – Definition of Probable and Range US GAAP Defines probable as “likely” (this has been generally interpreted as greater than a 70% chance of occurring) Where there is a continuous range of possible outcomes and each point in the range is as likely as any other to occur, under ASC 450-20-30-1, the minimum amount in the range is used to measure the provision. IFRS Probable is defined as “more likely than not” (more than a 50% chance of occurring). The midpoint of the range is used to measure the provision.

Range of Possible Outcomes Example Example 1: An entity sells webcams with a warranty under which customers are covered for the cost of repairs of any manufacturing defects that become apparent within the first six months after purchase. The company has only recently started operations and thus cannot estimate what percentage of webcams will likely be returned. They do know that if defects were detected in all products sold, repair costs would range from $2 million for minor repairs to $4 million for major repairs. Assuming all other criteria are met, how much should the entity book related to warranty repairs using US GAAP and IFRS? Show any required journal entries.

Range of Possible Outcomes Example Example 1 solution: US GAAP The minimum point of the range, $2.0 million, should be recorded. Warranty expense $2,000,000 Warranty liability $2,000,000 IFRS The midpoint of the range, $3.0 million, should be recorded. Warranty expense $3,000,000 Warranty liability $3,000,000 Since the entity only had a range to work with, the treatment using the two sets of standards is different. If no particular outcome within the range is better than another, then for US GAAP the entity would book the minimum of the range, whereas for IFRS the entity would book the midpoint range.

Range of Possible Outcomes Example Example 2: Use the same facts in example 1, except now assume the entity is able to perform an analysis on the historical data of returns and estimates (based on historical data), finding that 75% of the goods sold will have no defects, 20% of the goods sold will have minor defects and 5% of the goods sold will have major defects. Assuming all other criteria are met, how much should the entity book related to warranty repairs using US GAAP and IFRS? Show any required journal entries.

Probable Liability Example Example 2 solution: For both US GAAP and IFRS, $600,000 should be recorded. The most likely outcome is $600,000 explained as follows: (20% of $2 million for minor repairs = $400,000) + (5% of $4 million for major repairs = $200,000) + (75% without defects and, therefore, no impact on the estimate). Warranty expense $600,000 Warranty liability $600,000

Measurement of Provisions Should account for expected cash outflows only, disregarding any expected cash inflows Reimbursements must be virtually certain (not just probable) to be recognized Must review provisions at each end of reporting period

Definitions, Recognition & Measurement Rules Future operating losses: Excluded from the calculation of provisions Onerous contracts: Those that have more unavoidable cost than they expect the economic benefits to be The present obligation under an onerous contract must be recognized as a provision

Definitions, Recognition & Measurement Rules Restructuring provisions: The most controversial aspect of IAS 37 Restructuring provisions can be recognized as part of an acquisition of another business (IFRS 3) IAS 37 addresses non business combination restructuring

Restructuring Provisions May occur due to: Sale or termination of a line of business The closure of business locations in a country region or relocation of business activities Changes in the management structure Fundamental reorganizations

Restructuring Provisions Essential conditions to recognize a restructuring provision: Must have a present obligation to restructure Costs must be directly and necessarily caused by the restructuring If the restructuring involves the sale of an operation, a binding sale agreement is needed

Restructuring Provisions – Present Obligation Present obligation is considered to arise when the entity has a detailed plan identifying at least: The business (or part thereof) concerned The locations affected The employees affected The expenditures that will be undertaken The timing of implementation

Restructuring Provisions – Present Obligation Must have raised a valid expectation by those affected that it will carry out the plan by commencing restructuring or making an announcement to those affected In the case of restructuring provisions arising as part of an acquisition of another business, the provisions must be recognized in the books of the acquiree

Restructuring Provisions – Qualifying Costs Costs must be directly and necessarily caused by the restructuring and should not be associated with the ongoing operations Examples of qualifying costs include: The costs of terminating leases and other contracts Costs associated with employees dismantling plant etc. Employee redundancy costs Costs specifically excluded include: Employee retraining and relocation costs Marketing costs

Contingent Assets Possible asset arising from a past event whose existence will be confirmed by the occurrence/non-occurrence of one or more uncertain future events not within the control of the entity Contingent assets are not recognized in the statement of financial position but must be disclosed in the notes to the financial statements where an inflow of benefits is probable

Disclosure IAS 37 paras 84- 92 outline the disclosure requirements Disclosure for each class of provision required Disclosure for each class of contingent liability required Disclosure of nature of contingent assets Exemptions permitted in rare cases (para 92) Many analysts consider the contingent liabilities note to be one of the most important

Expected Future Developments IASB issued exposure draft in 2005 proposing significant changes: Title of standard New definitions of contingencies New recognition and measurement criteria The proposed changes are far reaching and have attracted widespread concern

Homework Exercise 5.4, 5.7, 5.11 DUE THURSDAY, OCTOBER 23