Solved tutorial question

Provision , contingent asset and liability

 What is provision ?
 What are criteria for recognition of provision ?
 Provision Liabilities of an uncertain timing or amount.
 Liabilities is the presents obligation of the entity arising from the past events ,
the settlements of which results in outflow of an economic resources.
WHEN PROVISION SHOULD BE RECOGNIZED?
provision should be recognized when meet the following criteria
a/ if an entity has presents obligation results from the past
EXAMPLE . sure, a bookseller sells books with a guarantee that if the books sold by him are returned within one month of sale, then the amount paid by the buyer for the book will be returned
– no questions will be asked. in this case, sure has a present obligation to return the amount paid by the buyer, within one month of sale. this obligation is a result of a past
event (the sale of books).
b/ probable ( more likely to occur ) the outflow of an economic benefit require to settle an obligation .
Example In the above example of Sure, it is probable that some buyers will return the book within one month. As the terms state that no questions will be asked on return of
books, Sure Co will have to return the amount to the buyer. Settlement of the obligation by Sure Co, will obviously lead to an outflow of resources embodying economic
benefits (i.e. cash returned to the buyer).

C/ A reliable estimate can be made of the amount of the obligation

In the above example, Sure Co can make a reliable estimate of the amount of the obligation. In order to make a reasonable estimate, it will rely on past records, to see what
percentage of books have been returned. In any case, the total provision will not exceed the total of the last month‘s sales figures
 Key hints to remember
 The above mentioned conditions can be remembered with the help of the following
mnemonic: P3 + E
 Where, P = Present obligation
 P = as a result of Past event
 P = Probable that outflow of resources, embodying economic benefits will be
required to settle the obligation
 E = reliable Estimate can be made of the amount of the obligation

 when provisions may not be made

if there is a situation where even one condition of the recognition criteria is not
fulfilled, then it does not constitute a liability which has to be provided for
 Continue . If one condition will not be fulfilled the provision will not be recognized
 Let us see what happens in the following situations:
 (a) A company is planning to give training to its employees to improve their leadership skills.
 In this case;
 An outflow of resources embodying economic benefits will be required to settle the obligation i.e. the training cost.
 A reliable estimate can be made of the amount of the obligation.
 However:
 This is not a present obligation based on a past event in the ordinary course of the business – the training has not started
yet. Also, the company has not yet entered into a contract with any training provider. Therefore, the training cost cannot be
recognized as liability.

OK
 1.4 Accounting for provisions
1. The journal entry to account for a provision is:
Dr Expense (Statement of profit or loss) X
Cr Provision for expense (Statement of financial position) x
Being expense provided for

2. THE JOURNAL ENTRY TO BE MADE WHEN ACTUAL PAYMENT IS MADE IS:

DR PROVISION FOR EXPENSE (STATEMENT OF FINANCIAL POSITION) XX
CR BANK XX
BEING PAYMENT MADE FOR AN EXPENSE PROVIDED FOR EARLIER.
 Goldernforward plc needs to make a provision for warranty claims in the following way:
 at the end of financial year one Tshs5,000,000
 At the end of financial year two Tshs6,000,000
 It settles warranty claims worth Tshs4,400,000 in year two. Required: Set out the journal entries that it should make in
respect of these transactions.

(AMOUNTS IN TSHS‘000) THE ACCOUNTING ENTRIES TO BE PASSED ARE: (AMOUNTS IN TSHS‘000)

AT THE END OF YEAR 1:
TSHS‘000 TSHS‘000
DR WARRANTY CLAIMS 5,000
CR PROVISION FOR WARRANTY CLAIMS 5,000
BEING PROVISION MADE FOR WARRANTY CLAIMS (BALANCE IN PROVISION ACCOUNT, AFTER THIS ENTRY, IS TSHS5,000)
FOR SETTLING WARRANTY CLAIMS IN YEAR 2:
DR PROVISION FOR WARRANTY CLAIMS 4,400
CR BANK 4,400
BEING WARRANTY CLAIMS PROVIDED FOR EARLIER AND NOW SETTLED.
(THE BALANCE IN THE PROVISION ACCOUNT, AFTER THIS ENTRY, IS TSHS600)
 Question
 the new environmental norms set out by the government require
the entities in the manufacturing sector to fit smoke filters in its
factories by the last date of June 20Y1. Required: Would a
provision be recognized in the financial statements if smoke filters
have not been fitted as on the following two reporting dates?
 31 December 20Y0
 31 December 20Y1

Answer
The date by which the smoke filters would be fitted is 30 June 20Y1.
As a result, in the statement of financial position dated 31 December 20Y0, there is no obligating event arising from the fitting of smoke filters or fines arising
from non-compliance. Hence no provision would be required.
In the statement of financial position dated 31 December 20Y1
Since the date for fitting the smoke filters has already passed, an obligation in respect of the cost of fitting smoke filters as well as in respect of the fines
incurred for not complying with the new legislation has already arisen.
As a result, a provision in respect of the expenses incurred as well as the fines estimated to be paid would need to be made. However, the capital equipment yet
to be acquired will not be recorded
 DISCLOSURE IN THE FINANCIAL STATEMENTS:
 The details of the change in the carrying amount of the provision during the year.
 A brief description of the nature of the obligation, the uncertainties and expected timing of any resulting outflows
and an indication of the uncertainties about the amount of those outflows.
 The amount of any expected reimbursement.

NEXT
 the measurement of provisions in accordance with international accounting standards.
 a/best estimates
 The best estimate of the expenditure required to settle the present obligation is the
amount that an entity would rationally pay to settle the obligation at the end of the
reporting period or to transfer it to a third party at that time
 Para 36 of IAS 37 state that the amount recognized as provision shall be the best
estimates required to settle the presents obligation at the reporting date.
How to determine the best estimates
 (i) Expected value: Statistical method of determining the best estimate When the
provision being measured involves large population of items, the ‗expected value‘
method is used. Under this statistical method, all the possible outcomes are weighed
by their respective probabilities and the amount of provision is estimated on that basis.
Therefore, the amount of provision differs according to the probabilities of a loss.
However, if there is continuous range of possible outcomes, the mid-point of the range
is used to determine the amount of provision. In extremely rare cases where a
liability exists but cannot be recognized due to non-availability of reliable estimates,
the liability is disclosed as a contingent liability.

NEXT
 Perfect Fit, a shirt manufacturing company, gives a guarantee that if any shirt
shrinks or fades within one month of sale, it will refund the amount paid for the shirt.
The last month‘s sales for the year ending 31 December 20X6 are Tshs25 million. Past
experience states that 5% of shirts will shrink and 10% of shirts will fade. The possibility
of a shirt both shrinking and fading is nil. However, the management is of the
opinion that, due to the new technology introduced in the business last year, the
possibility of shirts fading will go down to 5%

Solution
task is to find the total provision
sales 25,000,000
shrinking (5% x 25,000,000) 1,250,000
fading ( 5% x 25,000,000) 1,250,000
provision 2,500,000
 Continue how to determine the best estimates
 b/Most likely outcome:
 measurement of a single obligation, Where a single obligation is being measured, the most likely outcome may be the best estimate of the
liability. However, even in such a case, the entity considers other possible outcomes. Where other possible outcomes are either mostly higher or
mostly lower than the most likely outcome, the best estimate will be a higher or lower amount.
 Example
 A court case for damages was pending against Cart House on 31 December 20X6 which is the reporting date. Cart House‘s lawyers estimated
that:
 there is a 60% chance of Cart House incurring a liability of Tshs150 million
 there is a 40% chance of Cart House incurring a liability of Tshs120
 What is the amount of provision?

ANSWER
REMEMBER THE MOST LIKELY MEANS THE CHANCE TO TRANSFER ECONOMIC BENEFIT IS OVER 50%
THEREFORE, AS THE MOST LIKELY OUTCOME IS TSHS150 MILLION, THE ENTITY MADE A PROVISION FOR THIS AMOUNT.
  Quality Ltd sells digital cameras with a warranty under which customers are
covered for the cost of repairs or replacement of manufacturing defects found
within first 12 months after purchase. Quality Ltd has estimated that if every product
sold required minor repairs, the cost would be Tshs2 million. If the product was
replaced, the cost would be Tshs5 million. Quality Ltd‘s past experience and future
expectations indicates that 75% of all goods sold will have no defects, 15% will have
minor defects and 10% will need replacing.
 Required:
 Calculate the amount of provision

SOLUTION
GIVEN
COST FOR MINOR REPAIR 2,000,000
COST FOR REPLACEMENTS 5,000,000
COMPUTATION
MINOR DEFECTS (15% X 2,000,000) 3,00,000
REPLACEMENTS( 10% X 5,000,000) 5,00,000
PROVISION 8,00,000
 2.2 Reimbursements
 If a company is virtually certain that another party will reimburse the expenditure
required to settle the liability, then this amount of ‗receivable reimbursement‘ is
recognized in the financial statements in the following manner:
 As a separate asset in the statement of financial position.
 Deducted from the amount of expense and the net amount of expense is
transferred to the statement of profit or loss
 Note that
 However, the amount recognized for reimbursement cannot be more than the
amount of provision.

PRACTICE NEXT
 Optimax, a television set manufacturing company gives a guarantee that it will correct
all faults found in its television sets within six months of sale. Sales in the last six months
were Tshs40 million. The company knows that if all sets sold had minor defects, the cost
involved would be Tshs5 million and if all sets sold had major defects, the cost would
be Tshs15 million. From past experience, it estimates that 60% of its sets will have no
defects, 20% will have minor defects and 20% will have major defects. It has taken out
an insurance policy, the terms of which state that the insurance company will
reimburse half the amount the company pays by way of settling guarantee claims.
Required: Calculate the amount of provision to be reflected in the financial
statements of Optimax.

SOLUTION NEXT
 Solution
 First find provision
 Minor defects(20% x 5,000,000) 1,000,000
 Major defects (20% x 15,000,000) 3,000,000
 Provision( reflected in statements of financial position ) 4,000,000
 Calculate reimbursements
 Assumption made reimbursement is virtually certain
 Receivable reimbursements
 Reflected assets in SOFP 50% x 4,000,000 2,000,000
 Lastly determine the expenses reflected in profit and loss
 Amount of provision 4,000,000
 Less receivable reimbursements (2,000,000)
 Expenses will be 2,000,000

NEXT
 Changes in provisions
 Provisions are reassessed at the end of each reporting period and adjusted to
reflect the current best estimate. If it is no longer probable that an outflow of
resources embodying economic benefits will be required to settle the obligation,
the provision has to be reversed.

LAST PRACTICE
 Wine Co has signed a contract with its employees under which it has agreed to pay a long service
incentive of Tshs5 million to employees who stay with the company for a period of more than three
years.
 On 31 December 20X8, four employees are eligible for this incentive and accordingly a provision of
Tshs20 million is made in the accounts of that year. In 20X9, all the four employees are accused
of embezzling company funds and are fired. As an outflow of resources embodying economic
benefits will probably not be required to settle the obligation, the provision of Tshs20 million made
earlier will now be reversed, and a new provision will not be made.
 What is the accounting entries will be:
 Solution
 31 December 20X8
 Dr Employee costs Tshs20m
 Cr Provisions Tshs20m
 Being employee costs provided for
 31 December 20X9
 Dr Provisions Tshs20m
 Cr Statement of profit or loss Tshs20m
 Being the provision made for the employee costs reversed

THANK YOU