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SBR PTP MARCH 21 – QUESTION BANK

SBR Exam Alert – [Specimen 1 Q1: (a) (iii)] - IQ

Business Segment Restructure – IAS 19 & IAS 37

Kutchen has decided to restructure one of its business segments. The plan was agreed by the board
of directors on 1 October 20X6 and affects employees in two locations.

In the first location, half of the factory units have been closed by 31 December 20X6 and the affected
employees’ pension benefits have been frozen. Any new employees will not be eligible to join the
defined benefit plan.

After the restructuring, the present value of the defined benefit obligation in this location is $8
million. CURTAILMAENT

The following table relates to location 1.

Location 1 – $m
Value before restructuring:
Present value of defined benefit obligation (10)
Fair value of plan assets 7
Net pension liability (3)
In the second location, all activities have been discontinued. It has been agreed that employees will
receive a payment of $4 million in exchange for the pension liability of $2·4 million in the unfunded
pension scheme. = CURTAILMENT WITH SETTELEMENT

Kutchen estimates that the costs of the above restructuring excluding pension costs will be $6
million. = PROVISION

Kutchen has not accounted for the effects of the restructuring in its financial statements because it
is planning a rights issue and does not wish to depress the share price. Therefore there has been no
formal announcement of the restructuring.

Required:
Discuss, with suitable workings, how the pension scheme (IAS 19) should be dealt with after the
restructuring of the business segment and whether a provision for restructuring (IAS 37) should
have been made in the financial statement for the year ended 31 December 20X6.

(7marks)
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RESTRUCTURING:

VALID EXPECTATION SHOULD BE CREATED

1- PLAN ALREADY IMPLEMENT TO START OR

2- FORMAL PAN ALREADY COMMUNICATED

IAS 19 (R) – Employee Benefits:

Location 1 (2.5 Marks)

Knowledge - Explain the Curtailment – one line

CASE

After restructuring, the present value of the pension liability in location 1 is reduced to $8 million. Thus
there will be a curtailment only (negative past service cost) in this location of $(10 – 8) million, i.e. $2
million.

Dr Pension obligation $2m

Cr Retained earnings $2m

Location 2 (2.5 Marks)

Knowledge -Explain - Curtailment with Settlement – One Line
CASE

As regards location 2, there is a settlement and a curtailment as all liability will be extinguished by the
payment of $4 million. Therefore there is a loss of $(2·4 – 4.0) $1·6 million. The changes to the pension
scheme in locations 1 and 2 will both affect profit or loss as follows:

Dr Pension obligation $2·4m

Dr Retained earnings $1·6m
Cr Current liabilities $4m

(2 Marks)
IAS 37 Provisions, Contingent Liabilities and Contingent Assets states that a provision for restructuring
should be made only when a detailed formal plan is in place and the entity has started to implement
the plan, or announced its main features to those affected.
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CASE

A board decision is insufficient. Even though there has been no formal announcement of the
restructuring, Kutchen has started implementing it and therefore it must be accounted for under IAS
37.

A provision of $6 million should also be made at the year end.

SBR: MARCH 20

Background

The directors of Ecoma Co consider environmental, social and governance issues to be extremely
important in a wide range of areas, including new product development, reputation building and overall
corporate strategy. The company is taking a proactive approach to managing sustainability and is
actively seeking opportunities to invest in sustainable projects and embed them in their business
practices. The company’s financial year end is 30 September 20X5.

Head office

FUTURE OPERATING LOSS

Ecoma Co is committed to a plan to move its head office to a building which has an energy efficient
green roof that acts as a natural temperature controller. The move from the current head office, which
is leased, will take place at the company’s year end of 30 September 20X5. The new green roof building
requires less maintenance than a conventional building and produces oxygen which offsets Ecoma Co’s
CO2 emissions. The directors of Ecoma Co believe that the green roof building will save the company $2
million per annum over the useful life of the building. However, over the next two years, it anticipates
that the disruption of the move will cause the company to make a loss of $10 million per annum. The
company wishes to make a provision of $16 million which comprises the loss to be incurred over the
next two years net of the saving created by the green roof.

ONEROUS CONTRACT

Meanwhile, the company will have to vacate its currently leased head office building. At 30 September
20X5, the lease has two years to run at a rental of $600,000 per annum payable in advance on 1 October
each year. If the lease is cancelled, the full rental is payable on cancellation. The head-lease permits sub-
letting and Ecoma Co has sub-let the building for one year from 1 October 20X5 at a rental of $400,000
per annum payable in advance. Ecoma Co estimates that there is a 40% probability that it will be able to
extend the sub-lease at the same rental for a second year.

The costs of moving to the green building are estimated at $1 million and the costs of terminating the
lease in two years’ time are negligible. The pre-tax discount rate is 5%.

Required:

Discuss how the $16 million provision associated with Ecoma Co’s move to a new head office and the
sub-let of its old head office should be accounted for in accordance with IAS® 37 Provisions,
Contingent Liabilities and Contingent Assets. (6 marks)
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KNOWLEDGE = FUTURE OPERATING LOSSES + ONEROUS CONTRACT

CASE

Ecoma Co cannot make a provision of $16 million as the company cannot make a provision for the future
operating losses of $20 million (these are specifically not allowed by IAS 37 Provisions, Contingent
Liabilities and Contingent Assets), nor take account of the saving of $2 million per annum as no
obligation exists.

However, the lease represents an onerous contract and an appropriate provision should be made. IAS
37 defines an onerous contract as ‘a contract in which the unavoidable costs of meeting the obligations
under the contract exceed the economic benefits expected to be received under it.’

There are no explicit requirements for entities to ‘search’ for onerous contracts but it is implicit in the
onerous contract principles that reasonable steps should be taken to identify them. If an onerous
contract is identified, a provision must be recognised for the best suitable estimate of the unavoidable
cost.

IAS 37 defines the unavoidable costs under a contract as the least net cost of exiting from the contract,
which is the lower of the cost of fulfilling it and any compensation and penalties arising from failure to
fulfil it. Before a separate provision for an onerous contract is recognised, an entity recognises any
impairment loss which has occurred on assets dedicated to that contract.

The onerous contract should be measured by determining the present value of the unavoidable costs,
net of the expected benefits under the contract. The discount rate should be a pre-tax rate which
reflects current market assessments of the time value of money and the risks specific to the liability.

In this case, the requirements of the onerous contract must be considered along with the prohibition in
IAS 37 of providing for future operating losses. It is important to distinguish between unavoidable costs
under an onerous contract, and future operating losses. Future operating losses are not independent of
the entity’s future actions and do not normally stem from an obligation arising from a past event. A
provision for onerous contracts is recognised if the unavoidable costs of meeting the obligations under
the contract, or exiting from it, exceed the economic benefits expected to be received under it.

PROVISION FOR ONEROUS CONTRACT = MEASUREMENT

Therefore, the unavoidable cost of the onerous contract should be discounted to 30 September 20X5 is
(ADVANCE $600,000 + 1 YEAR DELAR $600,000/1·05), i.e. $1,171,429 PV.

LESS:

The expected benefit of sub-letting the building arising at 30 September 20X5 will be (ADVANCE
$400,000 + (PROB 40% x 400,000)/1·05), i.e. $552,381.

A provision of $(1,171,429 – 552,381) $619,048 can therefore be made.

In addition, a provision of $1 million can be made for the costs of moving to the new head office if it is
felt that the cost is unavoidable.
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This gives a total provision of $1,619,048.

Tutorial note:

IFRS16 Leases says that the right-of-use asset at the date of initial application is adjusted by the amount
of any provision for onerous leases recognised in the statement of financial position.

Defined benefit pension scheme HW

Ecoma Co is worried that the poor remuneration package offered to employees is putting the company
at risk of reputational damage. Consequently, Ecoma Co changed its pension scheme on 30 September
20X5 to include all of its staff. The benefits accrue from the date of their employment but only vest after
two years additional service from 30 September 20X5. The net pension obligation at 30 September 20X5
of $78 million has been updated to include this change. During the year, benefits of $6 million were paid
under the scheme and Ecoma Co contributed $10 million to the scheme. These payments had been
recorded in the financial statements. The following information relates to the pension scheme:

Net pension obligation at 30 September 20X5 78

Net pension obligation at 30 September 20X4 59

Service cost for year 18

Past service cost relating to scheme amendment at 30 September 20X5 9

Discount rate at 30 September 20X4 5·5%

Discount rate at 30 September 20X5 5·9%

Advise

Ecoma Co on the principles of accounting for the pension scheme, including calculations, for the year
to 30 September 20X5. (7 marks)

At each financial year end, the plan assets and the defined benefit obligation are remeasured.
Remeasurement gains and losses are recognised in other comprehensive income.

The statement of profit or loss records the change in the surplus or deficit except for contributions to
the plan and benefits paid by the plan and remeasurement gains and losses.

The amount of pension expense to be recognised in profit or loss is comprised of service costs and net
interest costs. Service costs are the current service costs, which is the increase in the present value of
the defined benefit obligation resulting from employee services in the current period, and ‘past-service
costs’. Ecoma Co’s past-service costs are the changes in the present value of the defined benefit
obligation for employee services in prior periods which have resulted from the plan amendment and
should be recognised as an expense. IAS 19 Employee Benefits requires all past service costs to be
recognised as an expense at the earlier of the following dates:
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1. when the plan amendment or curtailment occurs, and

2. when the entity recognises related restructuring costs or termination benefits

These costs should be recognised regardless of vesting requirements. Thus, the past service cost of $9
million will be recognised at 30 September 20X5.

Net interest on the net defined benefit liability is calculated by multiplying the opening net defined
benefit liability by the discount rate at the start of the annual reporting period. Net interest on the net
defined benefit liability can be viewed as effectively including theoretical interest income on plan assets.

The table below reflects the change in the net pension obligation for the period. The profit or loss will be
charged with the net interest component of $3·2 million and the service cost of $27 million ($18 million
+ $9 million). OCI will be credited with $1·2 million and this gain cannot be reclassified to profit or loss.
Benefits paid have no effect on the net obligation as both plan assets and obligations are reduced by $6
million.

Net pension obligation at 30 September 20X4 59

Net interest component (5·5% x 59m) 3·2 Profit or loss

Service cost for year 18 Profit or loss

Past service cost relating to plan amendment at 30 September 20X5 9 Profit or loss

Contributions (10) Already credited to cash

Remeasurement (1·2) To OCI

–––

Net pension obligation at 30 September 20X5 78

–––

Calculate the impact which the above adjustments in (b)(i) and (ii) will have on profit before tax of $25
million for the year ended 30 September 20X5. Ignore any potential tax implications. (2 marks)
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Thus profit before tax of $25 million will suffer as the profit available to the ordinary shareholders will
be reduced by:

Onerous contract provision (part (i)) 1·6

Net interest component 3·2

Past and current service cost 27

–––––

31·8

–––––

Thus a loss of $6·8 million ($25 million – $31·8 million) will now be reported.

Note: In each question, some marks are allocated for RELEVANT knowledge. Marks will not be awarded
for the reproduction of irrelevant knowledge or irrelevant parts of IFRS Standards. Full marks cannot be
gained unless relevant knowledge has been applied. Candidates may also discuss issues which do not
appear in the suggested solution. Providing that the arguments made are logical and the conclusions
derived are substantiated, then marks will be awarded accordingly.
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Provisions are liabilities where the amount required to settle them, or the timing of the
settlement, is uncertain.
To be useful, financial information must be relevant and must offer a faithful representation of
the underlying transaction. The measurement of provisions requires estimation, and this
increases the risk of manipulation and error.
When measuring provisions, it is vital that accountants adhere to the ACCA Code of Ethics and
Conduct. One of the core principles of this code is objectivity.
To ensure that provisions are faithfully represented, IAS 37 has extensive disclosure
requirements. Preparers of financial statements are required to outline the estimation
techniques used and uncertainties relating to the amount or timing of the eventual payments.
The Conceptual Framework states that an item should only be recognised in the financial statements if it
meets the definition of an element. However, not all items meeting the definition of an element are
recognised. One example of this is contingent liabilities.

Recognition of contingent liabilities in the financial statements would not provide a faithful
representation of the underlying transaction. Depending on the nature of the contingent liability, this
might be because:

• there is not enough certainty that an obligation exists, or

• the probability of an outflow of economic resource is too low, or
• the level of measurement uncertainty is too high.