Events after the reporting period, provisions and contingencies

IAS 10 Events after the reporting period

 

Definition

 

Events after the reporting period ‘are those events, both favourable and unfavourable, that occur between the reporting date and the date on which the financial statements are authorised for issue’ (IAS 10,

 

para 3).

 

There are two types of event after the reporting period:

 

• adjusting events

 

• non-adjusting events.

 

Financial statements are prepared on the basis of conditions existing at the reporting date.

Adjusting and non-adjusting events

 

Adjusting events provide evidence of conditions that existed at the reporting date.

 

Examples provided by IAS 10 include:

 

• the sale of inventory after the reporting date – this gives evidence about the net realisable value of inventory at the reporting date

 

• the bankruptcy of a customer after the reporting date – this confirms that an allowance is required against a receivables balance at the reporting date

 

• the discovery of fraud or errors – this shows that the financial statements are incorrect

 

• the settlement after the reporting period of a court case – this confirms the existence and value of the entity’s obligation at the reporting date.

 

Adjusting events result in changes to the figures recognised in the financial statements.

 

Events after the reporting period, provisions and contingencies

 

Non-adjusting events are those that are indicative of conditions that arose after the reporting period.

 

Examples provided by IAS 10 include:

 

• a major business combination after the reporting date or the disposal of a major subsidiary

 

• announcing a plan after the reporting date to discontinue an operation

 

• major purchases and disposals of assets after the reporting date

 

• destruction of assets by a fire after the reporting date

 

• announcing or commencing a major restructuring after the reporting date

 

• large changes after the reporting date in foreign exchange rates

 

• equity dividends declared or proposed after the reporting date.

 

Non-adjusting events do not affect any items in the statement of financial position or the statement of profit or loss and other comprehensive income. However, for material non-adjusting events, IAS 10 requires the following disclosures:

 

• a description of the event

 

• its estimated financial effect.

 

 

Problems with events after the reporting period

 

Judgement is involved when deciding if an event is adjusting or non-adjusting.

 

Suppose that an item of property, plant and equipment is valued shortly after the year-end and that this valuation reveals a significant fall in value. It may be that the fall in value occurred over a period of several months before the year-end, in which case the loss would be an adjusting event. However, it may be that the fall in value occurred after the year-end as a result of a particular event, such as an interest rate rise.

 

 

 

Test your understanding 1 – Adjusting events

 

The following material events have occurred after the reporting period and prior to the date of approval of the financial statements by the directors.

 

• The insolvency of a major credit customer

 

• The uninsured loss of inventory in a fire

 

• The proposal of a final equity dividend

 

• A change in foreign exchange rates.

 

Required:

 

State whether the above are adjusting or non-adjusting events.

 

Going concern issues arising after the reporting date

 

There is an exception to the rule that the financial statements reflect conditions at the reporting date. If, after the reporting date, management decides to liquidate the entity or cease trading (or decides that it has no realistic alternative to these actions), the financial statements cannot be prepared on a going concern basis.

 

• In accordance with IAS 1, management must disclose any material uncertainties relating to events or conditions that cast significant doubt upon an entity’s ability to continue trading. This applies if the events have arisen since the reporting period.

 

• If the going concern assumption is no longer appropriate then IAS 10 states that a fundamental change in the basis of accounting is required. In this case, entities will prepare their financial statements using the ‘break up’ basis.

 

• If the financial statements are not prepared on a going concern basis, that fact must be disclosed.

 

Events after the reporting period, provisions and contingencies

 

 

Going concern considerations

 

IAS 1 states that management should assess whether the going concern assumption is appropriate. Management should take into account all available information about events within at least twelve months of the end of the reporting period.

 

The following are indicators of a going concern uncertainty:

 

• A lack of cash and cash equivalents

 

• Increased levels of overdrafts and other forms of short-term borrowings

 

• Major debt repayments due in the next 12 months

 

• A rise in payables days – this may suggest that payments to suppliers are being delayed

 

• Increased levels of gearing

 

• Negative cash flows, particularly in relation to operating activities

 

• Disclosures or provisions relating to material legal claims

 

• Large impairment losses – this might suggest a decline in demand or productivity.

 

Where there is uncertainty, management should consider all available information about the future, including current and expected profitability, debt repayment finance and potential sources of alternative finance. If there is greater doubt or uncertainty, then more work will be required to evaluate whether or not the entity can be regarded as a going concern. Here, ‘the future’ means at least twelve months from the reporting date.

 

• Provisions

 

Introduction

 

Liabilities are obligations arising from a past event that will lead to an outflow of economic resources.

 

Most liabilities can be measured accurately. For example, if you take out a bank loan then you know exactly how much you have to repay, and when the repayments are due. Provisions, however, involve more uncertainty.

 

According to IAS 37 Provisions, Contingent Liabilities and Contingent Assets (para 10), ‘a provision is a liability of uncertain timing or amount’.

 

Recognition

 

IAS 37 (para 14) requires that a provision should be recognised when and only when:

 

• ‘an entity has a present obligation (legal or constructive) as a result of a past event

 

• it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation

 

• a reliable estimate can be made of the amount of the obligation’.

 

An obligation is something that cannot be avoided:

 

• A constructive obligation arises when an entity’s past practice or published policies creates a valid expectation amongst other parties that it will discharge certain responsibilities.

 

• A legal obligation arises from a contract or from laws and legislation.

 

An outflow of economic benefits is regarded as probable if it is more likely than not to occur. Only in extremely rare cases is it impossible to make a reliable estimate of the amount of the obligation.

 

Measurement

 

IAS 37 requires that provisions are measured at the best estimate of the expenditure required to settle the obligation as at the reporting date.

 

The best estimate of a provision will be:

 

• the most likely amount payable for a single obligation (such as a court case)

 

• an expected value for a large population of items (such as a warranty provision).

 

An entity should use its own judgement in deriving the best estimate, supplemented by past experience and the advice of experts (such as lawyers).

 

If the effect of the time value of money is material, then the provision should be discounted to present value. The discount rate should be pre-tax and risk-specific.

 

 

Events after the reporting period, provisions and contingencies

 

 

Test your understanding 2 – Warranty

 

Clean sells domestic appliances such as washing machines.

 

On 31 December 20X1, Clean decides to start selling washing machines with a warranty. Under the terms of the warranty, Clean will repair washing machines at no charge to the customer if they break within the warranty period. The entity estimates, based on past-correspondence with customers, that 20% of the washing machines sold will require repair within the warranty period at an average cost to Clean of $50 per machine.

 

Clean sold 200 washing machines on 31 December 20X1.

 

The time value of money should be ignored.

 

Required:

 

Calculate the warranty provision required.

 

 

 

Subsequent measurement

 

If a provision has been discounted to present value, then the discount must be unwound and presented in finance costs in the statement of profit or loss:

 

Dr Finance costs (P/L)

 

Cr Provisions (SFP)

 

Provisions should be remeasured to reflect the best estimate of the expenditure required to settle the liability as at each reporting date.

 

Derecognition

 

IAS 37 states that provisions should be used only for expenditure that relates to the matter for which the provision was originally recognised.

 

At the reporting date, a provision should be reversed if it is no longer probable that an outflow of economic benefits will be required to settle the obligation.

 

3 Contingent liabilities

 

A contingent liability is defined by IAS 37 as:

 

• a possible obligation that arises from past events and whose existence will be confirmed by the outcome of uncertain future events which are outside of the control of the entity, or

 

• a present obligation that arises from past events, but does not meet the criteria for recognition as a provision. This is either because an outflow of economic benefits is not probable or (more rarely) because it is not possible to make a reliable estimate of the obligation.

 

A contingent liability is disclosed, unless the possibility of a future outflow of economic benefits is remote.

 

If an outflow of economic benefits becomes probable then contingent liabilities must be reclassified as provisions.

 

4 Contingent assets

 

IAS 37 defines a contingent asset as a possible asset that arises from past events and whose existence will be confirmed by uncertain future events that are outside of the entity’s control.

 

A contingent asset should not be recognised:

 

• A contingent asset should be disclosed if the an inflow of future economic benefits is at least probable

 

• If the future inflow of benefits is virtually certain, then it ceases to be a contingent asset and should be recognised as a normal asset.

Provisions and contingencies: specific situations

 

 

Losses, contracts and repairs

 

Future operating losses

 

IAS 37 says that provisions should not be recognised for future operating losses because:

 

• They relate to future, rather than past, events

 

• The loss-making business could be closed and the losses avoided, meaning that there is no obligation to make the losses.

 

An expectation of future operating losses is an indication that assets may be impaired. An impairment review should be conducted in accordance with IAS 36 Impairment of Assets.

 

Onerous contracts

 

IAS 37 defines an onerous contract as one ‘in which the unavoidable costs of meeting the contract exceed the economic benefits expected to be received under it’ (IAS 37, para 10).

 

If an entity has an onerous contract, a provision should be recognised for the present obligation under the contract. The provision is measured at the lower of:

 

• the cost of fulfilling the contract, or

 

• the cost of terminating it and suffering any penalties.

 

Some assets may have been bought specifically for use in fulfilling the onerous contract. These should be reviewed for impairment before any separate provision is made for the contract itself.

 

Future repairs to assets

 

Some assets need to be repaired or to have parts replaced every few years. For example, an airline may be required by law to overhaul all its aircraft every three years.

 

Provisions cannot normally be recognised for the cost of future repairs or replacement parts. This is because there is no current obligation to incur the expense – even if the future expenditure is required by law, the entity could avoid it by selling the asset.

 

 

 

Test your understanding 3 – Danboy

 

Danboy is a company that owns several shops and which has a year end of 31 December 20X1.

 

One of the shops is loss-making. At 31 December 20X1, Danboy forecasts that this shop will make a loss of $50,000 in the year ended 31 December 20X2.

 

As at 31 December 20X1, one of the shop buildings requires repair. The cost has been reliably estimated at the reporting date at $10,000. The repair is made in the following accounting period at a cost $12,000.

 

Required:

 

Discuss the accounting treatment of the above in the financial statements for the year ended 31 December 20X1.

 

 

 

Test your understanding 4 – Smoke filters

 

Under new legislation, an entity is required to fit smoke filters to its factories by 31 December 20X7. At the reporting date of 30 June 20X7, the entity has not fitted the smoke filters.

 

Required:

 

Should a provision be made at the reporting date for the estimated cost of fitting the filters?

 

Environmental provisions

 

Environmental provisions are often referred to as clean-up costs because they usually relate to the cost of decontaminating and restoring an industrial site after production has ceased.

 

A provision is recognised if a past event has created an obligation to repair environmental damage:

 

• A provision can only be set up to rectify environmental damage that has already happened. There is no obligation to restore future environmental damage because the entity could cease its operations.

 

• Merely causing damage or intending to clean-up a site does not create an obligation.

 

– An entity may have a constructive obligation to repair environmental damage if it publicises policies that include environmental awareness or explicitly undertakes to clean up the damage caused by its operations

 

The full cost of an environmental provision should be recognised as soon as the obligation arises.

 

• The effect of the time value of money is usually material. Therefore, an environmental provision is normally discounted to its present value.

 

• If the expenditure results in future economic benefits then an equivalent asset can be recognised. This is depreciated over its useful life, which is the same as the ‘life’ of the provision.

 

Test your understanding 5 – Environmental provisions

 

• An entity has a policy of only carrying out work to rectify damage caused to the environment when it is required to do so by local law. For several years the entity has been operating an overseas oil rig which causes environmental damage. The country in which the oil rig is located has not had legislation in place that required this damage to be rectified.

 

A new government has recently been elected in the country. At the reporting date, it is virtually certain that legislation will be enacted that will require damage rectification. This legislation will have retrospective effect.

 

• Under a licence granted by a local government, an entity has constructed a rock-crushing plant to process material mined from the surrounding area. Mining activities have already started. Under the terms of the licence, the entity must remove the rock-crushing plant when mining activities have been completed and must landscape the mined area, so as to create a national park.

 

Required:

 

For each of the situations, explain whether a provision should be recognised.

 

 

Test your understanding 6 – Scrubber

 

On 1 January 20X6, Scrubber spent $5m on erecting infrastructure and machinery near to an area of natural beauty. These assets will be used over the next three years. Scrubber is well-known for its environmentally friendly behaviour and is therefore expected to restore the site after its use.

 

The estimated cost of removing these assets and cleaning up the area on 1 January 20X9 is $3m.

 

The pre-tax, risk-specific discount rate is 10%. Scrubber has a reporting date of 31 December.

 

Required:

 

Explain how the above should be treated in the financial statements of Scrubber.

 

6 Restructuring

 

 

Restructuring provisions

 

Definition

 

A restructuring is a programme that is planned and controlled by management and has a material effect on:

 

• the scope of a business undertaken by the reporting entity in terms of the products or services it provides

 

• the manner in which a business undertaken by the reporting entity is conducted.

 

IAS 37 says that a restructuring could include:

 

• the closure or sale of a line of business

 

• the closure of business locations in a country

 

• the relocation of business activities from one country to another.

 

When can a provision be recognised?

 

A restructuring provision can only be recognised where an entity has a constructive obligation to carry out the restructuring.

 

A board decision alone does not create a constructive obligation. IAS 37 states that a constructive obligation exists only if:

 

• there is a detailed formal plan for restructuring, that identifies the businesses, locations and employees affected as well as an estimate of the cost and timings involved

 

• the employees affected have a valid expectation that the restructuring will be carried out, either because the plan has been formally announced or because the plan has started to be implemented.

 

The constructive obligation must exist at the reporting date. An obligation arising after the reporting date requires disclosure as a non-adjusting event under IAS 10 Events after the Reporting Period.

 

Measuring a restructuring provision

 

A restructuring provision should only include the direct costs of restructuring. These must be both:

 

• ‘necessarily entailed by the restructuring

 

• not associated with the ongoing activities of the entity’ (IAS 37, para 80).

 

IAS 37 prohibits the following costs from being included in a restructuring provision:

 

• retraining staff

 

• relocating staff

 

• marketing products

 

• expenditure on new systems

 

• future operating losses (unless these arise from an onerous contract)

 

• profits on disposal of assets

 

The amount recognised should be the best estimate of the expenditure required and it should take into account expected future events. This means that expenses should be measured at their actual cost, where this is known, even if this was only discovered after the reporting date (this is an adjusting event after the reporting period per IAS 10).

 

 

Test your understanding 7 – Restructuring provisions

 

On 15 January 20X5, the Board of Directors of Shane voted to proceed with two reorganisation schemes involving the closure of two factories. Shane’s reporting date is 31 March, and the financial statements will be authorised for issue on 30 June.

 

Scheme 1

 

The closure costs will amount to $125,000. The closure will be announced in June, and will commence in August.

 

Scheme 2

 

The costs will amount to $45,000 (after crediting $105,000 profit on disposal of certain machines). The closure will take place in July, but redundancy negotiations began with the staff in March.

 

Required:

 

For each of the two schemes discuss whether a provision should be recognised and, if so, at what amount.

 

 

Test your understanding 8 – Delta

 

On 30 June 20X2, the directors of Delta decided to close down a division. This decision was announced to the employees affected on 15 July 20X2 and the actual closure occurred on 31 August 20X2, prior to the 20X2 financial statements being authorised for issue on 15 September.

 

Expenses and other items connected with the closure were as follows:

 

	$m
Redundancy costs (estimated)	22
Staff retraining (actual)	10
Operating loss for the 2 months to 31 August 20X2
(estimated at 30 June)	12
Profit on sale of property	5

 

The actual redundancy costs were $20 million and the actual operating loss for the two months to 31 August 20X2, was $15 million.

 

Required:

 

What is the amount of the restructuring provision to be recognised in the financial statements of Delta plc for the year ended 31 July 20X2?

 

7 Current issue

 

Criticisms of IAS 37

 

In 2012, the Board decided to make IAS 37 a research project. The project will focus on identifying aspects of IAS 37 that cause difficulties in application. These will be used as test cases for developing the Conceptual Framework.

 

The following criticisms have been made of IAS 37:

 

• IAS 37 requires entities to exercise a lot of judgement, which may increase the risk of bias and reduce comparability between entities.

 

• IAS 37 was issued many years ago and does not reflect the current thinking of the International Accounting Standards Board.

 

• The notion of a ‘present obligation’ is vague. It is unclear how unavoidable an obligation needs to be in order to not recognise a provision.

 

• There are differences between IAS 37 and US GAAP, which limit comparability.

 

• Provisions for single obligations are recognised at the ‘best estimate’ of the expenditure that will be incurred. Guidance in this area is lacking.

 

• IAS 37 does not specify what types of costs should be included when measuring a provision. For example, some entities include legal costs within provisions, but others do not.

 

• IAS 37 states that entities may need to make a risk adjustment to provisions, but it does not explain when to do this or how to calculate the adjustment.

 

• Contingent assets are not recognised unless the inflow of benefits is ‘virtually certain’. There is a lack of guidance about the meaning of ‘virtually certain’.

 

• With regards to contingencies, there can be timing differences between when one entity recognises a contingent liability and when the other entity recognises a contingent asset.

Test your understanding 1 – Adjusting events

 

• Non-adjusting.

 

• Non-adjusting.

 

• Non-adjusting.

 

Test your understanding 2 – Warranty

 

A provision is required.

 

A past event (the sale) has created a legal obligation to spend money on repairing machines in the future.

 

The best estimate can be determined using an expected value:

 

200 machines × 20% × $50 = $2,000.

 

Test your understanding 3 – Danboy

 

IAS 37 states that no provision should be made for future operating losses. Therefore, no provision should be made for the $50,000 forecast losses.

 

No provision should be made for future repairs despite it being probable and capable of being reliably measured. This is because there is no obligation at the year end. The repairs expenditure of $12,000 is expensed to profit or loss as it is incurred.

 

 

 

Test your understanding 4 – Smoke filters

 

No provision should be made for this future expenditure despite it being probable and capable of being reliably measured. There has been no obligating past event (the fitting of the filters).

 

Test your understanding 5 – Environmental provisions

 

For each situation, ask two questions.

 

• Is there a present obligation as the result of a past event?

 

• Is an outflow of economic benefits probable as a result?

 

A provision should be recognised if the answer to both questions is yes. In the absence of information to the contrary, it is assumed that any future costs can be estimated reliably.

 

• Present obligation? Yes. Because the new legislation with retrospective effect is virtually certain to be enacted, the damage caused by the oil rig is the past event that gives rise to a present obligation.

 

Outflow of economic benefits probable? Yes. Conclusion – Recognise a provision.

 

• Present obligation? Yes. There is a legal obligation under the licence to remove the rock-crushing plant and to make good damage caused by the mining activities to date (but not any that may be caused by these activities in the future, because mining activities could be stopped and no such damage caused).

 

Outflow of economic benefits probable? Yes.

 

Conclusion – Recognise a provision for the best estimate of the eventual costs of rectifying the damage caused up to the reporting date.

 

 

 

Test your understanding 6 – Scrubber

 

Scrubber has a constructive obligation to restore the area to its original condition as a result of a past event (erecting the infrastructure). Therefore, it should recognise a provision at 1 January 20X6. The best estimate of the expenditure is $3m, but this must be discounted to its present value of $2,253,000 ($3m × 0.751).

 

Scrubber could not carry out its operations without incurring the clean-up costs. This means that incurring the costs gives it access to future economic benefits. The estimated clean-up costs are therefore included in the cost of the property, plant and equipment (PPE):

 

Dr PPE	$2,253,000
Cr Provisions	$2,253,000

 

Each year, the discount unwinds and the provision increases. The unwinding of the discount is charged to the statement of profit or loss as a finance cost.

 

Movement on provision	20X6	20X7	20X8	20X9
	$000	$000	$000	$000
Opening balance	2,253	2,478	2,727	3,000
Finance cost at 10%	225	249	273	–
Utilisation	–	–	–	(3,000)
	–––––	–––––	–––––	–––––
Closing balance	2,478	2,727	3,000	–
	–––––	–––––	–––––	–––––
Initial cost of PPE				$000
Cash paid 1 January 20X6				5,000
PV of clean-up costs				2,253
				––––––
Total				7,253
				––––––

 

The effect on the financial statements is shown below:

 

Statements of profit or loss	20X6	20X7	20X8	20X9
Operating costs	$000	$000	$000	$000
Depreciation ($7,253/3 years)	2,418	2,418	2,417	–
Finance costs	––––––	––––––	––––––	––––––
Unwinding of discount	225	249	273	–
	––––––	––––––	––––––	––––––

 

	Statement of financial position	$000	$000	$000	$000
	PPE
	Cost	7,253	7,253	7,253	–
	Depreciation	(2,418)	(4,836)	(7,253)	–
		–––––– –––––– –––––– ––––––
	Carrying value	4,835	2,417	–	–
	Liabilities	–––––– –––––– –––––– ––––––
	Clean-up provision	2,478	2,727	3,000	–
		–––––– –––––– –––––– ––––––

 

 

Test your understanding 7 – Restructuring provisions

 

Scheme 1

 

The obligating event is the announcement of the plan, which occurs in June. This is after the year-end, so there can be no provision. However, the announcement in June should be disclosed as a non-adjusting event after the reporting date.

 

Scheme 2

 

Although the closure will not begin until July, the employees will have had a valid expectation that it would happen when the redundancy negotiations began in March. Therefore, a provision should be recognised. The provision will be for $150,000 because the expected profit on disposal cannot be netted off against the expected costs.

Test your understanding 8 – Delta

 

The only item which can be included in the provision is the redundancy costs, measured at their actual amount of $20 million.

 

IAS 37 prohibits the recognition of future operating losses, staff retraining and profits on disposals of assets.