nyovisions, Contin bi Bropblons Contingent Liabilities and Contingent A eat cl . Chapter 4 Provisions, Contingent Liabilities and Contingent Assets ed standard: P, iS hs a PAS 37 Provisions, Contingent Liabilities and arning Objectives State the recognition criteria for provisions. 2. Differentiate the accountin, | e e 6 Fequirements of a provision, a contingent liability and a contingent asset. 3. Describe the available measurement ba 4, Account for provisions, Les 1 ses for a provision. Provisions A provision is “a liability of uncertain timing or amount.” (Pas37.10) Provisions differ from other liabilities because of the uncertainty in the timing of their settlement or on the amount needed to settle them. Unlike other liabilities, provisions must necessarily be estimated. Although some other liabilities are also estimated, their uncertainty is generally much less compared to provisions. Examples of provisions: a. Warranty obligations b. Estimated liabilities on pending lawsuits ¢. Provisions for environmental damages d. Provisions of decommissioning costs of an item of PPE ©. Obligations caused by an entity's policy to make refunds to customers Obligations arising from guarantees . Provisions on onerous contracts (e.g., purchase commitment) h. Provisions for restructuring costs wm Provisions are presented in the statement of financial Position separately from other types o! Accounting Books PHRecognition A provision is recognizes met: ; a. The entity has a present obliga ing from a past event; b. Tu grovebe Mea an outflow of resources ¢ ™Mbodyin, economic benefits will be required to settle the oli ation; ant ¢. The amount of the obligation can be reliably estimated. the following condition, 4 when all of tion (legal OF constracy), if any of the conditions is not met, RO provision j recognized. (PAS974) Present obligation In rare cases where it is not clear obligation, an entity deems a past event to give rise t0 a presen, obligation if available evidence shows that it is more likely than no that a present obligation exists at the end of the reporting period whether there is 2 prey, Past event A past event that creates a present obligation is called a obligating event. An obligating event is one whereby the entity does not have any other recourse but to settle an obligation. This is the case where: a. the obligation is legally enforceable (legal obligation); or b. the entity’s actions (e.g., past practice or published policies have created valid expectations from others that the entity will discharge the obligation (constructive obligation). Financial statements deal with past or _historicd information. Therefore, no provision is recognized for futur operating costs. “The only liabilities recognized in an entity’ statement of financial position are those that exist at the end of t& reporting period.” (PAs 37.18) - Only those obligations arising from past events exists independently of an entity's future actions are recognized * Provisions. Thus, possible outfieWei Manatee ember Glan) All rights belongs to es ea ET Ue cyprovisions, Contingent Liabilities and Contingent Assets 167 economic benefits that the entity can avoid by changing its future actions are not recognized as provision . Although an obligation always involve another party to whom the obligation is owed (ie, obligee), itis not necessary that the identity of the obligee is known ~ indeed the obligee may be the public at large. For a constructive obligation to create a valid expectation from others, it is necessary that the commitment must have been communicated to the parties concemed before the end of the reporting period, Probable outflow of resources embodying economic benefits Probable means “‘more likely than not,” i.e., there is a higher chance that the event will cause an outflow of future economic benefits than not. We may think of it as a “51% or more” chance that the outflow will occur. If it is ‘50:50’, then it is not probable because there are equal chances of occurrence and nonoccurrence. A 50:50’ chance is “possible” but not “probable.” Reliable estimate of the obligation Provisions necessarily need to be estimated. If a reliable estimate cannot be made, no provision is recognized. Contingent liabilities Ina general sense, all provisions are contingent because they are of uncertain timing or amount. However, PAS 37 uses the term “contingent” to refer to those liabilities and assets that are not recognized because they do not meet all of the recognition criteria. A provision and a contingent liability are differentiated below: Elcom alle) ca al[Provision Contingent titi ine of an uncertain | > A possible obligation > A liability of an uncertain > timing or amount that meets all of the _ following conditions: a. present obligation; b. probable outflow; and ¢, reliably estimated existence will be contin only by the occurrenee non-occurrence of ong more un not wholly within the con, of the entity; or oI } Apresent obligation byt i. it is mot probeble thay, will cause an outflow its settlement; or its amount caret o tain future eign Contingent liabilities are disclosed only, except when the possibility of an outflow of resources embodying economic benefits is remote. Contingent assets Contingent assets are those that are not recognized because they do not meet all of the asset recognition criteria (ie, ‘resoure controlled arising from past events’, ‘probable inflow’, ani ‘reliable estimation’). Contingent assets include possible inflows of econom benefits from unplanned or unexpected events, such as claims that an entity is seeking through legal processes where the outcomes uncertain (e.g., claims under tax disputes and disputed insurane claims). Contingent assets are disclosed only, if the inflow # economic benefits is probable. They are not recognized bec recognizing them may result to the recognition of income !¥* may never be realized. However, when the realization of income is virtuéll certain (100% chance of occurrence), the asset is mot @ contr asset and therefore it is appropriate to recognize it. (PBEM nsecn aa All rights bree to respectiv » authors erie ms! " _rr asions, Contingent Liabilities end ¢, is, Contingent Labiltes nd Contingnt pm £ 169 ognize and Disdose Disclose onl Contingent asset [ltustration 1: Contingent asset ABC Co. is involved in a tax dispute. ABC has wrongfully paid xnesand is claiming for refund of the taxes it has previously paid As of December 31, 20x1, ABC’s legal counsel was very confident that ABC will be able to recover the tax refund amounting to PIOM in the coming year. What is the entry to recogni ; y the probable receipt of the tax refund? ene _ Disclose Brly Ignore _| 4Ignore | ignore Answer: None. Contingent assets are disclosed only when they are deemed probable. If possible or remote, contingent assets are not required to be disclosed. Illustration 2: Virtually certain In 20x1, there was a robbery in one of ABC’s branches. There has been a dispute on the P100M insurance claim that ABC has presented to its insurance provider. On December 31, 20x1, the insurance company approved the payment of 80% of ABC’s claim (ie, P80M). ABC received a letter that the settlement check fer that amount had been mailed, but such check was received only on January 5, 20x2. What is the entry to be made by ABC on December 31, 20x1? Answer: De 31 T Claims receivable (00M x 39%) Gain on settlement of insurance 80,000,000 in, it is not considered as a 80,000,000 Since the claim is virtually certa Contingent asset. Thus, recognition of the appre170 Measurement Provisions are measured at the best estimate of the needed to settle them at the end of the reporting period Making the estimate requires management's judg, supplemented by experience from similar transactions, mae some cases, reports from independent experts. The estimate , considers events after the reporting period ay If the provision being measured involves a large Popuiy of items, the obligation is measured at its “expected yj." Expected value is computed by weighting all possible outcome, their associated probabilities. 4 If there is a continuous range of possible outcomes, ang point in that range is as likely as any other, the mid-point range is used. , My pe (Nature of the outflow Measurement basis ~ Best estimate 1. General rule (e.g. one-off event) 2. Involvesa large population of v\v v Expected value items (Probability Weighieg Average) 3, Each possible outcome ina range | > Mid-point is as likely as any other Recording the provision Provisions are normally recognized as a debit to expense (or les} and a credit to an estimated liability account. Howere. sometimes a provision forms part of the cost of an asset fe example, provisions for restoration and decommissioning «0s are capitalized as part of the cost of a PPE. Illustration 1: Best estimate : In 20x1, ABC Co. received a court order requiring the cleam?® environmental damages caused by one of ABC's factory. ABC no other realistic alternative but to comply with the court ° ElPooalh aL CHa alprovisions, Contingent Liabilities and Contingent Asset soe 171 Other entities have incurred are und PI5M for similar cleanup; nowever, ABC'S best estimate * f the cost of cleanup is P20M. (Analysis: — — Step 1: Is th 4 present obligation? Yes, environmental di yes have already been caused neh eee ae Step 2:15 the oul probable? ~ Yes, “ABC has no other realistic alternative | but to comply with the court order" | Step 3: Cam the outflow be measured reliably? 7 ~ Yes, the problem indicates a “pest estimate” of P2UM. | Conclusion: A provision must be | accrued and disclosed in the amount of P20M. (PM, ee ee + Note: Before a provision can be recognized, the answer to all of the questions in “Steps 7 to 3” must by “yes.” If any of the questions has a “no” for an answer, no provision is recognized. When a provision is accrued, a disclosure must also be made. The entry to recognize the provision is as follows: a Environmental cleanup costs 20,000,000 ausi| _ Estimated liability for cleanup costs 20,000,000 Illustration 2: Expected value In 20x1, ABC Co. recalled a product due to a possible defect - caused by malfunctioning factory equipment. The products secalled will be repaired free of charge. ABC is uncertain whether all products recalled will have the possible defect. However, the following estimate was made by ABC's engineers and managerial accountants and approved by the board of directors. sair cost Probabilit 20,000,000 Bie 15,000,000 20% 10,000,000 35% 5,000,000 —ae__4 172 ie, The expected value of the provision js determined as follows, eS. = ae Probability __ Expected value _ ) =a) x) __ Repair cost a ( @) 20,000,000 «5% Bed 15,000,000 20% aD 10,000,000 35% 3%, 5,000,000 go 2.000000 a “The entry to recognize the provision is as follows ‘Dec. | Repair costs 9,500,000 2 | gatimated lability For repair con's 4.50004 Illustration 3: Mid-point In 20x1, a lawsuit was filed against ABC Co. for patent infringement. The plaintiff is claiming P100M in damages. ABCs legal counsel believes that it is probable that ABC will lose the lawsuit and pay damages of not less than P10M but not more than PI0OM, The probability of any amount within the range is as likely as any other amount also within the range. The plaintiff has offered to settle the lawsuit out of court for P90M but ABC did not agree to the settlement. How much is provision to be reported in ABC's year-end financial statements? Answer: P55M [(10M + 100M) + 2]. The mid. i aa +2]. -point of the range is used because each point in the range is as likely as any other. ane entry to recognize the provision is as follows: «31 Probable loss on lawsuit 55,000,000 Estimated liability on pending lawsuit |__| $5,000. Risk and uncertainties Estimate: S take into account risks and uncertainties. T™® estimates may be incre; ased by is " an allowance for imnprecsieny a risk adjustment factor to provideprovisions, Contingent Liabilities ang c, Po lites an ningent Asse ts 173 does not mean that the entity can make oxce: can deliberately overstate . ntily ssive provisions or liabilities ° Present value If the effect of time value of e ‘ estimate of a wision is discounte pro “scounted to its present value using a pre-tax discount rate, This is usually the case f isi io Case for provisions for restoration and decommissioning costs where ca: n sh outflows occur onl after arelatively long period of time from the date of initial Geen money is material, the Illustration 1: Present value Amanufacturer gives warranties at of its product. Under the terms manufacturer undertakes to make good, by repair or replacement, manufacturing defects that become apparent within one year from the date of sale. On the basis of experience, it is probable (ie, more likely than not) that there will be some claims under the warranties. the time of sale to purchasers Of the contract of sale, the Sales of P10 million were made evenly throughout 20X1. At December 31, 20x1 the expenditures for warranty repairs and replacements for the product sold in 20x1. are expected to be made 50% in 20x1 and 50% in 20x2. Assume for simplicity that all the 202 outflows of economic benefits related to the warranty repairs and replacements take place on June 30, 20x2. Experience indicates that 95% of products sold require no warranty repairs; 3% of products sold require minor repairs costing 10% of the sale price; and 2% of products sold require Major repairs or replacement costing 90% of sale price. The entity no reason to believe future warranty claims will be different from its experience. At December 31, 20x1, the appropriate discount factor for cash 0.95238. Furthermore, Movs expected to occur on June 30, 20 Gower Wcce rie celoian] All rights belongs to see rulesm4 tor to reflect the uncertaintie, in adjustment fact mean increment of © PEF Cent to yy, 3 d cash flows an appropriate risk the cash flow estimates i probability-weighted expecte Requirement: Compute for the warranty provision at December 3, 20x1 Solution: eee te I Analysis: salys Yes, products have already been sig | Step 1: Is there a preseat obligation? — ‘The obligating event for warranties 15 probable? ~ Yes, based on ABC'S past experienc, iis ibe some claims under the warranties | the act of selling. Step 2: Is the ouiflow probable that there wil Step 3: Can the outflow be measured reliably? ~ Yes, sufficient information sl available to make a reliable estimate. ied and disclosed. Conclusion: A provision must be aceru The amount of the provision is estimated as follows: Minor repairs (10M x 3% x 10%) som Mejor repairs (10M x 2% x 90%) 180000 Total 210,000 Multiply by: Present value factor (given) 0.95238 Total 200,000 Multiply by: Risk adjustment (100% + 6%) 106% Total ; 212,00 Multiply by: Amount to be settled in 20x2 50h Warranty provision - Dec. 31, 20x1 106 000 —=> Illustration 2.1: Present value msc aaa 4 Pa is the eiendanh in a patent infringement lawsuit. T giieeoges lieve there is a 30% chance that the court "it ‘ase and the entity will incur no outflow of econo benefits, However, if lawyers believe that there is ae a favor ofthe clara Tequired to pay damages of Poodaan ate ATR ena) pa y athe SOTA CoM AviS531 (0) 7-918) of)sions, Contingent Liabilities and Contin ent Asser es Rd Contingent Assets i , idan 80% chan, daimant) an ance that the entity will be » required t ay damages z P100,000 (the amount that wae recently nypacle py he same judge in asimitar case) Other cuteomer unlikely. The court is expected to rule in late D, + ecember 20x2, indication that the claimant will settle. MTree ut of court, A 7% risk adjustment factor to the cath flows is considered appropria the cash flow estimates. Probability-weighted expected te to reflect the uncertainties in Anapproptiate discount rate is 10% per year Requirement: Compute for the Provision for lawsuit at December 31, 20x1. Solittion: At twenty per cent chance: (200K x 20%) 40,000 At eighty per cent chance: (100K x 80%) 80,000 Total 120,000 Multiply by: PV of P1 @10%, n=1 0.90909 Total 109,091 Multiply by: Risk adjustment (100% + 7%) 107% Total 116,727 Multiply by: Probability of settlement (100% - 30%) 70% Provision for lawsuit — Dec. 31, 20x1 81,709 Illustration 2.2: Present value The facts are the same as in the immediately preceding illustration. However, in this question, because of extremely rare Crcumstances disclosure of some of the information about the case required by PAS 37 can be expected to prejudice Sees Position of the entity in the dispute over the alleged breach of Patent.Pers ——— 4 176 ee the entity account for the transac y si Requirement: How should ity 8 illustration? described in the preceding, Anster: R ive a pr at the amount determined ecogniz : " vceting.illustatio Jose the general nature of 4, eee that, and reason why, 4 the dispute, together w! | information has not been disdosed. | rovision measured. yn and disc! t value | The facts are the same as in the previous illustration. However, i, this question, the entity’s lawyers believe there is a 60 per cen, chance that the court will dismiss the case and the entity will inqyy no outflow. Illustration 2.3: Present Requirement: How should the entity account for the transaction described in the preceding illustration? Answer: ‘Analysis: Step I: Is there a present obligation? — Yes, patent infringement lawsuit. | ABC is currently a defendant in| Step 2: Is the outflow prateble? ~ No, a 40% chance of occurrence (100% mins 60%) is not probable. Probable means “more likely than not;” it connotes mr than 50% chance of occurrence. : Step 3: Can the outflow be measured reliably? ~~ Yes, sufficient information available to make a reliable estimate. Conclusion: A provision is not accrued. i | ; |. The enti i | contingent liability (possible obligation). on Geese Future events Futui obligation Hoy may affect the amount needed to settle # procniar ona ares fre events are considered in estima? entiation, 4 if is objective evidence that supports the "cr example, the Penalty for an environment damage may be aff increase the amount of mie. sae eae Se ~ions, Contingent Liabilities and Con — 2 177 law is anticipated only when jt jg Virtually certain that it will be enacted. Otherwise, it would not be appropy ate to anticipate it expected disposal of assets Gains from the expected disposal of assets acount when measuring a provision, separately when the disposals occur, are not taken into Gains are recognized Reimbursements Ifanother party is expected to reimbu et h a he settlement amount of a provision, a reimbursement asset ig rec ‘ognized if it is vi certain that the reimbursement will be eee ae reimbursement asset is presented in the statement of financial position separately from the provision. However, in the statement of comprehensive income, the expense related to the provision may be presented net of the reimbursement, The amount recognized for the reimbursement should not exceed the amount of the provision. An example of an instance where a reimbursement asset may be recognized is when the obligating event that caused the recognition of a provision is insured. The reimbursement asset would be the amount that the entity can claim from the insurance company. Illustration 1: Reimbursement ABC Co. is engaged in logistics services. During the year, a warehouse was destroyed by fire. It was estimated that ABC will Probably pay around P50M in damages caused to the goods owned by customers that were contained in the destroyed warehouse, The contents of the warehouse at any given point of time are insured for P20M. ABC's claim for the insurance has been approved for payment by the insurance company. The pertinent entries are as follows: swat °° 31 [Loss on fire 0000 | ano 2" [__Estimated liability on casualty I al Accounting Books PHha Pier, 178 erent i 20,000,000 | a eceivable E: | Insurance claims recelval [| 20,000,655 surance _— sm for the reimbursement iS Tecordeg .. "virtually certairt Ge APPLoved joy bursement will be received and it does ip on. The provision may be presentey loss and other comprehensive income “et 1oss of P30M (50M loss ming, Notice that the cla a separate asset because it payment) that the reimburse” exceed the amount of provisi in the statement of profit or I net of the reimbursement, i.e, 20M gain). ion 21: tible clause Illustration 2.1: Deduct dat ABC Co's bin jlosion occurre On Janmary 1, 20x2, an exp Al causing extensive property damage to area buildings. Although i f March 10, had yet been asserted against ABC as o} 2, Baer wang oncluded that it is likely tha: ABC’s management and counsel © “aime will be asserted and that it is probable that ABC will by held responsible for damages. ABC's P5,000,000 comprehensive public liability policy has a 7250,000 deductible clause. ABC estimates an outflow equal to its net liability on the comprehensive public liability policy. ABC's financial statements were authorized for issue on March 30, 20x2. Requirement: How should the event above be reported in ABC's December 31, 20x1 financial statements? Answer: As a note disclosure only indicating the probable loss of 250,000, ie, the extent of liability under the comprehensive insurance policy (deductible clause). No provision is recognized because there is 10 present obligation existing as of the end of seperting period (ie., Dec. 31, 20x1). The explosion occurred in Illustration 2.2: Deductible clause On pid 31, 20x1, an explosion occurred at ABC Co.'s Pett ig extensive property damages FAL AHO shgesuuks Pl Meet [ol eo Oc a LU Ue= me mndingent Assets 179 no claims had yet been asserted against ABC as of March 10, 20x2, {ABC's Management and counsel concluded that it is likely that daims will be asserted and that it is probable that ABC will be teld responsible for damages. ABC's 5,000,000 comprehensive public liability policy has a P250,000 deductible clause. ABC estimates. an outflow equal to its net liability on the comprehensive public liability policy. ABC’s financial statements were authorized for issue on March 30, 20x2. Requirement: How should the event above be reported in ABC's December 31, 20x1 financial statements? Answer: As a provision for P250,000, i.c., the expected outflow. Changes in provisions Provisions are reviewed at the end of each reporting period and adjusted to reflect the current best estimate. Changes in provisions are accounted for prospectively by accruing an additional amount or by reversing a previously recognized amount. When the provision is discounted, the unwinding (amortization) of the related discount which increases the carrying amount of the provision is recognized as interest expense. Use of provisions A provision is used only for the expenditure it was originally intended for. Charging expenditure against a provision that is intended for another purpose is inappropriate as it would conceal the impact of two different events. Illustration: Changes in provisions In 20x1, ABC Co. recognized provision for a probable loss on Pending lawsuit of P500,000. The entry in 20x1 to record the provision is as follows: «31, ] Probable loss on lawsuit 500,000 21 | Estimated liability on pending lawsuit al Accounting Books PHnn 20x2_ necessit The lawsuit remains unsettled auerntned ine ating, reassessment of the provision. ABC seins Probab Joss on the pending law suit should be J 9 record the additional prow is as follow, The entry in 20%2 ts : 22188 Probable loss on lawsuit (| red iablty ompperaing lawsuit || 20 Assumption #1: ‘The lawsuit was settled for (850,000 in 20x3. The entry to recorg the settlement is: ~ [ a0x3 | Estimated liability 0" pending Jawsuit | 700,000 my Loss on lawsuit 150,000 Cash 850,00) ‘Assumption #2; (Disregard assumption #2) The lawsuit was settled for P600,000 in 20x3. The entry to record the settlement is: [0x3 _| Estimated liability on pending lawsuit | 700,000 If a custome! oF | > Lfa customer does not have the option to purchase a Wate separately, the warranty 1S accounted for in accordance ip, | PAS 37 Provisions, Contingent Liabilities and Contingent Aso, | unless the promised warranty provides the customer wi, | service in addition to the assurance that the product comping { pon specifications. Illustration 1: Warranty expense ABC Co. provides 3-year warranty for the products it sells, ag¢ estimates that warranty costs P100 per unit sold. As of January |, 20x1, the liability for warranty has a balance ‘of P200,000 for units sold in 20x0. During the year ABC sold 5,000 units and actus! warranty costs incurred were P310,000. Requirements: 1. How much is the warranty expense to be recognized in 20x12 2. How much is the balance of the warranty obligation as of December 31, 20x1? Solutions: Requirement (): Warranty expense in 20x1 Total units sold in 20x1 5,000 Multply by: Estimated warranty cost per unit — Pind Warranty expense ~ 20x1 500,000 The entry to recognize provision for warranty in 20x! is * follows: ADE Recent All rights belongs to respective authorspris, Contingent Libiites ad Contingent Asan 197 Ma TS ron Saipan] ———] Estimated warranty liability 500,000 | Requirement (2): Warranty obligation as of December 31, 20x1 The entry to record warranty costs incurred in actually _discharging the Warranty obligation in 20x1 is as follows: 20x1 | Estimated warranty liability | 310,000 310,000 Cash (or cost replacement part) The warranty obligation as of December 31, 20x1 is determined through the T-account analysis provided below: Estimated warranty liabitity 200,000 Jan. 1, 201 (given) 500,000 __ Warranty expense Actual warranty costs 310,000 Dec. 31, 20x1 390,000 Ss ac Observe the following: © Warranty expense is computed based on estimated costs. * Warranty expense is unaffected by actual warranty costs, © Actual warranty costs are recognized as deduction from the estimated warranty liability. Illustration’2: Warrant liability ABC provides 2-year warranty for products sold. Estimated cost of warranty is 2% in the year of sale and 4% after the year of sale. Information on ABC's sales is shown below: Year Sales Actual warranty costs 20x1 10,000,000 400,000 20x2 12,000,000 500,000 Requirement; How much is the balance of the warranty obligation on December 31, 20x2 assuming those pertaining to 20x1 sales have not yet expired as of 20x2 year-end? Solution: Ele Neo maile cea198 eee _Estinetek warrant Warranty expense, ‘Actual warranty 490,000 | 600,000 (10M x 6%) ‘ costs - 20x1 M Warranty expense 25,5 Actual warranty 00 (12M x 6%) : sts - 2042 500, Dec. 31, 20%2 420,000 Notice that the warranty expenses: recognized in 20x, 20x2 are for the total estimated warranty costs for two years (go, 2% in 18 year + 4% in 2r4 year). This is because present obligatic, for total warranty costs is incurred at the point of sale. Liability for premiums Premiums refer to goods, services, cash prizes, or special rebates which are included in the main product or service being offerag, Premiums are intended to promote sales. Common examples of premiums include: (+ »/.« $rch a. Goods such as T-shirts, caps, umbrella, kitchen wares, toys, and CDs which are included in a main product or service purchased. b. Free health spa (or at discounted price), free movie tickets, ard free load included in a main product or service purchased. c. Cash prize found at the back of bottle crowns or entitlementto anentry toa raffle draw Customers may be entitled to such premiums for pis purchases by presenting proof of purchase (eg., produc wrappers, boxes, bottle crowns, cash register receipts, or coupons included in products). Applicable standard: PAS 37 vs. PFRS : > Accustomer option to acquire additional goods or services free or at a discount is accounted for under PERS 15 if option provides the customer a material right that customer would not receive without entering, into contract, (ewe eevee ine Baca aal 7 - wn NTT oT goo COM> 1-10 WE LOLUoLE| —— | protons Contingent Libis nad itngent Asses _199 y Acustomer option that does not provide the customer with a material right is not accounted for under PFRS 15; and therefore, accounted for in accordance with PAS 37 lustration 1: Premium expense ABC Co. launched! a sales promotion in 20x. For every ten empty packs retumed to ABC plus P50, customers will receive a set of Kitchen knives. ABC estimates that 40% of the packs sold will be redeemed. Information on transactions during the year is as follows: spre Units Amount nits Amount Sales - 500,000 750,000,000 Sets of kitchen knives purchased (P200 per set) 300,000 60,000,000 Number of packs redeemed 45,000 Requirement: Compute for the premium, expense in 20x1. Solution: The premium expense is computed as follows: Sales in units 500,000, Multiply by: Estimate of wrappers to be redeemed 40% Estimated wrappers to be presented for redemption 200,000 Divide by: Required number of wrappers for redemption 10 Estimates? number of premiums to be distributed 20,000 Multiply by: Net cost of premium {200 purchase cost less P50 cash requirement from customer) 150 Premium expense 3,000,000 The pertinent entries in 20x1 are as follows: 20x] Cash 750,000,000 Sales 750,000,000 to record sales Premiums (300,000 x 200) 60,000,000 Cash 60,000,000 te record the purchase of prendums |FB: Digital Accounting Books PH All rights belongs to es or ralesChap ae a Nie, Se - 3,000,000 [> 2ov1 | Premium expe vam , Estimated liability for prem 5 tone rmimspss 2031 | 5, racks 10) x 50 225, en eg 675,000 mated liability for premiums ks © 10) x PISO] 0 packs10)x 200 val ratemption during 201 a Observe the following: . © The present obligation for premiums arises from the sale of the main product and the constructive obligation of honoring redemptions. % Premium expense is recognized based on the estimatey premiums to be distributed and measured at the net cost of the premium, This is because ABC will recover a portion oj the purchase cost of the premium by requiring cash payment from redeeming customers. © Premium expense is unaffected by the actual distribution of premiums. ® Actual distribution of premiums is recorded as deduction to estimated liability for premiums. Illustration 2: Premium liability ABC Co. launched a sales promotion in 20x1. For every five bottles returned to ABC, customers will receive a T-shirt. The unit cost of T-shirt is P100. ABC estimates that 80% of sales will be redeemed. Additional information is as follows: Units | Sales in 20x1 500,000 | Sales in 202 900,000 T-shirts distributed in 20x1 60,000 | ‘T-shirts distributed in 20x2 147,600 | Requirement: How much is the liability for premiums as 0! December 31, 20x27 et . Elcom alle ca aa All rights belongs to respectiveYE ‘ontingent Liabilities 1 Coulingent Asset solution. Estimated premium tiabil Jan. 1, 20x1 ‘Actual cost of promis distributed - Premium expense - 0x1 (60,000 » 20x1 (500,000 x 80%. 100) 000,000 | 8,000,000. = 5x P10) Actual cost of premiums distributed - Premium expense - 20x2 (147,600 x 20x2 (900,000 x 80% 100) 14,400,000. +5 x P10) Dec. 31, 20x2 — Notice that the premium expenses are computed based on the gross purchase cost of the premium (j.e., P100) because there is no cash requirement from redeeming customers. Again, premium expenses are unaffected by the actual premium distribution. Guarantee for indebtedness of others There are instances where an entity guarantees the indebtedness of another entity (e.g., as a co-naker of a loan), The guarantor does not recognize any liability when the guarantee is made.- However, when it becomes probable that the guarantor will be held liable for the guarantee, such as when the original debtor defaults on the loan, a provision is recognized for the estimated amount that the guarantor will be held liable for the guarantee Ilustration: Guarantee for indebtedness of others On January 1, 20x1, ABC Co. guaranteed a 1,000,000 loan obtained by XYZ, Inc. from a bank. On December 31, 20x1, XYZ defaulted on its loan and it became probable that ABC will be held lable to the bank for the P1,000,000 loan taken by XYZ. The entri ets 2x IFB: Digital Accounting Books PH All rights belongs to es ee ralese 202 _ ~ ha AS “Dee 3%, ] Probable loss 0” BY 2001 mated liability | 1,000,000 }-—~ Ltn & Notes. ¥ © No provision is required on 2 guarantee UNleSs it beg, probable that the guarantor will be held liable, Mes #® Belore the liability on a guarantee becomes probable, re is made in the notes. Disclosure is normally lity for a guarantee is remote ide disclosu even in cases where the liabil _ Chapter 4: Summa © A provision is a liability of uncertain timing or amount, |r, distinguished from other liabilities on the basis Of te uncertainty in its timing or amount. Provisions necessijl; require estimates. * A provision is recognized if there is present obligation requiring outflow of resources embodying, economic bereis that is both probable and measured reliably © Provisions are presented separately from other liabilities. A contingent liability is not recognized because it is a possible obligation or a present obligation but with an improtable outflow or an outflow that cannot be estimated reliably, * Present obligation results from past event which either givs rise to a legal or a constructive obligation. | © When measuring a provision, an entity uses: estimate,(b) expected value, or (c) mid-point. ® When the provision arises from a single obligatiow the estimate of the amount the individual most likely out®) adjusted to take account of the effect of other posstle outcomes. * When the provision involves a large population of estimate of the amount reflects the weighting of all PO.” expected 28) fa) tet items, vl| fs Where there is a continuous « Reimbursements are considered provisions, Contin, Liabilities 4 d Comtingent Assets range of possible outcomes, and each point in that range is as likely as any other, the mid-point ofthe rangeis used, « When the effect of time y, should be discounted to pre-tax discount rate, + Where details of a proposed new law have yet to be finalized, an obligation arises only when the legislation is virtually certain to be enacted as drafted, Gains from the expected disposal of assets shall not be taken into account in Measuring a provision. alue of money is material, provisions their present values using a current only when their receipt is virtually certain | Changes in provisions are accounted for prospectively. + Restructuring provision does not include the following: (a) retraining or relocating continuing staff; (b) marketing; or (c) investment in new systems and distribution networks ° Identifiable future operating losses up to the date‘of a restructuring are mot included in a provision, unless they relate to an onerous contract * Restructering includes (a) sale or termination of a line of business; (b) the closure of business locations in a country or region or the relocation of business activities from one country or region to another; (c) changes in management structure, for example, eliminating a layer of management; and (d) fundamental reorganizations that have a material effect on the nature and focus of the entity’s operations. LC Case L Accounting treatment © Liability for pending | 9 Recognize a provision if there lawsuits, tax assessments, | is present obligation and government-imposed outflow is both probable and alties, and the like. * A defective product causes injury to | injury caused to customers. customers, No lawsuits | gation arises fromwe have yet been filed against the seller. [@ Environmental damages = Restructuring by sale of an operation. Refunds. ® Guarantee for indebtedness of others. | Offshore oil rig must be removed and sea bed restored. = Onerous (loss-m contract. ® An entity must train its employees to increase productivity and _efficiency & An entity bas aself pe re. | 2 Recognize a provision oni closure vite “ eso a detailed formal plan is SERS adopted and announced publicly on oF before the end _of reporting period. | Warranty, Premiums, and © Recognize a provision at the a —Lepte ‘ outflow is both probable ang estimable. & Recognize @ provision ifthe entity's policy is to clean y, even if there is no legal requirement to do so, S Recognize a provision only binding sale agreement jg obtained om or before the eng of reporting period point of sale if there is legal _constructive obligation, ~~ -&> Recognize a provision only when the liability for the guarantee S Recognize a provision only when the oil rig is installed. The provision is added to the outflow is both probable ant __ reliably estimable. © No provision; there is no obligation to provide the | training. \ zi No provision until an acl _lossis incurred. ~~ 8 No provision; 4; there i520 obligating event, unlessagent Assets 205 third party for the overhaul or | | repair. When there is (a) present obligation and (b) amounts can be estimated reliably, the following guidance shall | apply: | Probable sible Remote Recognize and di Disclose only ___Ignore Disclose only Ignore | Ignore PROBLEMS: | | | | PROBLEM 1: TRUE OR FALSE | 1. A provision is a liability of uncertain timing or amount | Pl y 8 | | | | | . Provisions differ from other liabilities because of the uncertainty about the timing or amount of expenditure required in settlement. Provisions are presented in the statement of financial position as part of the line item “Trade and other payables.” 4. Before a provision is recognized, there must be a present obligation arising from past events and that it is probable that there will be an outflow of resources embodying economic Tesources and the amount of outflow can be estimated | reliably. 5. A present obligation that requires an outflow that is | _ feasonably possible may recognized as a provision. | 6 Ifthe outflow of resources from a present obligation is remote, - I the entity shall disclose a contingent liability. | 7. A provision is measured at the best estimate of the outflow { | needed to settle the obligation. » A provision should never be discounted to the present value of the expected cash outflows needed to settle the obligation. * According to PAS 37, an entity shall recognize contingent assets that are probable. : According to PAS 37, restructuring is a program that is Planned and controlled by managed g Books PH All rights belongs to respective authorsShape, 206 cee 4 of a business undertaken by cope SCOP jch that business is conducted, changes either, the ScoP* entity; or the manner in whic OM DISCUSSION i ‘LASSRO! ia 7 eat 2 Tarai ets of conditions Would BiVe rige , 4 hich o! he ofac inder PAS 37? cr ontingency / : am re is reasonably estimable and event o¢¢y,, a. Amour s infrequently. ; b scion "yf loss is reasonably estimable and occurrence event is probable. Event is unusual in nature and occurrence of event i, probable. a. Event is unusual in nature and event occurs infrequently (Adapted) 2. When can a “provision” be recognized in accordance with PAS 37? ‘ ees ‘a. When there is a legal obligation arising from a pas. (obligating) event, the probability of the outflow of resources is more than remote (but less than probable) and a reliable estimate can be made of the amount of the obligation. b. When there is a constructive obligation as a result of a past (obligating) event, the outflow of resources is probable, and a reliable estimate can be made of the amount of the obligation, c. When there is a possible obligation arising from a past event, the outflow of resources is probable, and @ approximate amount can be set aside toward the obligation. hs d. When management decides that it is essential that * forse be made for unforeseen circumstances af Ping in mind this year the profits were enough b! next year there (Adapted) may be losses, ‘al Accounting Books PHer recisions, Contingenl Liakilties and Contingent Assed 207 3. A competitor has sued an entity for unauthorized use of its patented technology, The amount that the entity may be required to pay to the competitor if the competitor succeeds in the lawsuit is determinable with reliability, and according to the legal counsel it is less than probable (but more than remote) that an outflow of the resources would be needed to meet the obligation, ‘The entity that was sued should at yearend: a. Recognize a provision for this possible obligation, b. Make a disclosure of the possible obligation in footnotes to the financial statements. # ¢. Make no provision or disclosure and wait until the lawsuit is finally decided and then expense the amount paid on settlement, if any. d. Set aside, as an appropriation, a contingency reserve, an amount based on the best estimate of the possible liability. (adapted) 4. In which of the following events shall a provision most likely be recognized? a. An entity is sued for P100,000,000 for damages caused by its product. b, An entity receives inventory purchased under FOB destination. c. An entity’s building is razed by fire after the reporting period but before the financial statements are authorized for issue. The outflow is probable and can be measured reliably. 4, An entity sells a product. The entity has an implied policy of providing warranty for its products. The entity can reliably estimate the probability of product returns and the cost of warranty. 5. A factory owned by XYZ Inc. was destroyed by fire. XYZ Inc. lodged ‘an insurance claim for the value of the factory building, plant, and an amount equal to one year's net profit. During the year there were a num TTT a _208 Bey ance company. Finally, beto, year-end, it was decided that XYZ Inc. would receing compensation for 90% of its claim. XYZ Ine. received 9 ley that the settlement check for that amount had been maileg, but it was not received before year-end. How should xyz thy inancial statements? . a. Disclose the contingent asset the footnotes. e Wait until next year when the settlement check is actualy received and not recognize oF disclose this receivable at a since at year-end it is a contingent asset. Because the settlement of the claim was conveyed by letter from the insurance company that also stated that the settlement check was in the mail for 90% of the dlain, record 90% of the claim as a receivable as it is virtually certain that the contingent asset will be received. “ d. Because the settlement of the claim was conveyed by a letter from the insurance company that also stated that the settlement check was in the mail for 90% of the claim, record 100% of the claim as a receivable at year-end as itis virtually certain that the contingent asset will be received, and adjust the 10% next year when the settlement check is actually received. (Adapted) representatives of the insur treat this in its fi 6. Anew product introduced by Wilkenson Promotions carries a two-year warranty against defects. The estimated warranty costs related to peso sales are as follows: Year of sale .. Year after sale 3 percent 5 percent Sales and actual warranty expenditures for the years ended December 31, 2001 and 2002, are as follows: Actual Warranty Sales Ex aah P 300,000 20,000 ome 1,000,000 70,000 FB: Digital Accounting Books PH All rights bee to respective authorsjons Contingent Liabilities anid ¢ piso i Contingent Asset iB 2 pojuirenents “How much is the warranty expense }. How much is the estimated list Assume the 2001 wary in 20027 ility as of December 31, 2002? ‘anty did not yet expire adapted) 7, In an effort to increase sales, Blue Razor Blade Company inaugurated a sales promotion campaign on June 30, oc, whereby Blue placed a coupon in each package of razor blad sold, the coupons being redeemable for a piemiu Ti premium costs Blue P.50, and five coupons must be tented by a customer to receive a premium. Blue estimated that only &( percent of the coupons issued will be redeemed. For the six months ended December 31, 2002, the following information is available: Packages of razor blades sald 400,000 Premiums purchased 30,000 Coupons redeemed 100,000 Requirements: a. How much is the premium expense in 2002? b. How much is the estimated liability as of December 31, 2002? (Adapted) PROBLEM 3: EXERCISES |. In an effort to increase sales, Rofix Company began a sales promotion campaign on June 30, 2002, Part of this promotion included placing a special coupon in each package of candy bars sold. Customers were able to redeem ten coupons for a Frisbee. Each premium costs Rofix P1.50. Rofix estimated that 60 percent of the coupons issued will be redeemed. For the six months ended December 31, 2002, the following information is available: Packages of candy bars sold 3,200,000 Premiums purchased ‘pons redeemedPe Requirements: a. How much is the premi b. How much is the estima! (Adapted) jum expense in 2002? ted liability as of December 31, 295), > Monumental Studios, in an effort to promote the reteas, Tranny movie "Ninjas from Space," began 2 national promotion campaign. Two coupon’ from specially mathe Boxes (one coupon in each box) of "Sugar Charms’ cereal ay, redeemable for one ticket to the show. Tickets Monumental P150 each, Monumental estimates that percent of the coupons will be redeemed. At the end of 2a, the following information is available: Boxes of cereal sold 640.0% Movie tickets purchased by Monumental 140 Coupons redeemed 25004 What is the estimated liability for premium claims outstanding a December 31, (2002? Requirements: a. How much is the premium expense in 2002? b. How much is the estimated liability as of December 31, 2002? (Adapted) 3. Balley Co. includes one coupon in each bag of dog food t sells. In return for 3 coupons, customers. receive a dog toy that the company purchases for P1.50 each. Balley's experiont indicates that 60 percent of the coupons will be redeeme! During 2004, 100,000 bags of dog food were sold, 12,000 tis were purchased, and 45,000 coupons were redeemed. Dutié 2005, 120,000 bags of dog food were sold, 16,000 toys *** purchased, and 60,000 coupons were redeemed. Requirements: a. Compute for the premium expenses in 2004 ard = respectively. IFB: Digital Accounting Books PH belongs to es a ET Uel Eypee 211 p, Compute for the liabilities 2004 and December 31, 2995, iadapied for premium respectively as of December 31, Kiner Equipment Company solis the company sold 700 computers, Based on st Bee eee the company has estimated the total 2-year while P40 for parts and PSO for labor. (Assume all sales coeur n December 31, 2004 and warranty obligations are expected to be settled evenly throughout the ‘Warranty period.) . In 2005, Kiner incurred actual warranty costs relative to 2004 computer sales of P10,000 for parts and 24,000 for labor Requirements: a Under the expense warranty treatment, give the entries to reflect the above transactions (accrual method) for 2004 and 2005. b, Under the cash basis method, what are the Warranty Expense balances for 2004 and 2005? «The transactions of part (a) create what balance under current liabilities in the 2004 balance sheet? (Adapted) 5, Yummy Candy Company offers a coffee mug as a premium for every ten 50-centavo candy bar wrappers presented by customers together with P1.00. The purchase price of each mug to the company is ?0.90; in addition it costs P0.60 to mail each mug. The results of the premium plan for the years 2004 and 2005 are as follows (assume all purchases and sales are for cash): 2004 2005 Coffee mugs purchased 960,000 800,000 Candy bars sold 7,500,000 9,000,000 Wrappers redeemed 3,800,000 5,600,000 2004 wrappers expected to be redeemed in 2005 2,600,000 2005 wrappers expected to be redeemed feeRap rere AO Oren All rights belongs to respective authors