ACCOUNTING 2

(ACC211E)

UNIT 10: PROVISIONS,

CONTINGENT LIABILITIES AND
CONTINGENT ASSETS

Lecturer: Ntombi Mnconywa

LEARNING GUIDE
Unit 10 IAS 37: Provisions, contingent liabilities and
contingent assets
After studying this topic, you should be able to:
 Explain the objective and scope of IAS 37;
 Identify and define a provision, a liability, an obligating event, a legal
obligation, a constructive obligation, a contingent liability, a contingent
Outcomes asset and an onerous contract;
for this unit  Discuss the recognition, measurement, presentation and disclosure of
provisions, contingent liabilities and contingent assets in the financial
statements;
 Recognise, measure, present and disclose provisions in the financial
statements; and
 Disclose contingent assets and contingent liabilities in the financial
statements.

None

Prior
learning
The whole argument about the recognition or non-recognition of provisions,
contingent liabilities and contingent assets is very complex. You must
understand the difference between provisions, contingent liabilities and
contingent assets, as well as the relationship between the three.
Overview of
the study The whole standard is covered in General Accounting II, except for the section
topic dealing with restructuring (IAS 37 par 70 – 83).

Gripping GAAP – 2022/2023 edition

Chapter 18 PART A (ignore 4.8 Change in provision for decommissioning and
5.3 Restructuring)
Literature
GAAP Graded questions – 2022/2023 edition
Ignore 18.1 to 18.5

Additional material
Notes, examples and old test / exam questions (attached)

This topic is normally assessed in the following ways:

Manner of
 Theoretical questions involving case studies;
assessment
 As part of a statement of financial position question involving
identification, recognition, measurement, presentation and disclosure.

This topic is often combined with events after the reporting period.

LEARNING GUIDE
EXTRA NOTES [extracted from IAS 37]
Recognition, measurement, presentation and disclosure of provisions

Definitions:
Provision
...liability of uncertain timing or amount.

Liability
A liability is a present obligation to transfer an economic resource resulting from past
events.

An obligation is a duty that the entity has no practical ability to avoid.

Onerous contract
...contract in which the unavoidable costs of meeting the obligations under the contract
exceed the economic benefits expected to be received under it.

Recognition
A provision is recognised when:
1. the entity has a present obligation arising from a past event (i.e. an OBLIGATING event);
2. it is probable that there will be an outflow of economic benefits to settle the obligation; and
3. the amount can be reliably determined.

Measurement
The amount recognised as a provision must be the best estimate of the amount necessary to
settle the present obligation at the end of the reporting period.

The estimate must take into account any risks and uncertainties relating to the obligating event /
circumstances. If the outflow of economic benefits is likely to take place over a period of time, it
may be necessary to consider the “time value of money”. i.e. Calculate the provision as the
present value of the expected future expenditures. (NB discount rate must be pre-tax).

Future events which may affect the amount necessary to settle the obligation must be reflected in
the calculation of the provision, if there is sufficient evidence to suggest that the future events will
occur.

Gains from expected future disposals of assets, linked to the obligating event, must not be taken
into account in measuring the provision. [offsetting is NOT permitted!!]

Recognition, measurement, presentation and disclosure of provisions (continued)

If some / all of the amount needed to settle the provision is expected to be reimbursed by a third
party, the amount reimbursed can only be recognised once it is “virtually certain” that it will be
received. This amount would be recognised as an asset and would not be set-off against the
provision. (In the statement of comprehensive income, the expense and the amount re-reimbursed
can, however be set-off.)

At the end of the reporting period, the provision must be adjusted to reflect the best estimate at that
date. If it is no longer probable that an outflow of economic benefits will occur, the provision must
be reversed. A provision may only be used for expenditures, for which it was originally
recognised.

An expected future operating loss does not constitute a liability and cannot be recognised as a
provision. (...but consider the possibility of impairing assets...)

If an entity has an onerous contract, the present obligation under the contract must be recognised
as a provision (amount to be recognised = least net cost of exiting the contract).
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Disclosure
The provision liability must be disclosed as a separate line item in the statement of financial
position.

Note disclosure:
For each class of provision disclose (comparative info not required):
 carrying amount (beginning and end of the period);
 additional provisions made in the period, including increases to existing provisions;
 amounts used (i.e. incurred and charged against the provision) during the period;
 unused amounts reversed during the period; and
 the increase during the period in the discounted amount arising from the passage of time and
the effect of any change in the discount rate.

The following shall also be disclosed for each class of provision:

 description of nature of obligation & expected timing of resulting outflows of economic benefits;
 indication of uncertainties about amount / timing of outflows. Major assumptions made
concerning future events must also be disclosed, where necessary to provide adequate
information.
 amount of expected reimbursement, stating the amount of asset recognised for that expected
reimbursement.

If a group of provisions or contingent liabilities are treated as a class, the nature of the items must
be sufficiently similar for a single statement about them to meet disclosure requirements.

Where a provision and a contingent liability are linked this must be made clear by the disclosure.

If the disclosure requirements of IAS 37 are expected to seriously prejudice the position of the
entity in a dispute with other parties on the subject matter of the provision, contingent liability or
contingent asset, the entity need not disclose the information. Instead disclose the general nature
of the dispute, together with the fact that, and reason why, the information has not been disclosed.
(extremely rare)

Where any of the information required above is not disclosed because it is not practicable to do so,
that fact shall be stated.

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Recognition, measurement, presentation and disclosure of contingent liabilities

Definition
Contingent liability
(a) a possible obligation that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future
events not wholly within the control of the entity; or
(b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic
benefits will be required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability.

Recognition
Do not recognise.

Disclosure
Disclose for each class of contingent liability at the the end of the reporting period date a brief
description of the nature of the contingent liability and, where practicable:
 estimate of its financial effect;
 indication of the uncertainties relating to the amount or timing of any outflow; and
 the possibility of any reimbursement.

[If the possibility of any outflow in settlement is remote, disclose nothing].

Where any of the information required above is not disclosed because it is not practicable to do so,
that fact shall be stated.

Recognition, measurement, presentation and disclosure of contingent assets

Definition
Contingent asset
...possible asset that arises from past events and whose existence will be confirmed
only by the occurrence or non-occurrence of one or more uncertain future events not
wholly within the control of the entity.

Recognition
Do not recognise.

Disclosure
Where an inflow of economic benefits is probable, an entity shall disclose:
 a brief description of the nature of the contingent assets at the the end of the reporting period
date; and
 where practicable, an estimate of their financial effect.

Note: It is important that disclosures for contingent assets avoid giving misleading indications of the
likelihood of income arising.

Where any of the information required above is not disclosed because it is not practicable to do so,
that fact shall be stated.

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Flowchart: Does a present obligation give rise to a contingent liability or provision?
[See slide]

Class example 1

Big Mike's Oil Company Limited (BMOC) operates a number of oil rigs of the coast off Equatorial
Guinea.

The following independent situations have arisen:

a) The local coast line has been contaminated as a result of an oil spill by one of BMOC's oil
rigs. Currently no legislation requiring clean up exists, but the company's technical director
has indicated that the country is virtually certain to pass the legislation (with retrospective
effect).

b) The local coast line has been contaminated as a result of an oil spill by one of BMOC's oil
rigs. Currently no legislation requiring clean up exists, further the company has the policy
of only cleaning up if absolutely required by law.

c) The local coast line has been contaminated as a result of an oil spill by one of BMOC's oil
rigs. Currently no legislation requiring clean up exists, however, as the company is a good
“corporate citizen” it has the generally known policy of cleaning all contamination that it
causes.

d) In terms of the BMOC's agreement with Equatorial Guinea' s Ministry of Oil, the company is
obliged to remove all oil rigs at the end of their useful life and rehabilitate the sea floor.
90 % of the “clearing costs” relates to removal of the oil rigs and rehabilitation of the
seabed, only 10% relates to the actual extraction of oil. At the end of the reporting
period the oil rigs had been constructed but were not yet operating.

e) Recently 100 members of a coastal fishing village died as a result of eating contaminated
fish. Lawyers for the families of the dead have blamed BMOC, and have launched legal
action in civil court. BMOC is disputing liability. The lawyers of BMOC have indicated that
due to the nature of the contamination, it is unlikely that BMOC will be found liable.

f) Recently 100 members of a coastal fishing village died as a result of eating contaminated
fish. Lawyers for the families of the dead have blamed BMOC, and have launched legal
action in civil court. BMOC is disputing liability. The lawyers of BMOC have indicated that
due to the nature of the contamination, it is likely that BMOC will be found liable.

g) BMOC has sued a competitor oil company over illegal drilling in one of BMOC's oil fields.
BMOC's legal advisers have indicated that BMOC will probably win the law case.

h) In terms of legislation, BMOC has to perform major maintenance every 5 years. The
financial director believes that this is an obligating event and would like to create a
maintenance provision.

i) Same facts as d), the director would like to reduce the provisions required by the scrap
value of the oil rigs.

REQUIRED

For each of the above scenarios,

1. Discuss the recognition and measurement of any resulting contingent assets, contingent
liabilities or provisions.
2. Discuss presentation and disclosure.

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QUESTIONS

Question PROV (1) - 2005 Test question.

Question PROV (2) - 2006 Test question.
Question PROV (3) - 2007 Test question.
Question PROV (4) - 2008 Test question.
Question PROV (5) - 2009 Test question.

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PROV(1) (50 MARKS)

This question consists of two INDEPENDENT PARTS

PART A (25 MARKS)

Timid Ltd has a financial year-end of 31 December. The following information is provided to you
relating to the year ended 31 December 20x5.

1. The annual financial statements for the year ended 31 December 20x5 were finalised by the
accountant on 13 March 20x6 and an announcement of the earnings given to the press on
16 March 20x6. The Board approved the AFS (annual financial statements) on
20 March 20x6.

2. The board of directors discussed and approved the extension of the current manufacturing
facility in the following financial year. They decided to raise a long-term loan to finance the
expansion. They would offer the new assets as security for the loan.
a) Capital expenditure already contracted for R1 500 000
b) Capital expenditure approved but not contracted R1 750 000

3. On 20 March 20x6 the board of Timid Ltd declared a dividend of 11c per share to all
shareholders that were registered on 28 February 20x6. The issued share capital of Timid
Ltd consists of 1 000 000 ordinary R2 shares.

4. During February 20x6 a severe thunderstorm caused electrical damage to a number of the
computers and network equipment at Timid Ltd. A large amount of data was lost and the
cost to restore the data is estimated at R750 000. Equipment with a carrying amount of
R450 000 at 31 December 20x5 was irreparably damaged by the storm. Timid Ltd is insured
for these types of events and expects to receive an insurance payout to cover the full loss.

5. Timid Ltd makes provision for present obligations when it is likely that they will have to make
payment to settle the obligations and when they can measure the amount of the provision
reliably.

At 31 December 20x5 provisions included a provision for warranty claims of R50 000 and a
provision for a court case with one of its ex-employees of R150 000. An amount of R40 500
or 90% of the balance on the provision for warranty claims at 31 December 2004 was used
to settle claims during 20x5.

During the year the company had settled another court case by making an out-of-court
settlement payment to a customer of R250 000. The customer had originally sued Timid Ltd
for R500 000 but finally accepted the lower settlement after new evidence favourable to
Timid’s case was presented to the judge. Timid Ltd had recognised the original amount as a
provision at 31 December 2004.

6. During 20x5 Timid Ltd had pledged R150 000 of its movable assets as security for the
overdraft facility of Scarey (Pty) Ltd, one of its subsidiaries. During the process of finalising
the financial statements of the subsidiary, which also has a 31 December year end, it was
discovered that the subsidiary was unlikely to be able to settle its liabilities as they became
due. The bank overdraft balance on the subsidiary’s bank account on 31 December 20x5
was R133 045. On 4 April 20x6 the subsidiary’s bank called for immediate repayment of the
overdraft which amounted to R147 650 at that date.

REQUIRED:
Prepare only those notes to the Statement of Financial Position that arise from the information
supplied above. Accounting policy notes are not required. (25)

Note: The current tax rate is 30%. Comparative figures are NOT required
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PROV(1) (CONTINUED)

PART B (25 MARKS)

1. pH Ltd is a manufacturing company that manufactures and sells spices and soup powder in
South Africa. During February 20x5 they discovered that the dye they used to enhance the
red colour of certain spices is actually a harmful product and they withdrew all of the spices
from the supermarket shelves.

Two people have instituted claims against pH Ltd for their medical costs as well as personal
discomfort caused by indigesting large quantities of the spices containing this harmful
ingredient. (1

2. pH Ltd has issued press statements to all the major daily newspapers in which it promises all
customers that have purchased any of its spices and soup powder in the last 6 months to
come forward and claim refunds or have the goods replaced.

3. pH Ltd instituted a claim against the supplier of the dye. The supplier agreed to refund pH
Ltd for the cost of the purchases of the last 6 months. pH Ltd also claimed an amount for
damages and loss of profit but this matter is still under negotiation with the supplier.

REQUIRED:

Discuss how each of the cases should be treated for accounting purposes (identify and recognise if
appropriate) in terms of IAS 37 (Provisions, contingent liabilities and contingent assets). (25)

Supply all the relevant definitions in your discussion.

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PROV(1) (SUGGESTED SOLUTION)

PART A
Timid Ltd
Notes to the Statement of Financial Position at 31 December 20x5

1) Date of authorisation of issue of financial statements

The financial statements were authorised for issue on 20 March 20x6.

(usually disclosed at the front of the AFS)

2) Dividends declared

An ordinary dividend of 11c per share was declared on 20 March 20x6 for all shareholders
registered on 28 February 20x6.

Ordinary dividend declared R110 000

3) Provisions

Warranty Court Subsidiaries

claims cases overdraft

Carrying amount at 31 December 2004 45 000  500 000 

Additional provisions made ∴45 500  150 000  133 045 
Amounts used (40 500)  (250 000) 
Unused amounts reversed on case with (250 000) 
customer

Carrying amount at 31 December 20x5 50 000 150 000 133 045

Provision has been made for warranty claims arising from sales made during the financial
year. The provision is based on past experience of claims in previous years.

A provision has been made for a claim made in court against the company by an ex- employee.

The company pledged R150 000 of its movable assets as security for the overdraft of Scarey
(Pty) Ltd, a subsidiary of the company. Provision has been made for the balance on the
bank overdraft at 31 December of R133 045.

4) Events after the reporting period

During February 20x6 a thunderstorm damaged computer equipment with a carrying amount
of R450 000. It also caused the loss of electronic data with an estimated cost for
restoration of R750 000 (after taxation R367 500). The company is insured against
such events and expects to receive insurance payment for the full amount of the loss.

5) Commitments

Capital expenditure:
Contracted for 1 500 000
Approved but not yet contracted for 1 750 000
The capital expenditure will be financed by raising a new long-term loan and the assets
purchased offered as security for the loan.
(30  25 marks)

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PROV(1) (SUGGESTED SOLUTION CONTINUED)

PART B

a) Discuss how each of the cases should be treated for accounting purposes (identify and
recognise if appropriate)

1) Claim against the company

Identification:

One should consider whether the company has a present obligation or not.

An obligating event is an event that creates a legal or constructive obligation that results
in an entity having no realistic alternative to settling that obligation.

As the claim has not been settled and no information is available as to whether pH Ltd has
accepted the claim there is no legal or constructive obligation.

One should therefore consider a contingent liability.

A contingent liability is:

 A possible obligation
 that arises from past events and
 whose existence will be confirmed only by the occurrence or non-occurrence of one or
more uncertain future events.
 not wholly within the control of the entity,

OR

A present obligation that arises from past events but is not recognised because:
◦ It is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation or
◦ The amount of the obligation cannot be measured with sufficient reliability.

This is a contingent liability as pH Ltd has a possible obligation.

Recognition:

A contingent liability is not recognised but it is disclosed.

(12  10 marks)
2) Refund of spices and soup powders

Identification:

Again we will consider whether the company has a present obligation or not.

The obligation may be legal or constructive.

A constructive obligation is an obligation that derives from an entity’s actions where:

a) By a sufficiently specific current statement, the entity has indicated to other
parties that it will accept certain responsibilities; and
b) as a result, the entity has created a valid expectation on the part of those other
parties that it will discharge those responsibilities.
The company has a constructive obligation because of the press statements.

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PROV(1) (SUGGESTED SOLUTION CONTINUED)

A provision is a liability of uncertain timing or amount. The total amount involved is

uncertain and the timing of the refund/replacement is uncertain.

Recognition:
A provision should only be recognised 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 and
 A reliable estimate can be made of the amount of the obligation.

The company must create a provision for the total cost of the refund or replacement.
(10  8 marks)

3) Claim against the supplier

Refund:
Identification and recognition:

A contingent asset is

 a possible asset that arises from past events and

 whose existence will be confirmed by the occurrence or non-occurrence of one or more
uncertain future events
 notwholly within the control of the entity.

The supplier is going to reimburse pH Ltd for the cost of the dye that was purchased over
the last 6 months.

Because the supplier has agreed to this refund, the realisation of this income is virtually
certain. It is therefore not a contingent asset and it shall be recognised as an asset.

Damages and loss of profits:

Identification and recognition:

The claim for damages and loss of profits is still under negotiation. This is therefore a
contingent asset.

Contingent assets are not recognised but they are disclosed.

(9  7 marks)

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PROV(2) (50 MARKS)

You are the auditor of Lemony-Snickett Trading Limited, a company which has suffered a series of
unfortunate events. The managing director has asked for your advice on how to deal with the
following independent events / transactions, for the year ended 31 December 20X6, prior to
finalising the financial statements:

1. On 12 January 20X7, a fire destroyed one of the company's four factories. The bookkeeper
was unfortunately hospitalised as a result of smoke inhalation, and has not been able to
record any accounting entries arising from the fire. On 27 January 20X7 the directors
approved plans to build a replacement factory, but have not yet contracted a construction
company.

2. On 15 January 20X7, a major customer was declared insolvent. On 31 December 20X6,

the customer owed Lemony-Snickett Trading Limited R500 000. The customer has been in
financial difficulty for most of the past year.

3. On 15 December 20X6, the company ran a Christmas promotion on children's furniture,

involving a petting zoo and a caged lion. Unfortunately, the lion escaped and ate 5
children. The company has already incurred R30 000 in medical costs (final hospital bill
estimated to be R50 000), and is also being sued by the distraught parents of the eaten
children. The company's lawyers have indicated that the company will “more likely than
not” lose the case. The lawyers have estimated that the damages will probably be in the
region of R1 000 000.

4. On 28 December 20X6, one of the company's trucks transporting a load of radioactive

waste crashed on its way to a disposal facility. This caused a public outcry that the
contamination might affect the local water supply. In order to quell public fear, the
company has made a public statement that it will rehabilitate the affected area. The
company has been unable to estimate what the rehabilitation costs will be. A study has
been initiated, but the results will only be available after the financial statements have been
issued.

5. The company stood surety for one of its suppliers, Paul's Skateboards Ltd, to the extent of
R250 000 on 17 July 20X3. Since then, the suppliers' business has gone from strength to
strength.

6. The company stood surety for one of its suppliers, Justin's Power Tools Ltd, to the extent of
R350 000, on 27 June 20X4. Since then, the financial condition of the supplier has
deteriorated, with the company eventually being declared insolvent on 15 January 20X7.

REQUIRED:

a) Define the following terms and provide the appropriate recognition criteria (in terms of
IAS 37):
i) Provision
ii) Contingent liability

b) Define the term “obligating event” and briefly discuss the different types of obligation
which an obligating event can create (in terms of IAS 37).

c) Explain the two different types of “event after the reporting period” dealt with by IAS 10.

d) Write a memo to the managing director, explaining how the above events should be treated
in the financial records and financial statements of Lemony-Snickett Trading Limited for the

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PROV(2)(CONTINUED)

year ended 31 December 20X6, in accordance with International Financial Reporting

Standards and the Company's Act Your answer should address the following issues:
 Identification of event / transaction (example: provision, contingent liability, event after
the reporting period...type of event, etc);
 Application of the facts to the appropriate definition and recognition criteria;
 Accounting adjustments required in the accounting records for the year ended 31
December 20X6; and
 Disclosure requirements.

Note:
Ignore taxation.

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PROV(3) (25 MARKS)

Smart Stores Ltd is a company that runs a line of chain stores. The company is protective of its
good name, as it is widely renowned for its good business practices.

You are the audit clerk involved in the audit of the company’s financial statements for the year
ended 30 April 20.4. As you are still studying towards your B.Com (Accounting), the accountant
who is soon to retire, approaches you for advice with regard to IAS 37 (Provisions, contingent
liabilities and contingent assets). The accountant is uncertain about the following issues:

a) The provision for doubtful is estimated at 7% of the credit sales annually.

b) The company provides a 12 month assurance warranty on all electrical products. The
company undertakes to replace all defective products or to repair them free of charge within
12 months after purchase. The company knows from experience that 80% of all sales give
no problems, 12% will require repairs and 8% will have to be replaced. Repair costs amounts
to R300 000 per year on average.

The company has an agreement with the supplier of the electrical products whereby the cost
price of all products that need to be replaced, is refunded by the supplier to Smart Stores Ltd
in terms of a suppliers' guarantee. Smart Stores Ltd maintains a 100%-mark-up on all
products purchased.

c) Smart Stores Ltd has a refund policy for the purchase of clothing by dissatisfied customers.
Smart Stores Ltd gained prominence with this policy as they were the first retailer in South
Africa to offer it. The company is not obliged by law to make refunds. Refunds of clothing
sales amount to 4% of sales.

Sales for the year were as follows:

R'000 Note:
Cash sales 16 450 60% of all sales relates to electrical
Credit sales 22 600 products and 40% to clothing.
39 050

REQUIRED:

Distinguish between a provision, a liability, a legal obligation and a constructive obligation (in terms
of IAS 37 (Provisions, contingent liabilities and contingent assets) . (9)

Discuss how each of the above cases should be treated in terms of in terms of IAS 37 and how
much should be disclosed in the financial statements for the year ended 30 April 20.4. (16)
____
(25)

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PROV(3) (SUGGESTED SOLUTION)

A provision
 is a liability of uncertain timing or amount. 

A liability
 is a present obligation of the entity 
 arising from past events 
 the settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits. 

A legal obligation is an obligation that derives from

 a contract (through its explicit or implicit terms) 
 legislation, or
 other operation of law 

A constructive obligation is an obligation that derives from an entity’s action where:

 by an established pattern of past practice, published policies or a sufficiently specific current
statement, the entity has indicated to other parties that it will accept certain
responsibilities, and 
 as a result , the entity has created a valid expectation on the part of those other parties that
it will discharge those responsibilities. 

a) Provision for bad debts

In terms of IAS 37 a provision for bad debts is not regarded as a provision, but rather
as an adjustment against the carrying amount of debtors.

The provision for bad debts should be R1 582 000.

b) Provision for guarantee claims

 The provision for warranty is a present obligation arising from past obligating events. 
 The obligating event is the sale of the product with a warranty which results in a legal
obligation. 
 A legal obligation is an obligation that derives from a contract (through its explicit or implicit
terms), legislation or other operation of law. 
 It is probable that an outflow of resources embodying economic benefits will be
 required to settle the obligation, and indeed probable for the warranty in total.
 The amount can be estimated reliably. 
 The following amount should be recognised:
Provision for warranty = (300 + (8% x (39 050 x 60%)) x 50%) = R1 237 200
 The reimbursement from the supplier of 937 200 should be shown separately as an asset in the statemen

c) Refund policy
 A present obligation exists as a result of a past obligating event. 
 The obligating event is the sale of the product which results in a constructive
 obligation due to the entity’s action creating a valid expectation on the part of the
clients that the entity will refund these purchases. 
 It is probable that an outflow of resources embodying economic benefits will occur. 
 The amount can be estimated reliably -  the company knows that 4% of sales are
refunded. 
 The following amount should be provided:
= Provision for refunds = 4% x (39 050 x 40%) = 624 800 ____
18 Limited to (16)
(25)

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PROV(4) (50 MARKS)

You are the auditor of Hack n' Slash Tools Limited, a company which manufactures power tools for
the export market. After hearing that the chief financial officer (CFO) is not available you are told
by the chief executive office (CEO), “Just before year-end our CFO suffered an unfortunate
incident whilst demonstrating a chainsaw to members of SARS...he will not be available for a while
so we will be needing your help in dealing with a few matters, in order to finalise our annual
financial statements for the year ended 31 December 20X8.”

Other information:
1. Naturally curious you request further information from the CEO regarding the “chainsaw
incident”. The CEO says, “...well the boardroom looked like the scene of a cheap horror
film. Afterwards all our CFO could say was, “...left hand debit, right hand credit” which he
kept on muttering until he was taken away. At this stage we are not quite sure whether the
chainsaw suffered a breakdown, or if it was our CFO. It doesn't really matter though, our
lawyers tell us we will be liable either way. It will be expensive too, the “legal eagles”
reckon that it will probably cost us R3 million per victim, and given that there were 3 bodies
in the boardroom that works out to R9 million...subject of course to the findings of the court
or the outcome of negotiations with the victims' families. Our insurer has indicated, in
writing, that they will cover 80% of the claim.” [20 marks]

2. Groaning, the CEO goes on, “But wait there is more...the family of the CFO are claiming
that the “chainsaw incident” was brought on by work-related stress and that somehow we
are responsible...they are suing us for lost earnings, pain and suffering, and legal costs. We
are not insured for this, but the lawyers reckon that we will probably successfully defend the
case, although they have also said that there is a “stronger than remote” chance that we
might lose, whatever that means...” [8 marks]

3. Now in a talkative mood, the CEO continues, “Confidentially, it has been quite stressful
around here lately, on 20 December 20X8, we discovered that the underground chemical
tanks have been leaking and possibly polluting the water-table. You may have also heard
about the mutant turtles recently found in the local lake. Now I am NOT saying we are
responsible, but you never know. Luckily there are a number of facilities in the area with
similar tanks which are probably just as leaky as ours. Our very busy lawyers tell us that
given the circumstances it would be exceptionally difficult to prove that we are responsible
for the lake pollution...and given the bad publicity we have had, we will definitely NOT
accept responsibility. We did hire a contractor to upgrade the tanks (cost: R200 000) and
remove the polluted soil (R50 000) on our side of the fence, on 28 December 20X8. The
contractor started the work on 5 January 20X9.” [9 marks]

4. Rolling his eyes, the CEO says, “...things get worse, on 30 September 20X8 we entered
into a contract to deliver 50 000 power drills to a major American chain store on 22 January
20X9 at a unit price of R300. Unfortunately our cost accountant made an transposition
error when working out the cost – he erroneously calculated the production cost to be R40
per unit, when in fact the actual cost is R400 per unit. We cannot possibly make any
money on this deal. In terms of the contract we will have to pay a penalty of R6 million if
we cancel the agreement. Luckily the goods had yet not been shipped at year-end, so this
will only be a problem in next year's financial statements.” [8 marks]

5. The CEO then says, “Last but not least, Alpha Corp, one of our major customers went
insolvent on 3 January 20X9 and as a result we will have to write-off R500 000 in bad
debts. Thankfully they did not go insolvent during 20X8!” [5 marks]

REQUIRED:
Write a memo to the CEO, explaining how the above events should be treated in the financial
records AND financial statements of Hack n' Slash Tools Limited for the year ended 31 December
20X8, in accordance with Generally Accepted Accounting Practice and the Companies Act.
Page 17
PROV(4)(continued)

Your answer should be structured as follows:

 Identification of event / transaction (example: provision, contingent liability, event after
reporting period, type of event after reporting period, etc);
 Appropriate definitions and recognition criteria;
 Application of the facts to the appropriate definitions and recognition criteria;
 Recognition and measurement required in the accounting records for the year ended 31
December 20X8 (provide journal entries where appropriate); and
 Disclosure requirements (actual disclosure is NOT required).

Note:
1. Do not repeat definitions, recognition criteria or disclosure requirements – rather refer to the
paragraph of your answer where the definitions, recognition criteria or disclosure
requirements are first given.
2. Marks will be awarded for presentation.
3. Mark allocations per paragraph are approximate.
____
(50)

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PROV(4) (SUGGESTED SOLUTION)

Memo - suitable format for memo, salutation, etc...

1. CFO hacks SARS employees to bits

Identification: Provision

A provision is a "liability of uncertain timing or amount.”

The amount is uncertain as it is subject to legal action / negotiation.

Recognition criteria:
A provision is recognised when:
1.the entity has a present obligation arising from a past event (i.e. an OBLIGATING event);
CFO breakdown / chainsaw breakdown

2.it is probable that there will be an outflow of economic benefits to settle the obligation; and
Lawyers think case will be lost

3.the amount can be reliably determined.

Based on experience (?) lawyers think that the cost will be R3mil per victim i.e.
R9million.

[Note – 3 marks for the definition of a liability “present obligation...arising from past
'event...settlement of which is expected to result in an outflow of econ benefits”]

Accounting treatment:
Legal damages must be recognised – Dr Legal damages (or similar) R9m , Cr Provision R9m

The amount to be covered by the insurer is known as a reimbursement.

It may not be set off against the provision...
..but must instead be shown as a separate asset...
...if it “virtually certain” that the amount will be received.

In this case the amount has been confirmed by the insurer so must be recognised -

Dr Reimbursement receivable (or similar) R7,2m, Cr Legal damages R7.2 m

Note: the income and expense may be set-off!

Disclosure requirements:

For each class of provision disclose (comparative info not required):

~carrying amount (beginning and end of the period);
~additional provisions made in the period, including increases to existing provisions;
~amounts used (i.e. incurred and charged against the provision) during the period;
~unused amounts reversed during the period; and
~the increase during the period in the discounted amount arising from the passage of time and the
effect of any change in the discount rate.

The following shall also be disclosed for each class of provision:

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PROV(4) (SUGGESTED SOLUTION CO

~description of nature of obligation & expected timing of resulting outflows of economic benefits
~indication of uncertainties about amount / timing of outflows. Major assumptions made
concerning future events must also be disclosed, where necessary to provide adequate
information.
~amount of expected reimbursement, stating the amount of asset recognised for that expected
reimbursement.

In this case it may be prejudicial to disclose the above, if so the information

may be omitted, with the dispute being disclosed in general terms,
together with the fact that, and reasons for, non-disclosure.

2. Legal action by CFO's family

Identification: Contingent liability

A contingent liability can be defined as:

“(a) a possible obligation that arises from past events and whose existence will be confirmed
only by the occurrence or non-occurrence of one or more uncertain future events not wholly within
the control of the entity; or
(b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability.”

Recognition criteria: NONE!

Part (a) of the definition is applicable – although it is probable that the company
will defend the case there is a stronger than remote chance it might lose.

Nothing recognised, instead a contingent liability will be disclosed.

Accounting treatment:
None

Disclosure requirements:
Disclose for each class of contingent liability at the end of the reporting period a brief description
of the nature of the contingent liability and, where practicable:
estimate of its financial effect;
indication of the uncertainties relating to the amount or timing of any outflow; and
the possibility of any reimbursement.

[If the possibility of any outflow in settlement is remote, disclose nothing].

Where any of the information required above is not disclosed because it is not practicable to do
so, that fact shall be stated.

In this case it may be prejudicial to disclose the above, if so the information

may be omitted, with the dispute being disclosed in general terms,
together with the fact that, and reasons for, non-disclosure.

Where a provision (example 1) and a contingent liability arise from the same set of
circumstances, disclosure must be made in a way that links them.

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PROV(4) (SUGGESTED SOLUTION CO

3. Leaking tanks

Identification: Provision / Contingent liability ??

Definitions, recognition criteria, etc – refer case 1 & 2.

The definition of a provision is satisfied, but the recognition criteria are not satisfied.

It will be exceptionally difficult to prove that the company is responsible for the
water-table pollution / turtle mutation, therefore NO LEGAL OBLIGATION

As the company will be not be accepting responsibility NO CONSTRUCTIVE

OBLIGATION.

There is therefore no present obligation and no need to recognise a provision.

Contingent liability...
The possibility of economic outflows appears to be less than remote, therefore not necessary
to disclose a contingent liability.

Accounting treatment:
None

Disclosure requirements:
None

3. Leaking tanks upgraded

Identification: Capital commitment

The directors have authorised capital expenditure, and have appointed a

contractor (iro upgrade of tanks).

Accounting treatment:
None

Disclosure requirements:
This must be disclosed in the 20X8 financial statements by way of note “capital
commitment – approved and contracted”.
Proposed source of funds must also be disclosed (eg: insurance, issue of shares, etc).

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PROV(4) (SUGGESTED SOLUTION CO

4. Contract calculation error

Identification: Onerous contract

An onerous contract is a contract where the costs to fulfill the terms are greater than
the benefits that will be derived from it.

In this the unavoidable costs associated with the contract should be provided for.

The unavoidable costs are the lower of:

the cost of fulfilling the contract; or
the penalties to be incurred if the contract were canceled

In this example the company has contracted to sell drills, which cost R400 each at
a price of R300 each, incurring a loss of R100 per unit. As 50 000 units are to be
delivered the total loss will be R5 000 000. If the company cancel, the penalty will
be R6 000 000. Therefore provided for R5m.

Accounting treatment:
Dr Contract cost (or similar) R5m, Cr Provision for onerous contract R5m.

Disclosure requirements:
Provision disclosure required – refer case 1.

5. Major customer declared insolvent

Identification: Event after the reporting period – adjusting.

An adjusting event provides evidence of conditions that existed at the end of the
reporting period.

Bankruptcy of customer soon after year end usually confirms that a loss existed at
year-end on accounts receivable.

Accounting treatment:
The loss of R500 000 will be included in “Other expenses” in the statement of
comprehensive income / income statement.
Debtors will be reduced by R500 000, bad debts will increase by R500 000.

Disclosure requirements:
No specific disclosure is required unless the amount is considered material, in which
case, the nature and amount will be separately disclosed.

Page 22
PROV(5) (30 MARKS)

You are the auditor of Crunchie Biscuits Limited, a confectionery manufacturer. The chief financial
officer (CFO) has asked for your assistance in order to finalise the annual financial statements for
the year ended 31 December 20X8.

Other information:
1. On 1 December 20X8, the company entered into a contract to supply biscuits to Super
Stores Limited. In terms of the agreement, 100 000 boxes of store-brand biscuits are to be
supplied to Super Stores Limited per month for 12 months at an agreed price of R15 per
box. The management accountant estimated that 1 box of biscuits would cost R12 to
produce. In terms of the agreement either party can cancel the agreement upon payment
of a penalty fee of R1 000 000. The CFO says, “At the end of December we discovered
that the management accountant had made a mistake in determining the cost of a box of
biscuits...the actual cost is 50% higher than anticipated! We have tried to renegotiate with
Super Stores Limited, but they told us 'a contract is a contract'. We are considering
cancelling the contract.” [10
marks]

2. The CFO continues, “On 15 November 20X8, we were sued by a rival biscuit manufacturer
for defamation after our chief executive officer (CEO) allegedly badmouthed their products.
At year-end our lawyers assured us that we would probably win the case, however on 1
February 20X9, the lawyers advised me that the plaintiffs had received a video tape from
an 'unnamed intelligence agency' which clearly shows our CEO saying nasty things. This
means that we will probably lose the case. The lawyers indicate that this will probably cost
us R500 000.” [12
marks]

3. The CFO then says, “To add to our troubles, we forgot to declare the annual dividend! We
had intended to declare a dividend of R700 000 for 20X8 on 31 December, but only got
around to having the necessary meeting on 5 January 20X9...we have not yet recorded this
item” [3
marks]

4. The CFO informs you, “Our products are sold with a 'money back guarantee' – if a
customer is dissatisfied with one of our products we will refund them 'no questions asked'.
Past experience has indicated that 3% of the previous months sales will be returned for
refund. Ours sales for December 20X7 and December 20X8 amounted to R750 000 and
R1 000 000 respectively. During January 20X8, refunds of R20 000, relating to December
20X7 sales, were made.” [5
marks]

REQUIRED:

a) Paragraph 1 – 3 only: Write a memo to the CFO, explaining how the events / transactions
per paragraphs 1 to 3, above, should be treated in the financial records AND financial
statements of Crunchie Biscuits Limited for the year ended 31 December 20X8, in terms of
the minimum requirements of International Financial Reporting Standards and the
Companies Act. Your answer should be structured as follows:
 Identification of event / transaction (example: provision, contingent liability, event
after reporting period, type of event after reporting period, etc (this list is NOT
complete));
 Appropriate definitions and recognition criteria;
 Application of the facts to the appropriate definitions and recognition criteria;
 Recognition and measurement required in the accounting records for the year
ended 31 December 20X8 (provide journal entries where appropriate); and
 Disclosure requirements are NOT required. (25 Marks)
Page 23
PROV(5) (continued)

b) Paragraph 4 only: Disclose the transaction / events per paragraph 4 in the notes to the
statement of financial position of Crunchie Biscuits Limited at 31 December 20X8, in
accordance with the minimum requirements of International Financial Reporting Standards
and the Companies Act. Comparative information is not required. (5 Marks)

Note:
1. Do not repeat definitions, recognition criteria or disclosure requirements – rather refer to the
paragraph of your answer where the definitions, recognition criteria or disclosure
requirements are first given.
2. Marks will be awarded for presentation.
3. Mark allocations per paragraph are approximate.
____
(30)

Page 24
Competency
checklist
Check Date
I can explain the objective and scope of IAS 37.

I can identify and define: a provision, a liability, an

obligating event, a legal obligation, a constructive
obligation, a contingent liability, a contingent asset
and an onerous contract.

I can discuss the recognition, measurement,

presentation and disclosure of provisions, contingent
liabilities and contingent assets

I can recognise, measure, present and disclose

provisions in the financial statements.

I can disclose contingent assets and contingent

liabilities in the financial statements.

Page 25