Chapter 11 Provisions, contingent

liabilities and contingent assets

Chapter Learning Objectives

Upon com pletion of this chapter you will be able to:

· Explain why an accounting standard on provisions is necessary

· Distinguish between legal and constructive obligations

· Explain in what circum stances a provision m ay be m ade

· Explain in what circum stances a provision m ay not be m ade

· Show how provisions are accounted for

· Explain how provisions should be m easured

· Define contingent liabilities and contingent assets

· Explain the accounting treatm ent of contingent liabilities and

contingent assets

· Identify and account for warranties/guarantees

· Identify and account for onerous contracts

· Identify and account for environm ental and sim ilar provisions

· Identify and account for provisions for future repairs and

refurbishm ents

REPORTINGCH11ACCAF7INTJCV1 - 1 -
 PROVISIONS

CONTINGENT CONTINGENT
ASSETS LIABILITIES

SPECIFIC TYPES OF
PROVISIONS

EVENTS AFTER
THE BALANCE
SHEET DATE

REPORTINGCH11ACCAF7INTJCV1 - 2 -
 1 Provisions

1.1 The problem

Until the issue of IAS 37, Provisions, contingent liabilities and contingent assets, there was no
accounting standard covering the general topic of provisions. This led to various problem s as
follows.
Provisions were often recognised as a result of an intention to m ake expenditure, rather
than an obligation to do so.
Several item s could be aggregated into one large provision that was reported as an
H[FHSWLRQDOLWHP WKHµELJEDWK¶
Inadequate disclosure m eant that in som e cases it was difficult to ascertain the
significance of the provisions and any m ovem ents in the year.

Illustration 1
Shortly before the end of 20X1, the Board of Directors of a com pany decides to carry out a
reorganisation. A provision for reorganisation costs is set up. However, the Board is not
com m itted to the plan and early in 20X2 the decision is reversed.

The directors expect that the com pany will m ake losses in the years 20X2 and 20X3.
Therefore the provision becom es a provision for future losses and is released to the profit and
loss account in 20X2 and 20X3, in each case artificially turning a loss into a sm all profit.

REPORTINGCH11ACCAF7INTJCV1 - 3 -
 Expandable text

The problem w ith provisioning

The m aking of provisions was an area of accounting abuse prior to the introduction of any
relevant accounting standard. Users of financial statem ents found it very difficult to
understand profit figures arrived at after the charging or releasing of provisions at
m anagem ent's discretions. A com m on exam ple was on the appointm ent of a new
m anagem ent team to a business:
· on appointm ent the new m anagem ent would set up large provisions for
reorganisations (depressing profits), saying they were needed as a result of the actions of the
SUHYLRXVP DQDJHP HQW±VXFKGHSUHVVHGSURILWVFRXOGWKHUHIRUHEHEODP HGRQWKDWSUHYLRXV
m anagem ent team

· one or m ore years later the new m anagem ent would 'discover' that not all those
provisions were necessary, so they would be written back (enhancing profits), probably
without any disclosure. So the profits under the new m anagem ent would look im pressive,
when in reality they had been created by the release of provisions charged in an earlier
period.

1.2 Objective of IAS 37

The objective of IAS 37 Provisions, contingent liabilities and contingent assets is:

. to ensure that appropriate recognition criteria and m easurem ent bases are applied to
provisions, contingent liabilities and contingent assets

. to ensure that sufficient inform ation is disclosed in the notes to the financial
statem ents to enable users to understand their nature, tim ing and am ount.

1.3 What is a provision?

A provision is a liability of uncertain tim ing or am ount.

A liability is a present obligation of the enterprise arising from past events, the settlem ent of
which is expected to result in an outflow from the enterprise of resources em bodying
econom ic benefits.

REPORTINGCH11ACCAF7INTJCV1 - 4 -
1.4 Recognition of a provision

A provision should be recognised when:

· an enterprise has a present obligation (legal or constructive) as a result of a past event
· it is probable that an outflow of resources em bodying econom ic benefits will be required to
settle the obligation; and
· a reliable estim ate can be m ade of the am ount of the obligation.

Expandable text
Recognition
If any one of these conditions is not m et, no provision m ay be recognised. An intention to
m ake a paym ent is not enough on its own to justify a provision. There m ust be an actual
obligation to m ake a paym ent.

This is im portant in the accounting for repairs or refurbishm ents known to be required in
future. As an exam ple, if a property lease includes a requirem ent that the prem ises are
repainted every five years and the future cost is estim ated at, say, $100,000, the lessee
would probably prefer to spread this cost over the five years, by charging $20,000 against
profits each year. In this way there will be a provision of $100,000 in five years' tim e and
profits have been equally affected each year.

IAS 37 does not perm it this approach, because there is no obligation to incur this cost until
the five years have elapsed. Over the first four years this is a future obligation which can be
avoided by the sim ple m eans of selling the lease to som eone else! IAS 37 requires the full
cost to be recognised in the fifth year; the lessee probably will not like the way profits are
unaffected by this cost over four years but then suffer a m ajor hit in the fifth.

REPORTINGCH11ACCAF7INTJCV1 - 5 -
1.5 Obligations

A provision m ay be necessary as a result of

. a legal or

. a constructive obligation.

A legal obligation is an obligation that derives from :

· a contract

· legislation

· other operation of law.

A constructive obligationLVDQREOLJDWLRQWKDWGHULYHVIURP DQHQWLW\¶VDFWLRQVZKHUH

· by an established pattern of past practice, published policies or a sufficiently specific

current statem ent, the enterprise has indicated to other parties that it will accept certain
responsibilities; and

· as a result, the enterprise has created a valid expectation on the part of those other
parties that it will discharge those responsibilities

Test your understanding 1

A retail store has a policy of refunding purchases by dissatisfied custom ers, even though it is
under no legal obligation to do so. Its policy of m aking refunds is generally known.

Required:
Should a provision be m ade at the year end for the refunds in respect of sales m ade just
before the year end?

Solution

REPORTINGCH11ACCAF7INTJCV1 - 6 -
The policy is well known. It creates a valid expectation, i.e. there is a constructive obligation.
It is probable som e refunds will be m ade. These can be m easured using expected values.

Yes, a provision is required.

1.6 Measuring provisions

The am ount recognised as a provision should be:

. a realistic estim ate and

. a prudent estim ate of the expenditure needed to settle the obligation existing at the
balance sheet date

. should be discounted whenever the effect of this is m aterial.

Expandable text

M easurement

The am ount recognised as a provision should be the best estim ate of the expenditure
required to settle the present obligation at the balance sheet date.

Risks and uncertainties should be taken into account but they are not justification for creating
excessive provisions.

If there is a considerable tim e lag until the obligation provided for is to be settled, the present
value of the expenditures should be taken, using a pre-tax discount rate reflecting the risks
specific to the liability.

If som e or all of the expenditure required to settle a provision is to be reim bursed by a third
party, this should only be recognised when it is virtually certain to be received, and should be
treated in the balance sheet as a separate asset rather than a reduction in the provision. In
the incom e statem ent, however, the net am ount m ay be shown.

1.7 Changes in estimates of provisions

Provisions should be reviewed at each balance sheet date:

. adjusted as necessary,

REPORTINGCH11ACCAF7INTJCV1 - 7 -
. adjustm ents being recognised in the profit and loss account.

REPORTINGCH11ACCAF7INTJCV1 - 8 -
 Illustration 2

A com pany has a provision brought forward at the start of the financial year in respect of the
expense of m aking good dam age to the environm ent caused by m ining. It is m easured at
$3,500,000, being the am ount payable in 10 years' tim e discounted at 6% .

During the year the discounted cost is re-estim ated at $4,000,000 as a result of increases in
clean-up costs.

At the end of the year: $ $

Debit ([SHQVHV±LQFRP HVWDWHP HQWZLWKWKHH[WUDFRVW 500,000

Debit )LQDQFHFRVWV±LQFRP HVWDWHP HQWZLWKWKHXQZLQGLQJ
of the discount (4,000 x 6%) 240,000

Credit ProYLVLRQV±EDODQFHVKHHWZLWKWRWDO 740,000.

Expandable text

Use of provisions
Provisions should only be used for the purposes for which they were set up. So a com pany
which finds that in term s of provisions brought forward:
· the provision for redundancies is in excess of what is needed, but
· the provision for warranty claim s is too low
m ight well wish to charge additional warranty claim s direct to the redundancy provision,
thereby avoiding any recognition in the incom e statem ent. IAS 37 does not perm it this, but
requires both the excess and the shortfall to be recognised in the incom e statem ent, probably
being separately disclosed.

1.8 Methods of measuring uncertainties

Methods of m easuring uncertainties include:
w eighting the cost of all probable outcom es according to their probabilitiesµexpected
value¶
considering a range of possible outcom es.

REPORTINGCH11ACCAF7INTJCV1 - 9 -
Illustration 3
An enterprise sells goods with a warranty covering custom ers for the cost of repairs of any
defects that are discovered within the first two m onths after purchase. Past experience
suggests that 90% of the goods sold will have no defects, 5% will have m inor defects and 5%
will have m ajor defects. If m inor defects were detected in all products sold, the cost of repairs
would be $10,000; if m ajor defects were detected in all products sold, the cost would be
$100,000.

Solution

The expected value of the cost of repairs is $5,500 ((5% ´ 10,000) + (5% ´ 100,000)).

Illustration 4

An enterprise has to rectify a serious fault in an item of plant that it has constructed for a
custom er. The m ost likely outcom e is that the repair will succeed at the first attem pt at a cost
of $400,000, but there is a significant chance that a further attem pt will be necessary,
increasing the total cost to $500,000..

Solution

$SURYLVLRQIRU…LVUHFRJQLVHG

This is because although the best estim ate of the liability m ay be its m ost likely outcom e,
other possible outcom es m ust be considered. The 'significant chance' m akes $500,000 the
best estim ate. Note that where there is a range of other possible outcom es which are either
m ostly higher or m ostly lower than the m ost likely outcom e, the best estim ate will be a higher
or lower am ount.

Test your understanding 2

(a) Explain why there was a need for IAS 37 regarding provisions.

(b) Describe the recognition criteria for provisions under IAS 37 .

Solution

REPORTINGCH11ACCAF7INTJCV1 - 10 -
(a) Creative accounting: profit sm oothing.

(b) Criteria: estim able, obligatory, future transfer.

1.9 Disclosure

For each class of provision, an enterprise should disclose:

· opening and closing balance and m ovem ents during the year
· a brief description of the nature of the obligation and the expected tim ing of any resulting
outflows, including an indication of the uncertainties about the am ount and tim ing of
outflows.

REPORTINGCH11ACCAF7INTJCV1 - 11 -
2 Contingent liabilities and contingent assets

2.1 Objective of IAS 37 Provisions, contingent liabilities and

contingent assets

The objective of IAS 37 in relation to contingencies is to ensure that:

· Contingencies are recognised and m easured consistently

· Sufficient inform ation is disclosed to enable a user of the accounts to understand the
nature, am ount and uncertainties relating to any contingencies.

REPORTINGCH11ACCAF7INTJCV1 - 12 -
2.2 Contingent liabilities

A contingent liability is:

· a possible obligation that arises from past events and whose existence will be
confirm ed only by the occurrence or non-occurrence of one or m ore uncertain future
events not wholly within the control of the enterprise; or

· a present obligation that arises from past events but is not recognised because:
± it is not probable that an outflow of resources em bodying econom ic benefits will be
required to settle the obligation; or
± the am ount of the obligation cannot be m easured with sufficient reliability.

2.3 Contingent assets

A contingent asset is:

. a possible asset that arises from past events and
. whose existence will be confirm ed only by the occurrence or non-occurrence of one
or m ore uncertain future events not wholly within the control of the enterprise.

Illustration 5

A com m on exam ple of contingencies arises in connection with legal action. If Com pany A
VXHV &RP SDQ\ % EHFDXVH LW EHOLHYHV WKDW LW KDV LQFXUUHG ORVVHV DV D UHVXOW RI &RP SDQ\ %¶V
faulty products, then Com pany B m ay be liable for dam ages. W hether or not the dam ages will
actually be paid depends on the outcom e of the case.

Solution

Until this is known, Com pany B has a contingent liability and Com pany A has a contingent
asset.

REPORTINGCH11ACCAF7INTJCV1 - 13 -
 2.3 Accounting for contingent liabilities

Contingent liabilities:
. should not be recognised in the balance sheet itself
. should be disclosed in a note unless the possibility of a transfer of econom ic benefits
is rem ote.

2.4 Accounting for contingent assets

Contingent assets:

. should not be recognised, but

. if the possibility of inflows of econom ic benefits is probable, they should be disclosed.

. if a gain is virtually certain, it falls within the definition of an asset and should be
recognised as such, not as a contingent asset

The accounting treatm ent can be sum m arised in a table:

Degree of probability of an Outflow Inflow

outflow/inflow of resources

Virtually certain Liability Asset

Probable Liability Disclose by note

Possible Disclose by note No disclosure

Rem ote No disclosure No disclosure

Expandable text

Note that when there is the possibility of the recovery from a third party of all or part of a
contingent liability, this m ust be treated as a separate m atter, and a contingent asset only
recognised if its receipt is virtually certain, as shown in the table.

2.5 Disclosure of contingencies

The principle disclosure requirem ents regarding contingencies are:

· The nature of the contingency.

· The uncertainties expected to affect the ultim ate outcom e.

· An estim ate of the potential financial effect.

REPORTINGCH11ACCAF7INTJCV1 - 14 -
.

Illustration 6

The Sun newspaper accused the above of selling babies on the internet, which was total
rubbish. Conti is suing and is highly likely to win. Dam ages are estim ated at $1 m illion.

Required:
Describe and explain the effect of the above on both com panies.

Solution

The Sun: provide

Conti: disclose

Test your understanding 3

During the year to 31 March 20X9, a custom er started legal proceedings against a com pany,
claim ing that one of the food products that it m anufactures had caused several m em bers of
his fam ily to becom e seriously ill. The com pany's lawyers have advised that this action will
probably not succeed.

Solution

Legal advice is that the claim is unlikely to succeed. It is unlikely that the com pany has a
present obligation to com pensate the custom er and therefore no provision should be
recognised. However, there is a contingent liability. Unless the possibility of a transfer of
econom ic benefits is rem ote, the financial statem ents should disclose a brief description of
the nature of the contingent liability, an estim ate of its financial effect and an indication of the
uncertainties relating to the am ount or tim ing of any outflow.

REPORTINGCH11ACCAF7INTJCV1 - 15 -
3 Specific types of provision

3.1 Warranties

A warranty is often given in m anufacturing and retailing businesses:

. it is either express (legal obligation)
. or im plied (constructive obligation)
. to m ake good or replace faulty products.

A provision is required at the tim e of the sale not the tim e of the repair/replacem ent as:

. the m aking of the sale is the past event

. giving rise to an obligation

This requires the seller to analyse past experience so as to be able to estim ate:
· KRZP DQ\FODLP VZLOOEHP DGH±LIP DQXIDFWXULQJWHFKQLTXHVLP SURYHWKHUHP D\EHIHZHU
claim s in the future than there have been in the past
· KRZP XFKHDFKUHSDLUZLOOFRVW±DVWHFKQRORJ\EHFRP HVP RUHFRP SOH[HDFKUHSDLUP D\
cost m ore.

The provision set up at the tim e of sale:

. is the num ber of repairs expected in the future tim es
. at the expected cost of each repair
. should be reviewed at the end of each accounting period in the light of further
experience.

Illustration 7

A com pany offers a warranty on the sale of all its goods for one year after the date of sale.
The probability of a warranty claim on an individual item is estim ated at 15%. If a warranty
claim is m ade then on average the repair or replacem ent costs 40% of the original sales
value. Sales for the year ended 31 Decem ber 20X0 totalled $2 m illion. W arranty claim s in
respect of those sales prior to 31 Decem ber 20X0 totalled $40,000.

Solution

The total expected warranty claim s in respect of 20X0 sales are $120,000 ($2 m illion ´ 15%
´ 40%).

Claim s of $40,000 have been m ade before the year end.

7KHUHIRUHDSURYLVLRQLVUHTXLUHGIRUH[SHFWHGIXWXUHFODLP VRI±

REPORTINGCH11ACCAF7INTJCV1 - 16 -
 Test your understanding 4

A m anufacturer gives warranties at the tim e of sale to purchasers of its product. Under the
term s of the contract for sale the m anufacturer undertakes to m ake good m anufacturing
defects that becom e apparent within three years from the date of sale. On past experience it
is probable that there will be som e claim s under the warranties.

How should this be treated in the financial statem ents?

Solution

3UHVHQWREOLJDWLRQ"±<HV

The past (obligating) event is the sale of the product, which gives rise to a legal obligation
(under the contract).

7UDQVIHURIEHQHILWVSUREDEOH"±<HV7KHUHZLOOSUREDEO\EHFODLP VIRUWKHZDUUDQWLHV
Conclusion±5HFRJQLVHDSURYLVLRQ

3.2 Guarantees
In som e instances (particularly in groups) one com pany will m ake a guarantee to another to
pay off a loan etc if the other com pany is unable to.
Should this guarantee be provided for?
. only if it is probable that the paym ent will have to be m ade
. m ay have to disclose as contingent liability

Illustration 8

During 20X1, A gives a guarantee of certain borrowings of B, whose financial condition at

that tim e is sound.

How should this be treated in the financial statem ents?

Solution

3UHVHQWREOLJDWLRQ"±<HV7KHJLYLQJRIWKHJXDUDQWHHKDVJLYHQULVHWRDOHJDOREOLJDWLRQ

7UDQVIHURIEHQHILWVSUREDEOH"±1R

REPORTINGCH11ACCAF7INTJCV1 - 17 -
Conclusion±'RQRWUHFRJQLVHDSURYLVLRQ'LVFORVHWKHJXDUDQWHHDVDFRQWLQJHQWOLDELOLW\
unless the probability of having to honour it is rem ote.

3.3 Future operating losses

No provision m ay be m ade for future operating losses because:

. they arise in the future and

. therefore do not m eet the criterion of a liability

3.4 Onerous contracts

An onerous contract is a contract in which the unavoidable costs of m eeting the obligations
under the contract exceed the econom ic benefits expected to be received under it.

Onerous leases

Expandable text
An onerous lease is an onerous contract, i.e. one where the unavoidable costs under the
lease exceed the econom ic benefits expected to be gained from it. So if leased prem ises
have becom e surplus to requirem ents but the lessee cannot find anyone to sub-lease the
prem ises to, the lessee will still have to m ake the regular lease paym ents, without being able
to use the prem ises.
The signing of the lease is the past event giving rise to the obligation to m ake the lease
paym ents and those paym ents, discounted if the effect is m aterial, will be the m easure of the
excess of cost over the benefits. A provision for this net cost should be recognised as an
expense in the incom e statem ent in the period when the lease becom es onerous. In
subsequent periods, this provision will be increased by the unwinding of the discount
(recognised as a finance charge) and reduced by the lease paym ents m ade.

Illustration 8

A com pany has ten years left to run on the lease of a property that is currently unoccupied.
The present value of the future rentals at the balance sheet date is $50,000. Subletting
possibilities are lim ited but the directors feel that likely future subletting rentals could have a
present value of $10,000.

W hat is the accounting treatm ent?

REPORTINGCH11ACCAF7INTJCV1 - 18 -
Solution

A provision of $40,000 would be required in respect of this onerous contract.

Test your understanding 5

During Decem ber 20X8 a division of a com pany m oved from Buckingham to Sunderland in
order to take advantage of regional developm ent grants. It holds its m ain prem ises in
Buckingham under an operating lease, which runs until 31 March 20Y1. Annual rentals under
the lease are $10 m illion. The com pany is unable to cancel the lease, but it has let som e of
the prem ises to a charitable organisation at a nom inal rent. The com pany is attem pting to rent
the rem ainder of the prem ises at a com m ercial rent, but the directors have been advised that
the chances of achieving this are less than 50% .

W hat is the accounting treatm ent required?

Solution

The lease contract appears to be an onerous contract as defined by IAS 37(i.e. the
unavoidable costs of m eeting the obligations under it exceed the econom ic benefits expected
to be received under it).

Because the com pany has signed the lease contract, there is a clear legal obligation and the
com pany will have to transfer econom ic benefits (pay the lease rentals) in settlem ent.
Therefore the com pany should recognise a provision for the rem aining lease paym ents. The
com pany m ay recognise a corresponding asset in relation to the nom inal rentals currently
being received, if these are virtually certain to continue. (In practice, it is unlikely that this
am ount is m aterial). As the chances of renting the prem ises at a com m ercial rent are less
than 50%, no further potential rent receivable m ay be taken into account.

The financial statem ents should disclose the carrying am ount of the provision at the balance
sheet date, a description of the nature of the obligation and the expected tim ing of the lease
paym ents, and the am ount of any expected rentals receivable from sub-letting. If an asset is
recognised in respect of any rentals receivable, this should also be disclosed.

3.5 Environmental provisions

A provision will be m ade for future environm ental costs:

. if there is either a legal or constructive obligation to carry out the work

. and this will be discounted to present value at a pre-tax m arket rate

REPORTINGCH11ACCAF7INTJCV1 - 19 -
Illustration 10

Rowsley is a com pany that carries out m any different activities. It is proud of its reputation as
DµFDULQJ¶RUJDQLVDWLRQDQGKDVDGRSWHGYDULRXVHWKLFDOSROLFLHVWRZDUGVLWVHP SOR\HHVDQGWKH
wider com m unity in which it operates. As part of its annual financial statem ents, the com pany
publishes details of its environm ental policies, which include setting perform ance targets for
activities such as recycling, controlling em issions of noxious substances and lim iting use of
non-renewable resources.

The com pany has an overseas operation that is involved in m ining precious m etals. These
activities cause significant dam age to the environm ent, including deforestation. The com pany
expects to abandon the m ine in eight years tim e. The m ine is situated in a country where
there is no environm ental legislation obliging com panies to rectify environm ental dam age and
it is very unlikely that any such legislation will be enacted within the next eight years. It has
been estim ated that the cost of cleaning the site and re-planting the trees will be $25 m illion if
the re-planting were successful at the first attem pt, but it will probably be necessary to m ake a
further attem pt, which will increase the cost by a further $5 m illion.

Solution

It is clear that there is no legal obligation to rectify the dam age. However, through its
published policies, the group has created expectations on the part of those affected that it will
take action to do so. There is therefore a constructive obligation to rectify the dam age and a
transfer of econom ic benefits is probable.

The com pany m ust recognise a provision for the best estim ate of the cost. As the m ost likely
outcom e is that m ore than one attem pt at re-planting will be needed, the full am ount of $30
m illion should be provided. The expenditure will take place som e tim e in the future, and so the
provision should be discounted at a pre-tax rate that reflects current m arket assessm ents of
the tim e value of m oney and the risks specific to the liability.

The financial statem ents should disclose the carrying am ount of the provision at the balance
sheet date, a description of the nature of the obligation and the expected tim ing of the
expenditure. The financial statem ents should also give an indication of the uncertainties about
the am ount and tim ing of the expenditure.

REPORTINGCH11ACCAF7INTJCV1 - 20 -
 Test your understanding 6

Laws have been passed that require an entity to fit sm oke filters to its factories by 30 June
20X2. At 31 Decem ber 20X1 (the balance sheet date) the entity has not yet fitted the sm oke
filters.

How should this be accounted for in the financial statem ents?

Solution

Present obligation? - No. The obligating event would be either the fitting of the filters (which
has not happened) or the illegal operation of the factory without the filters (which has not
happened because the filters are not yet legally required).

Conclusion±'RQRWUHFRJQLVHDSURYLVLRQ

3.6 Restructuring provisions

A restructuring is a program m e that is planned and controlled by m anagem ent, and m aterially
changes either:
· the scope of a business undertaken by an enterprise; or

· the m anner in which that business is conducted.

A provision m ay only be m ade if:

. a detailed, form al and approved plan m ust exist
. this has been announced to those affected

Am ount of restructuring provision:

. direct expenditure arising from restructuring
. no costs associated with ongoing activities

REPORTINGCH11ACCAF7INTJCV1 - 21 -
 Expandable text

Any provision m ay only be m ade if a present obligation exists. In the context of a

restructuring, a detailed, form al and approved plan m ust exist, but this is not enough, because
m anagem ent m ay change its m ind. A provision should only be m ade if the plan has also and
it m ust have been announced to those affected. This creates a constructive obligation,
because m anagem ent is now very unlikely to change its m ind.
The restructuring provision m ay only include direct expenditures arising from the
restructuring, which are both necessarily entailed by the restructuring, and not associated with
the ongoing activities of the enterprise. So it should include the costs such as redundancies
and write-downs on property plant and equipm ent. Costs associated with retraining or
relocating staff, m arketing or investm ent in new system s and distribution networks m ay not be
included in the provision, because they relate to the future conduct of the business.

Illustration 11

a) On 12 Decem ber 20X0 the board of an entity decided to close down a division. Before
the balance sheet date (31 Decem ber 20X0) the decision was not com m unicated to any of
those affected and no other steps were taken to im plem ent the decision. The division was
closed on 5 May 20X1.

Required:
Should a provision be m ade at the year end for the cost of closing down the division?

b) On 12 Decem ber 20X0 the board of an entity decided to close down a division m aking
a particular product. On 20 Decem ber 20X0 a detailed plan for closing down the division was
agreed by the board; letters were sent to custom ers warning them to seek an alternative
source of supply and redundancy notices were sent to the staff of the division. The division
was closed on 5 M ay 20X1.

Required:
Should a provision be m ade at the year end for the cost of closing down the division?

Solution

a) No constructive obligation exists. This is a m ere board decision, which can be

reversed.

No provision can be m ade.

REPORTINGCH11ACCAF7INTJCV1 - 22 -
b) The detailed plan and the public announcem ent create a valid expectation and
therefore the constructive obligation.

Yes, a provision is required.

Test your understanding 7

On 1 Decem ber 20X8 the board of an entity decided to close down a division on 31 March
20X9. On 31 January 20X9 a detailed plan for closing down the division was agreed; letters
were sent to custom ers inform ing them of the decision and redundancy notices were sent to
the staff of the division.
Should a provision be recognised in the accounts for the year ended 31 Decem ber 20X8?

Solution
No provision should be recognised. There was no present obligation at the balance sheet
date. The obligating event is the announcem ent of the plan, which creates a constructive
obligation. This did not take place until after the balance sheet date.

REPORTINGCH11ACCAF7INTJCV1 - 23 -
4IAS 10 Events after the balance sheet date
4.1 Events after the balance sheet date

Events after the balance sheet date are those events, both favourable and unfavourable,
which occur between the balance sheet date and the date on which the financial statem ents
are approved for issue by the board of directors.

Expandable text

The date on w hich the financial statements are authorised for issue is the date the board
of directors form ally approves a set of docum ents as the financial statem ents. In respect of
unincorporated enterprises, the date of approval is the corresponding date. In respect of
consolidated accounts, the date of approval is the date when the consolidated accounts are
form ally approved by the board of directors of the parent com pany.

4.2 Adjusting and non-adjusting events

Adjusting events are post balance sheet events which provide additional evidence of
conditions existing at the balance sheet date.

Non-adjusting events are post balance sheet events which concern conditions that arose
after the balance sheet date.

4.3 Adjusting events

Exam ples of adjusting events include:

. bad debts arising after the balance sheet date m ay help to quantify the bad debt
allowance as at the balance sheet date.
· allowances for inventories due to evidence of net realisable value
· am ounts received or receivable in respect of insurance claim s which were being
negotiated at the balance sheet date
· the discovery of fraud or errors.

REPORTINGCH11ACCAF7INTJCV1 - 24 -
4.4 Non-adjusting events

Exam ples of non-adjusting events include:

· a m ajor business com bination after the balance sheet date
· the destruction of a m ajor production plant by a fire after the balance sheet date
·abnorm ally large changes after the balance sheet date in asset prices or foreign
exchange rates.

4.5 Accounting for adjusting and non-adjusting events

Adjusting events:

. adjustm ent of am ounts recognised in the financial statem ents.

Non-adjusting events:

. should be disclosed by note if they are of such im portance that non-disclosure would
affect the ability of the users of the financial statem ents to m ake proper evaluations
and decisions.
. the note should disclose the nature of the event and an estim ate of the financial
effect, or a statem ent that such an estim ate cannot be m ade.

Expandable text
Non-adjusting events
These are events arising after the balance sheet date but which, unlike those events above,
do not concern conditions existing at the balance sheet date. Such events will not, therefore,
have any effect on item s in the balance sheet or incom e statem ent being prepared.

However, where non-adjusting events after the balance sheet date are of such im portance
that non-disclosure would affect the ability of the users of the financial statem ents to m ake
proper evaluations and decisions, an enterprise should disclose the following inform ation for
each non-adjusting event after the balance sheet date:
· the nature of the event
· an estim ate of its financial effect, or a statem ent that such an estim ate cannot be m ade.

Going concern
If an event after the balance sheet date indicates that the going concern assum ption is
inappropriate for the enterprise, then the balance sheet should be adjusted onto a break-up
basis.

REPORTINGCH11ACCAF7INTJCV1 - 25 -
Illustration 12

Shortly after the balance sheet date a m ajor credit cusotm er of a com pany went into
liquidation because of heavy trading losses and it is expected that little or nothing will be
recoverable for the debt.

In the financial statem ents the debt has been written off, but one of the directors has pointed
out that, as a post balance sheet event, the debt should not in fact be written off but
GLVFORVXUHVKRXOGEHP DGHE\QRWHWRWKLV\HDU¶VILQDQFLDOVWDWHP HQWVDQGWKHGHEWZULWWHQRII
next year.

Solution

Under IAS 10 an event after the balance sheet event is an event which occurs between the
balance sheet date and the date on which the financial statem ents are approved by the board
of directors.

The receivable existed at the balance sheet date and the liquidation of the m ajor custom er
provides m ore inform ation about that receivable.

In accordance with IAS 10, this is an adjusting event which would require the bad debt to be
ZULWWHQRIILQWKLV\HDU¶VILQDQFLDOVWDWHP HQWV

4.6 Proposed dividends

A m ajor change in IAS 10 (as revised) is that:

. equity dividends proposed before but declared after the balance sheet date m ay no
longer be included as liabilities at the balance sheet date.

. the liability arises at the declaration date so they are non-adjusting events after the
balance sheet date and m ust be disclosed by note as required by IAS 1.

REPORTINGCH11ACCAF7INTJCV1 - 26 -
 Test your understanding 8
How should the following m atters be dealt with?

(a) W henGUDIWLQJWKHILQDQFLDOVWDWHP HQWVDFRP SDQ\¶VDFFRXQWDQWLQFOXGHVDILJXUHRI

$2,000 as the net realisable value of dam aged item s of inventory.

The cost of these item s was $3,000, and the norm al selling price would be $4,000.
Between the balance sheet date and the approval of the financial statem ents the item s
are sold for $3,100.

(b) A com pany is engaged in the construction of a factory for sale. The estim ated value on
com pletion is $200,000, costs to date are $80,000 and at the balance sheet date
expected further costs to com pletion were $90,000.
$IWHUWKHEDODQFHVKHHWGDWHVHULRXVGHIHFWV±ZKLFKP XVWKDYHH[LVWHGXQQRWLFHGIRUVRP H
WLP H±DUHGLVFRYHUHGLQWKHIRXQGDWLRQVRIWKHEXLOGLQJQHFHVVLWDWLQJSDUWLDOGHP ROLWLRQDQG
rebuilding at an estim ated cost of $70,000 (in addition to the estim ated further costs to
com pletion of $90,000).

Solution

(a) The valuation in the accounts should be adjusted to $3,000, i.e. cost, since net
realisable value has, in the event, turned out to be greater than cost. This is an event
after the balance sheet date requiring adjustm ent.
(b) This is also an event after the balance sheet date requiring adjustm ent. There is
an anticipated loss on the factory of $40,000 (value $200,000 less costs to date $80,000 less
estim ated further costs $160,000). The asset should, therefore, be valued at $40,000 (costs
to date $80,000 less attributable loss $40,000).

REPORTINGCH11ACCAF7INTJCV1 - 27 -
Chapter Summary

PROVISIONS

CONTINGENT CONTINGENT
ASSETS LIABILITIES

SPECIFIC TYPES OF
PROVISIONS

WARRANTIES REORGANISATIONS

ONEROUS FUTURE
CONTRACTS LOSSES

ENVIRONMENTAL

REPORTINGCH11ACCAF7INTJCV1 - 28 -
 EVENTS AFTER
THE BALANCE
SHEET DATE

REPORTINGCH11ACCAF7INTJCV1 - 29 -
REPORTINGCH11ACCAF7INTJCV1 - 30 -