Stage 3 – Recognising an impairment loss

Chapter 14 – Provisions and Contingencies Page 174

4.1.3 Restructuring

A provision should only be recognised in respect of restructuring costs, for example closing a division or reducing the number of employees, where specific criteria have been met, as detailed below. A constructive obligation to restructure an entity only arises when: [IAS 37.72]  a detailed formal plan has been made. This should include identifying the area of the business and location that is going to be restructured, an estimate of the number of employees that will be affected, the likely cost of the restructuring and the estimated time scales involved; and  an announcement about the restructuring plan has been made to those who will be affected. Time scales should be mentioned as part of this announcement, or the entity should have started to carry out the restructuring. Evidence that a restructuring plan has commenced might be the removal or dismantling of assets at the affected location. If an announcement has been made then commencement of the plan should be within a short period of time to reduce the likelihood of significant changes being made. A restructuring provision should only include direct expenditure arising from the restructuring. Costs which relate to the future activities of the entity should not be provided for as part of the restructuring, for example relocating or retraining staff. [IAS 37.80]

4.2 Contingent liabilities and contingent assets

A contingent liability or asset should be disclosed in the financial statements rather than being recognised in the statement of financial position. [IAS 37.27, 37.31] A contingent liability should be disclosed unless the possible outflow of resources to meet the liability is remote. If the outflow is thought to be remote, no disclosure is required. A contingent asset should be disclosed when the expected inflow of economic benefits is probable. An example of a contingent asset is a legal claim that the entity is pursuing, where the outcome is uncertain although it is probable that the entity will gain some financial benefit from it. Where the outflow of resources is probable, a provision should be recognised rather than a contingent liability disclosed. However, in relation to assets a ‘probable’ inflow of economic benefits only results in the disclosure of a contingent asset; for an asset to be recognised, the inflow of benefits should be ‘virtually certain’. Chapter 14 – Provisions and Contingencies Page 175 5 Measurement

5.1 Best estimate

In order to recognise a provision an entity is required to calculate its best estimate of the expenditure required to settle the present obligation at the end of the reporting period. This is the amount an entity would rationally pay to settle the obligation or to transfer it to a third party. [IAS 37.36] Management will generally be required to make a number of judgements to arrive at a best estimate for a provision. Judgements should be supplemented by experience of similar transactions and, where appropriate, by advice from independent experts. The outcome of events occurring after the reporting period should be taken into account in making estimates, for example, if a retail business sees that the proportion of sales giving rise to refunds increases in the first few weeks of a new financial year the increased proportion should be used in estimating the amount of the provision at the end of the previous financial year. Where there are a number of possible outcomes probability weightings should be used. If the best estimate for a single obligation is CU10,000, and there is a 55 chance of the expenditure being incurred, then the best estimate is CU10,000, not 55 of CU10,000. When making an estimate management will need to take into account the risks and uncertainties surrounding the likely outcome. Illustration 2 A business sells goods which carry a one-year repair warranty. If minor repairs were to be required on all goods sold in 2007, the repair cost would be CU100,000. If major repairs were needed on all goods sold, the cost would be CU500,000. It is estimated that 80 of goods sold in 2007 will have no defects, 15 will have minor defects, and 5 will have major defects. The provision for repairs required at 31 December 2007 is: CU 80 of the goods will require no repairs - 15 will require minor repairs 15 x CU100,000 15,000 5 will require major repairs 5 x CU500,000 25,000 Best estimate of provision required 40,000

5.2 Present value

The expenditure required to settle an obligation may occur within a short period after the end of the reporting period, in which case the time value of money can be ignored. However, if the outflow of resources is expected to occur a significant time after the obligation itself arose, the effect of the time value of money should be taken into account in estimating the provision. [IAS 37.45] The discount rate used should be a pre-tax rate that reflects the current market assessments of the time value of money and the risks specific to the liability. The unwinding of the discount each period should be recognised as a finance cost in profit or loss. [IAS 37.47] Chapter 14 – Provisions and Contingencies Page 176

5.3 Other measurement points

It is possible that the amount required to settle an obligation will be dependent on a number of future events. For example, where it is expected that there will be technological advances that will reduce, say, future clean up costs, the expected effect of these future events should be taken into account in assessing the provision. Gains from the expected disposal of assets should not be taken into account in measuring a provision. IAS 37 does not override other standards, so such gains should be dealt with under the relevant standard. For plant and equipment the relevant standard is IAS 16 Property, plant and equipment. [IAS 37.51] Chapter 14 – Provisions and Contingencies Page 177 6 Reimbursement, Decommissioning and Waste Management

6.1 Reimbursements

In some cases, an entity may be able to look to another party, such as an insurance company or a supplier under a warranty, for reimbursement of all or part of the entity’s expenditure to settle a provision. The entity generally retains the contractual obligation to settle the provision, even if the other party fails to make the reimbursement. IAS 37 requires that the reimbursement should be recognised only when it is virtually certain that the amount will be received. If it is only probable that a reimbursement will be received then the amount is considered to be a contingent asset and will be disclosed. If an asset in respect of the reimbursement can be recognised then it should be reported as a separate asset in the statement of financial position and not netted against any outstanding provision. The recognition of any reimbursement asset is restricted to the amount of the related provision. [IAS 37.53] Although the provision and reimbursement asset cannot be netted off in the statement of financial position, the two amounts may be netted off in the statement of comprehensive income. [IAS 37.54] Because provisions are inherently uncertain amounts, IAS 37 requires them to be reviewed at the end of each reporting period and adjusted to reflect the most up to date information about the estimate. If at the end of the reporting period it is assessed that a transfer of economic benefits is no longer probable, the provision should be reversed. A provision should only be utilised against the expenditure which it was originally set up for. [IAS 37.59, 37.61] Illustration 3 An entity has received a claim for damaged goods from a customer. The entity’s legal advisors believe that it is probable that a settlement will need to be made of CU10,000 in favour of the customer. However, in their opinion it is also probable that a counterclaim by the entity against their supplier for contributory negligence would successfully recover the damages. A provision should be made for CU10,000 as the outflow of economic benefits is probable. The counterclaim asset is not recognised since it is only probable that it will be received. It can only be recognised when it is virtually certain to be received. It should be disclosed as a contingent asset.

6.2 Decommissioning, restoration and environmental funds

Some entities may have an obligation to carry out environmental restoration work or to decommission specific assets; as a result the entity may wish to segregate specific funds to meet this future obligation. The need to have a separate fund may be a requirement set by local law. More than one entity may contribute, or be required to contribute, funds to the separate fund. IFRIC 5 Rights to interests arising from decommissioning, restoration and environmental rehabilitation funds was published in December 2004 to establish how a contributor should account for its interest in such separate funds and the appropriate treatment for additional funds that may be needed to meet such decommissioning and restoration works. An entity that has an obligation to pay decommissioning costs should recognise a liability. If the entity has an interest in a decommissioning fund, then this interest should be recognised separately. The fund should be recognised by the entity by considering whether it has control, joint control or significant influence over the fund. An entity should make such an assessment by reference to IAS 27 Consolidated and separate financial statements, IAS 31 Chapter 14 – Provisions and Contingencies Page 178 Interests in joint ventures and IAS 28 Investments in associates. If an entity has no such influence over the fund, then the interest should be recognised as an asset or a contingent asset in accordance with IAS 37. If an entity has an obligation to make additional contributions to make up any shortfall in the fund, this should be recognised as a contingent liability in accordance with IAS 37.

6.3 Waste management costs

Following the publication, in particular, of the European Union’s Directive on Waste Electrical and Electronic Equipment, the International Financial Reporting Interpretation Committee IFRIC was asked to provide guidance on how IAS 37 should be applied to waste management costs. The European Directive provided a cut off date of 13 August 2005 for European Union nations to have systems in place to deal with waste electrical and electronic equipment. Equipment sold prior to 13 August 2005 is called “historical” waste and equipment sold after this date is called “new” waste. The European Directive sets out that producers of electronic equipment should pay towards the disposal of such goods sold to private households prior to 13 August 2005. However, entities required to meet the waste disposal costs are only those that are in the market in what is described as the measurement period. The waste disposal costs for the historical waste are not necessarily met by the entities that traded in the period in which the related goods were sold. The issue that IFRIC was asked to address was when such a liability for the disposal of historical household electrical equipment should be made. IFRIC 6 Liabilities arising from participating in a specific market – Waste electrical and electronic equipment published in September 2005 sets out that a provision for historical waste management costs should be recognised when the obligation arises in accordance with IAS 37. The obligation is deemed to arise in the “measurement period”, because it is entities participating in the market in this period that are required to contribute towards the disposal costs. It is for each EU member state to determine the measurement period. Illustration 4 An entity manufactures and distributes television equipment in Muldovia. Muldovia has determined that the decommissioning costs for historical waste from private households for television equipment in 2007 should be borne in direct proportion to the market share of the entities operating in that market during 2006. The entity’s market share in 2006 was 10 and the estimated decommissioning costs in 2007 are at CU270. The measurement period is 2006 and the entity would recognise a liability for CU27 in its 2007 financial statements until it is finally determined and paid. If the entity had ceased its television market operations in 2005 then it would have no liability for historical waste as it was not in the market during 2006. However, another entity entering the market in 2006 would have a liability even though the historical waste was created before it entered the market. Chapter 14 – Provisions and Contingencies Page 179 7 Disclosure A number of disclosures are required in relation to provisions, contingent liabilities and contingent assets. For a provision, a full reconciliation should be presented, clearly identifying movements during the period. These might include revisions of the estimate, utilisation of the provision or a release of part of the provision. [IAS 37.84] An explanation should be provided for each class of provision, detailing what the provision is for, the expected timing of outflows, an indication of uncertainties over timing or amount of expected outflows and whether any reimbursement has been recognised. [IAS 37.85] For a contingent liability, assuming the expected outflow is not remote, a brief description should be provided for each class of contingent liability. This should include an estimate of the financial effect, an indication of any uncertainties and the likelihood of any reimbursements being forthcoming. [IAS 37.86] Where a contingent asset is disclosed because the receipt of economic benefits is probable, the entity should briefly explain the nature of the contingent asset and where practicable the financial effect of such an asset. If information about a contingent liability or asset is not disclosed because it is not practicable to do so, then this fact should be disclosed. [IAS 37.89, 37.91] If the disclosure of information surrounding a provision, contingent liability or contingent asset would be seriously prejudicial to an entity, then the general nature of the item should be disclosed with an explanation of why no additional disclosure has been made. This is expected to be extremely rare in practice, although it may be appropriate in circumstances where there are legal proceedings in progress, the outcome of which could be affected by the disclosure of the estimated settlement. [IAS 37.92] 8 Chapter Review This chapter has been concerned with the recognition, measurement and disclosure requirements for provisions, contingent liabilities and contingent assets. This chapter has covered:  the objectives and scope of IAS 37;  the critically important definition of provisions, contingent liabilities and contingent assets;  the application of these definitions to a range of practical situations;  the criteria for recognising provisions, contingent liabilities and contingent assets; and  the measurement criteria and disclosure requirements in IAS 37. Chapter 14 – Provisions and Contingencies Page 180 9 Self Test Questions Chapter 14 1. According to IAS37 Provisions, contingent liabilities and contingent assets, which of the following is the correct definition of a provision? A A possible obligation arising from past events B A liability of uncertain timing or amount C A liability which cannot be easily measured D An obligation to transfer funds to an entity 2. According to IAS37 Provisions, contingent liabilities and contingent assets, which TWO of the following best describe the sources of a legal obligation? A legal obligation is an obligation that derives from A legislation B a contract C a published policy D an established pattern of past practice 3. Are the following statements in relation to a contingent liability true or false, according to IAS37 Provisions, contingent liabilities and contingent assets? 1 An obligation as a result of the entity creating a valid expectation that it will discharge its responsibilities is a contingent liability. 2 A present obligation that arises from past events but cannot be reliably measured is a contingent liability. Statement 1 Statement 2 A False False B False True C True False D True True 4. Under IAS37 Provisions, contingent liabilities and contingent assets, a liability of uncertain timing or amount is best described as select one answer A a provision B an obligating event C an accrual D a contingent liability Chapter 14 – Provisions and Contingencies Page 181 5. The Snowfinch Company is closing one of its operating divisions, and the conditions for making restructuring provisions in IAS37 Provisions, contingent liabilities and contingent assets have been met. The closure will happen in the first quarter of the next financial year. At the current year end, the company has announced the formal plan publicly and is calculating the restructuring provision. Which ONE of the following costs should be included in the restructuring provision? A Retraining staff continuing to be employed B Relocation costs relating to staff moving to other divisions C Contractually required costs of retraining staff being made redundant from the division being closed D Future operating losses of the division being closed up to the date of closure 6. Which ONE of the following is within the scope of IAS37 Provisions, contingent liabilities and contingent assets? A Financial instruments carried at fair value B Future payments under employment contracts C Future payments on vacant leasehold premises D An insurance companys policy liability 7. The Silktail Company is being sued for damages. When preparing its 20X4 financial statements the directors took the view that the likelihood of any payments having to be made to the claimant was remote. In preparing the 20X5 financial statements their view was that it was possible that such payments would have to be made, and in preparing the 20X6 statements their view was that such payments were probable. For the 20X7 statements there was virtual certainty that the payments would have to be made. The payments were made in the 20X8 accounting period. Under IAS37 Provisions, contingent liabilities and contingent assets, in which set of financial statements should provision for the payments first be made? A 20X4 B 20X5 C 20X6 D 20X7 Chapter 14 – Provisions and Contingencies Page 182 8. The Kuma Company is being sued for damages. When preparing its 20X4 financial statements the directors took the view that the likelihood of any payments having to be made to the claimant was remote. In preparing the 20X5 financial statements their view was that it was possible that such payments would have to be made and in preparing the 20X6 statements their view was that such payments were probable. For the 20X7 statements there was virtual certainty that the payments would have to be made. The payments were made in the 20X8 accounting period. Under IAS37 Provisions, contingent liabilities and contingent assets, in which set of financial statements should a contingent liability first be disclosed? A 20X4 B 20X5 C 20X6 D 20X7 9. According to IAS37 Provisions, contingent liabilities and contingent assets, for which ONE of the following should a provision be recognised? A Future operating losses B Obligations under insurance contracts C Reductions in fair value of financial instruments D Obligations for plant decommissioning costs 10. For which TWO of the following should be provisions be recognised under IAS37 Provisions, contingent liabilities and contingent assets? A Divisional closure costs before a public announcement is made B Restructuring costs after a binding sale agreement has been signed C Rectification costs relating to defective products already sold D Future refurbishment costs due to introduction of a new computer system Chapter 14 – Provisions and Contingencies Page 183 11. The Dipper Company operates chemical plants. Its published policies include a commitment to making good any damage caused to the environment by its operations. It has always honoured this commitment. Which ONE of the following scenarios relating to Dipper would give rise to an environmental provision as defined by IAS37 Provisions, contingent liabilities and contingent assets? A On past experience it is likely that a chemical spill which would result in Dipper having to pay fines and penalties will occur in the next year B Recent research suggests there is a possibility that the companys actions may damage surrounding wildlife C The government has outlined plans for a new law requiring all environmental damage to be rectified D A chemical spill from one of the companys plants has caused harm to the surrounding area and wildlife 12. The Cullen Company is finalising its annual financial statements. According to IAS37 Provisions, contingent liabilities and contingent assets, which ONE of the following should be disclosed in the financial statements as a contingent liability? A The company has accepted liability prior to the year end for unfair dismissal of an employee and is to pay damages B The company has received a letter from a supplier complaining about an old unpaid invoice C The company is involved in a legal case which it may possibly lose, although this is not probable D The company has not yet paid certain claims under sales warranties