University of Ghana Business School

ACCT 302: Financial Reporting 2

Lecture 7
Lecture days: Mondays/Tuesdays; Time: 1.30-3.30/7:30am – 9:30am
Tutorial days: Thursdays; Times: 9.30am-10.20am
Office hours: Mondays 2.00pm-5.00pm; Tuesdays 2.00pm-5.00pm
Office: G13
email: [email protected]
mobile: 0266225129
Lecturer: C. Agyenim-Boateng (PhD, MSc, BSc, FCCA)

LECTURER: C. AGYENIM-BOATENG (PhD, MSc, BSc, FCCA)

 Lecture 7

IAS 37: Provisions, Contingent Liabilities and

Contingent Assets

LECTURER: C. AGYENIM-BOATENG (PhD, MSc, BSc, FCCA)

 Learning Outcomes
At the end of the session, the student will be able to
Describe the issues IAS 37 Provisions, Contingent Liabilities and
Contingent Assets attempts to address
Define provisions and contingencies
Account for provisions and contingencies in accordance with IAS 37
Appraise the recognition and measurement criteria of IAS 37
Describe the presentation requirements in relation to provisions and
contingencies
Identify the likely changes to IAS 37
 Why is this topical?
• Accounting for uncertainty
• Another area that is highly judgemental and subjective
• Potential for manipulation
• Under scrutiny (expected changes to relevant accounting standard)

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IAS 37: Provisions and contingencies
Definitions and the need for a standard

5
 Definition: Provision
• A provision is a liability of uncertain timing and amount (IAS 37)
• 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 (IASB framework
definition)
IASB: International Accounting Standards Board
• Examples?

6
The background issue: Big bath accounting
• A company with annual expected future profits of GH¢2.5m decides to
recognise a provision (on the grounds of prudence) for reorganisation costs
for future years of GH¢2m in the current year when its expected profits are
GH¢4.5m. The reorganisation involves decentralisation of all activities
relating to purchases and sales to the enterprises’ outlying units from the
centre. In the event the charges for the reorganisation are GH¢0.5m next
year, GH¢0.5m the following year and thereafter no further costs arise.

• Show the effect of the proposed accounting treatment for the reorganisation
costs on the profits for the company for the current and future years.
Comment on this treatment.
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 Note 1: Provision
GH¢m Year 1 Year 2 Year 3 Year 4
Provision b/f 0 2.0 1.5 0
Expense 0 (0.5) (0.5) 0
Income statement charge 2.0 0 (1.0) 0
Closing provision 2.0 1.5 0 0

Income Statement
GH¢m Year 1 Year 2 Year 3 Year 4
Profits 4.5 2.5 2.5 2.5
Provision charged to income statement (2.0) 0 1.0 0
Profit after provision 2.5 2.5 3.5 2.5
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Comments
• Big bath accounting
• Creation of provisions where no obligation to a liability exists
(intention only)
• The use of provisions to smooth profits

IAS 37 created to address problems of this nature

• The standard also requires greater disclosure in relation to provisions

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IAS 37: Provisions and contingencies
Recognition and measurement

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 IAS 37 provision criteria
• In order to recognise a provision under IAS 37, must meet three
criteria:

• Have a present obligation from past event

• Have a probable outflow of economic benefits
• Have a method to evaluate timing and amount (so can ‘measure
reliably’)

• If all three are satisfied, recognise a provision. Usually expense and

liability
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 Obligation
• The obligation can be one of two types:

• Legal (contract/legislation/operation of law) – e.g. environmental

legislation
OR
• Constructive (past practice or statements have created a valid
expectation that the company will act in a certain way)

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• Identify which of the following is a constructive obligation of the enterprise:
• A leisure company owned by Yaw and Kofi Agyenim-Boateng causes
severe damage to the habitat of wildlife in Ghana, where there is no legal
protection for the wildlife. The company has a high profile in the support
of wildlife as it makes large contributions to the World Wildlife Fund. The
owners are wildlife enthusiasts and campaign vigorously on its behalf. To
rectify the damage to the habitat a charge of GH¢1m is likely.
• Yaw Agyenim-Boateng [Snr] owns an enterprise in the oil industry. This
enterprise causes severe pollution when one of its tankers grounds off a
Pacific island. The enterprise has avoided costs of cleaning up such
contamination in the past and pays little regard to environmental issues.
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Identify which of the following is a constructive obligation of the enterprise:
• A leisure company owned by Yaw and Kofi Agyenim-Boateng causes severe
damage to the habitat of wildlife in Ghana, where there is no legal protection for
the wildlife. The company has a high profile in the support of wildlife as it makes
large contributions to the World Wildlife Fund. The owners are wildlife enthusiasts
and campaign vigorously on its behalf. To rectify the damage to the habitat a
charge of GH¢1m is likely. Yes – there is a constructive obligation
• Yaw Agyenim-Boateng [Snr] owns an enterprise in the oil industry. This enterprise
causes severe pollution when one of its tankers grounds off a Pacific island. The
enterprise has avoided costs of cleaning up such contamination in the past and
pays little regard to environmental issues. No – no constructive obligation
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 Provisions: Disclosures
• Table showing movement in each category of provisions (e.g. extra
amounts added, amounts utilised or released) since last year end (no
comparatives necessary)
• Narrative disclosure about the nature of each category of provisions

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 Contingent liability: Definition
• 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 enterprise; 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

• i.e. where not all of the provision criteria are met – contingent liability
(disclose in notes to financial statements)

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 Contingent liabilities: Disclosures
• For each class of contingent liability (unless the possibility of an
outflow is remote):
• an estimate of its financial effect
• an indication of the uncertainties relating to the amount or timing
of any outflow
• the possibility of any reimbursement

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 Contingent liabilities: example – Vodafone
plc
 
2010 2009
GH¢m GH¢m

Performance bonds 5 35
Credit guarantees – third party
5,112 5,317
indebtedness
Other guarantees and contingent
224 231
liabilities

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 Contingent liabilities: example – Vodafone
plc
Performance bonds
Performance bonds require the Company to make payments to third parties in the event that the
Company or its subsidiaries do not perform what is expected of them under the terms of any related
contracts.
Credit guarantees – third party indebtedness
Credit guarantees comprise guarantees and indemnities of bank or other facilities.
A subsidiary of the Company has granted put options exercisable between 8 May 2010 and 8 May
2011 to members of the Essar group of companies that, if exercised, would allow the Essar group
to sell its 33% shareholding in Vodafone Essar to the Group for US$5 billion or to sell up to US$5
billion worth of Vodafone Essar shares to the Group at an independently appraised fair market
value. The Company has guaranteed payment of up to US$5 billion related to these options.
At 31 March 2010 the Company had also guaranteed debt of Vodafone Finance K.K. amounting to
GH¢1,821 million (2009: GH¢1,820 million). This facility expires in March 2011.

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 Contingent liabilities: example – Vodafone
plc
Other guarantees and contingent liabilities
Other guarantees principally comprise of a guarantee relating to a
commitment to the Spanish tax authorities of GH¢221 million (2009:
GH¢229 million).
As discussed in note 29 to the consolidated financial statements the
Company has covenanted to provide security in favour of the Trustee
of the Vodafone Group UK Pension Scheme in respect of the funding
deficit in the scheme.

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 Contingent liabilities: example – Vodafone
plc
Legal proceedings
Details regarding certain legal actions which involve the Company are
set out in note 29 to the consolidated financial statements.
The Company and its subsidiaries are currently, and may be from time
to time, involved in a number of legal proceedings, including inquiries
from or discussions with governmental authorities, that are incidental
to their operations. However, save as disclosed below, the Company
and its subsidiaries are not involved currently in any legal or
arbitration proceedings (including any governmental proceedings
which are pending or known to be contemplated) which may have, or
have had in the 12 months preceding the date of this report, a
significant effect
21 on the financial position or profitability of the
 Contingent liabilities: example – Vodafone
plc
Summary of legal proceedings
2001 and 2002 Four actions filed in Columbia, US, in respect of
personal injury, including brain cancer, from mobile phone use
2004 and 2006 Legal challenges relating to UK tax treatment of
Luxembourg holding company
2007 Class action complaint in relation to alleged securities fraud
(financial statements were alleged to be misleading therefore leading
to losses in relation to share purchases by pension funds)
2007 Legal challenge relating to Indian tax liabilities

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Decision tree to determine existence of provision or contingent liability

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 Upside: Contingent Assets
• Definition:

• A 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
enterprise

• Examples?

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Summary of accounting for these items
Probability and rule of Liability Asset
thumb
Remote Ignore Ignore
Possible (<50% Disclose (contingent Ignore
likely) liability)
Probable (>50% Recognise (provision Disclose (contingent
likely) – expense and asset)
liability)
Virtually certain Recognise (provision Recognise (full asset –
– expense and income and
liability) receivable)

Two things to notice – asymmetrical (prudent? biased?) and line in the sand
between probable and possible
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 Provide or not?
• An airline enterprise is required by law to overhaul its aircraft once every three
years. The aircraft were purchased a year ago.

• An enterprise catered for a wedding reception in September 2011. Subsequent to

the wedding several people have died of food poisoning. The enterprise is
disputing liability for the case brought against it by the relatives of the dead and
its lawyers advise that it is probable that they will not be found liable.

• The government of the country in which an enterprise operates makes

substantial changes to the health and safety legislation under which it must
operate. The enterprise will have to retrain a large proportion of its staff to
ensure compliance with the new legislation. No retraining has yet taken place.
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 Provide or not?
• An airline enterprise is required by law to overhaul its aircraft once every three
years. The aircraft were purchased a year ago. No

• An enterprise catered for a wedding reception in September 20X1. Subsequent to

the wedding several people have died of food poisoning. The enterprise is disputing
liability for the case brought against it by the relatives of the dead and its lawyers
advise that it is probable that they will not be found liable. No

• The government of the country in which an enterprise operates makes substantial

changes to the health and safety legislation under which it must operate. The
enterprise will have to retrain a large proportion of its staff to ensure compliance
with the new legislation. No retraining has yet taken place. No
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 Measuring a provision: the best estimate

• The amount recognized as a provision shall be the best estimate of the

expenditure required to settle the present obligation at the balance
sheet date
• the amount an entity would rationally pay to settle the obligation
or to transfer it to a third party
• the amounts are determined by judgement of the management
supplemented by experience and in some cases by expert reports
(e.g. legal opinion for court cases)
• If there are a large number of events/outcomes, uncertainties shall
be measured by the weighting of all possible outcomes (=
‘expected value’) (e.g. warranty provisions)
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 Measurement: examples Expected value illustration
• Kofi Agyenim-Boateng sells goods under warranty. Past experience indicates that 80% of
goods sold will have no defects, 15% will have minor defects and 5% major defects. If
minor defects occurred in all goods sold, the cost of rectification would be GH¢5m and for
major defects GH¢15m.
• What is the expected value of the provision to be recorded in the financial statements?
• A provision should be made as the company has a present obligation arising from a past
event and an outflow of resources will have to be made. As there are three different possible
outcomes (independent outcomes) with significantly different monetary effects the required
provision should be calculated as follows: P(A or B or C) = P(A)+P(B)+P(C)

Expected value = (80% x 0) + (15% x 5) + (5% x 15) = GH¢1.5m

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Where would the percentages come from?
 Measurement: examples
• Phokar-Game enterprise is facing a substantial legal claim for GH¢52m from Wayemi Financial
Engineers. The lawyers for Phonkar-Game estimate that there is a 40% chance of successfully
defending the claim.

• At what value should this provision be shown in the accounts?

Tricky question!!!!

There aren’t multiple outcomes here (Phonkar-Game will either win or lose) so expected value is not
an appropriate method

Single most likely outcome is lose (60% likely) so provide at full GH¢52m

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 Other points regarding measurement
• Discounting – if time value of money is material, discount provision to
present value using a pre-tax rate reflecting any specific risks
• Unwind the discount to interest expense in income
statement

• Reimbursement (e.g. counter-claims or insurance) – show any asset (if

virtually certain) separately from provision in the balance sheet (can
net off income statement effects)
• If asset is only probable (contingent asset) then disclose
in notes according to IAS 37 and recognise provision
only on balance sheet
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Provisions: specific applications of the standard

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 Provisions: some specific applications of the
recognition and measurement rules

• Future operating losses

• Can’t provide
• Why not?
• Manipulation

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 Provisions: some specific applications of the
recognition and measurement rules

• Onerous contracts [unavoidable cost]

• Where contracts ‘go bad’ e.g. A leased building you vacate and
can’t sublet, or a commercial contract that become loss-making
• Can provide (why?) once contract becomes onerous - unavoidable
• At lowest cost of exit
- losses if continue/penalties for exit

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 Provisions: some specific applications of the recognition and
measurement rules
• Restructuring
• What is it?
• sale or termination of a line of business
• the closure of business locations in a country or region
or the relocation of business activities from one country
or region to another
• changes in management structure,e.g. eliminating a
layer of mangement
• fundamental reorganisations that have a material effect
on the nature and focus of the entity’s operation
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 Provisions: some specific applications of the recognition and
measurement rules – Restructuring: Recognition of provision

A constructive obligation to restructure arises only when an enterprise:

– has a detailed formal plan for the restructuring identifying at least:
• the business or part of a business concerned
• the principal locations affected
• the location, function and approximate number of employees who will
be compensated for termination of their services
• the expenditures that will be undertaken
• when the plan will be implemented
– and restructures by starting to implement that plan or announcing its main
features to those affected by it (IAS 37 para. 72)
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 Restructuring provisions example
• The management board of Yaw-Kofi Ltd takes a decision on 24 February to
close down one of its divisions. The board also agrees the detailed plan for
closure put forward on 24 February. No further action is taken on the closure
and the year end for Yaw-Kofi is 28th February.

• What should Yaw-Kofi Ltd provide in the accounts in respect of the closure?

Present obligation? No – not announced or started, so can backtrack

So no provision (yet)!
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 What costs can be included in a restructuring
provision?
• Manipulation
• A restructuring provision shall include only those direct expenditures arising
from the restructuring, which are those that are both:
– necessarily entailed by the restructuring
– not associated with the ongoing activities of the entity

• Meaning…exclude gains from expected asset disposal, relocation costs, new

systems, retraining staff

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 Further Illustrations: Boat Engines Ltd

• Boat Engines Ltd sells and services forestry equipment. Provisions have to be
made in the accounts of Boat Engines Ltd for the year to 31st March, 2013.

 We will use the illustrations to explain, using appropriate figures, the effects
on the financial statements of Boat Engines Ltd for the year to 31st march,
2013.
 Prepare the provision disclosure note for inclusion in the 31st march, 2013
accounts
Environmental Damage – constructive obligation
As part of the servicing schedule of forestry vehicles, Boat Engines Ltd is required to
replace the engine oil. A special tank is used to collect the old oil, which is emptied on a
regular basis and recycled. A leaked developed in the tank, causing environmental damage
to a nearby river. The company has spent GH¢50,000 on clear-up costs at the year end but
further work requires to be done. Advisors estimate that there is a 50% likelihood that the
additional work will cost GH¢75,000, 30% likelihood it will cost GH¢90,000, and a 20%
likelihood that it will cost GH¢110,000.

  A provision should be made as the company has a present obligation arising from a past
event and an outflow of resources will have to be made. As there are three different
possible outcomes (independent outcomes) with significantly different monetary effects
the required provision should be calculated as follows: P(A or B or C) = P(A)+P(B)+P(C)
  GH¢
50% x GH¢75,000 37,500
30% x GH¢90,000 27,000
20% x GH¢110,000 22,000
GH¢86,500
 
The GH¢50,000 which was spent during the year is an expense of the period.
 Warranties – constructive/legal obligation
1. Boat Engines sells log splitters. The following details are available

Model Warranty Number of units sold in

Period the year
Basic 1 year 400
Standard 1 year 310
Super 2 years 250

• The company estimates that 15%, 12% and 20% of basic, standard and super, respectively, will require
repair within the warranty period. Estimated repair costs are GH¢150, GH¢200, GH¢220 for basic,
standard and super, respectively. During the year, the company spent GH¢15,500 on repairing log splitters
sold in the year.

• The company has a present obligation from past events i.e. a warranty has been given on sales made in the
period and it is probable that some items will require to be repaired. The provision is calculated as follows:
   
 
GH¢
Basic 400 x 15% x GH¢150 = 9,000
Standard 310 x 12% x GH¢200 = 7,440
Super 250 x 20% x GH¢220 = 11,000
27,440
Less : paid in year 15,500
Provision required at year end GH¢11,940
 
Note that as the total estimated repair cost is GH¢27,440 and GH¢15,500 has already been
paid, only GH¢11,940 requires to be provided. In addition, although the Super model has a
two year warranty period, the likelihood is 20% of a repair at some time in that two year
period and consequently the provision is calculated on a prudent basis i.e. it recognises
immediately the full possible cost of repairs in the two year period.
 Legal claim
At 31st March, 2012, the accounts contained a provision of GH¢195,000, relating to potential
damages arising from a court case being brought against the company. The company reached an out-
of-court settlement in June, 2012, with Boat Engines Ltd making a full and final payment of GH
¢148,000.

• The payment of GH¢148,000 should be offset against the provision brought

forward of GH¢195,000.
• As the payment is a full and final settlement no obligation remains and the
balance of GH¢47,000 (GH¢195,000-148,000) should be credited back to the
income account in the current year.
 Provisions Note

Environmental Warr Legal

damages anties Case Total
GH¢ GH¢ GH¢ GH¢
At 1 April, 2012 - - 195,000 195,000
Provided in year 86,500 11,940 98,440
Charged in year - - (148,000) (148,000)
Unused amount reversed - - (47,000) (47,000)
At 31 March 2013 86,500 11,940 - 98,440
 
The environmental provision is the estimated amount required to rectify
damage caused by an accidental oil leak. The precise amount will be
determined in the next year.
 
The warranty provision is in respect of items sold in the current year. The
warranty lasts for a maximum of two years from the balance sheet date.
 
 Successful in preventing abuse?
• IAS 37 goes some way to eliminating abuse because it
identifies specific areas that were the subject of abuse:
– Restructuring: (any constructive or legal obligation)
– future operating losses: (not provision as they do not meet the
definition of a liability)
– onerous contracts: (unavoidable costs)
• It requires provisions to only be used for the purpose for
which they were originally established.

• But still involves some judgments, eg directors deciding

on probabilities and estimates!
Provisions: future changes????

46
 Future developments
• IAS 37 is being rewritten (to clarify liability identification and measurement, eliminate
inconsistencies with other standards and US GAAP convergence project)
• ED issued in 2005 – very unpopular, prompting a rethink by the IASB
• Further ED issued January 2010 to try to clarify proposals on measurement of liabilities
• IASB now behind on timetable for this project
• Major expected changes: Widening of scope of standard – addressing ‘non-financial
liabilities’ (i.e. not IAS 32/39)
• Will remove idea of provision and contingent liability, so that more liabilities will be
recognised and probability will be reflected in amount recognised
» Probability will be reflected in liability measurement (expected value
method) instead of the arbitrary 50% threshold
47
 Future developments: An example
How might things work under the new standard?
• Being sued for GH¢20m, 10% chance of losing court case

Existing IAS 37 New standard

Possible not probable – contingent Obligation exists because court case
liability (disclosed in notes) started (past event). Provide at 10%
x GH¢20m = GH¢2m

• Problem(s) with this approach?

48
 End of lecture
Thank you!
Any comments/questions?
Remember my contacts
email: [email protected]
mobile: 0266225129
Office: GBS13 Executive Block

LECTURER: C. AGYENIM-BOATENG (PhD, MSc, BSc, FCCA)