Provisions and Contingencies – IAS 37 - Accounts

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Adjusting for inflation :- For the purpose of measuring provisions, cash flows are usually expressed in expected future prices and should, therefore, be discounted using a ‘nominal rate’. Alternatively, where cash flows are expressed in current prices they should be discounted using a ‘real rate’.

Real Rate :- (1+ Nominal Rate) / (1 + Inflation Rate) - 1

Adjusting for Risk :- The risks and uncertainties about the amounts and timing of cash flows required to meet a provision must be taken into account in reaching the best estimate of the expenditure required to settle the present obligation at the balance sheet date. To estimate a current settlement amount, the cash outflows are estimated under different possible outcomes, taking account of the various risks and uncertainties. Where all risk adjustments are reflected in the cash flows, then the cash flows are discounted at a risk free rate.

Effects of taxation :- Discount rate applied to future cash flows associated with an obligation should be a pre tax rate. Govt. Bond rates, are usually pre – tax.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Example :- A company has a known cash flow of 1200 MINR which is payable in two years time. As the cash flow is an allowable expense, tax relief at 30% will be given when it arises. The pre – tax risk free rate is 4.5%.

Discount Rate NPV Year 1 Year 2

Pre Tax Risk Free Rate 4.5% 1099 1148 1200

Tax Relief (360)

Initially a provision will be recognised for 1099 MINR .

At the end of year one the provision will grow by 49 MINR and this will be charged as a borrowing cost in the income statement. It will grow by further 52 MINR in year 2 to arrive at the final amount to be settled of 1200 MINR. The tax consequences of these changes in provision should also be considered to determine whether a deferred tax asset should be provided in accordance with IAS 12.

The appropriate discount rate to be used when estimating the amount to be provided should be the nominal risk free pre tax rate. Typically, a government bond yield rate should be used, as this is nominal risk free pre tax rate.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

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CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Changes in estimates – IFRIC 1

IFRIC - 1 “Changes in existing decommissioning restoration and similar liabilities” requires a fully prospective treatment when accounting for changes in estimates of such liabilities.

Where such a liability is recognised both as part of an assets cost in accordance with IAS 16 and as a liability in accordance with IAS 37, changes in the measurement of the liability resulting from either a change in the estimated timing or amount of the outflow of resources, or a change in the discount rate should be added to or deducted from the cost of the asset and depreciated prospectively over its remaining useful life.

The particular treatment in any set of circumstances will depend on whether the related asset is measured using the cost model, or the revaluation model.

If under the cost model a reduction in the estimated provision is required then the amount deducted from the cost of the asset must not exceed the assets carrying amount. Any excess should be recognised immediately in the income statement.

If the provisions to increase, then the carrying value of the asset will also increase, and management will need to consider whether the indicates that the asset will no longer be fully recoverable, in which case an impairment test need to be performed.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Where the asset is measured using the revaluation model, the treatment will depend on the direction of the change in the liability. A decrease in the liability should be credited to the revolution surplus in equity, except to the extent that it reverse a revaluation deficit that was previously recognised in the income statement.

If the decrease in the liability exceeds the carrying amount that would have been recognised under the cost model, the excess should be recognised in the income statement. An increase in the liability should be recognised in the income statement, except that it should be debited directly to the revaluation surplus to the extent of any existing credit balance in the revaluation surplus.

Either way, a change in the liability is an indication that the asset may have to be revalued to ensure that the carrying amount does not materially differ from that which would be determined using fair value at the balance sheet date. Whether the asset held at cost, or revalued, once the asset has reached the end of its useful life all changes to the estimated liability should be recognised in the profit or loss in the period of change.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Change in estimate of Provision

In practice, Companies may well re-estimate their provisions at each year end.

Example :- A Company has estimated a provision at the beginning of the year as 800 and at the end of the year its estimated has increased to 850. If Risk free pre tax rate is 4.5%. Than provision should increase up to 836. Therefore, it would be appropriate to charge 36 as a finance cost in the income statement. The difference between the uplifted provision of 836 and the re estimated amount of 850. In this case 14 minr should be charged to the income statement as an operating expense. Similarly, if the re- estimate of the provision at the end of year 1 was 820, it would be appropriate to charge 36 as a finance cost in the income statement and credit operating costs with a release of the re estimated provision of 16.

The same basis, if 50 has been paid in relation to the provision during the year. The provision would decrease from 800 to 750, without taking into accounts the effects of discounting. If the repayment arose evenly throughout the period, the average provision outstanding during the year would be 775. The effect of the discount rate of 4.5% on this amount would be 35 and this amount would be charged as a finance cost in the income statement. Taking into account the repayment of 50 and the increase due to the discount rate of 35, the adjusted provision at the beginning of the year 1 is 785. In this case the difference of 65 between this amount and the re-estimated provision of 850 should be charged as an operating expense.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Future Operating Losses

IAS 37 states that provision should not be recognised for future operating losses. Because future operating losses do not meet the definition of a liability and the general recognition criteria set out for the provision in the standard.

The reason that future operating losses do not meet the definition of a liability is that they do not result from a past event. This is similar to the prohibition on provisions for future operating costs where its not acceptable under IAS 37 to make provision for costs that will be incurred in order to operate in the future, if those costs could be avoided by the entity’s future actions.

Where a company is expected to incur future operating losses, this is an indication that an impairment review should be carried out on the appropriate CGU in accordance with the rules in IAS 36. Such a review would determine whether those assets have suffered an impairment and need to be written down.

Alternatively, anticipated future operating losses might indicate that a company has an onerous contract. In certain circumstances, its necessary to provide for the onerous element of a contract.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Restructuring

Restructuring mean “ A programme that is planned and controlled by management and materially changes either the scope of business or the manner in which that business is conducted.” IAS 37 provides few examples of events that may qualify :

§ Sale or termination of a line of business

§ Closure of business locations in a region or relocation of business activities from one location to another

§ Changes in management structure, such as elimination of a layer of management

§ Fundamental reorganization of the entity such that it has a material and a significant impact on its operations.

Although many fundamental structural changes to an entity’s operations would be significant enough to warrant disclosure in footnotes to the financial statements, not all of these changes qualify as restructuring that necessitates recognition (as opposed to disclosure), because they do not meet the criteria for recognizing a provision. Recognition of the provision is required because a constructive obligation may arise from the decision to restructure. In other words, a constructive obligation may not arise in all cases.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

A constructive obligation arises when, and only when, an entity

§ A detailed formal plan for the restructuring which identifies at least

§The business or part of the business being restructured;

§The principal locations affected by the restructuring;

§the location, function, and approximate number of employees who will be compensated for terminating their services their employment;

§when the plan will be implemented and

§The expenditures that will be undertaken;

§ Has raised valid expectations in the minds of those affected that the entity will carry out restructuring by starting to implement that plan or announcing its main features to those affected by it.

The standard indicates examples of this type of evidence needed to demonstrate that the entity has started to implement a restructuring plan. This includes,

§ Dismantling Plant

§ Selling Assets

§ Public announcement of the Plan’s main features

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

A restructuring provision should include only direct expenditures arising from the restructuring, which are those that are necessarily entailed by the restructuring and not associated with the ongoing activities of the entity.

The Standard has specifically excluded certain types of expenditures as expenditure arising from restructuring

§ Costs of retraining or relocating continuing staff

§ Marketing

§ Investment in new systems and distribution networks

Its not possible to make a provision where only a management or board decision to restructure has been taken before the balance sheet date, as this does not in itself give rise to a constructive obligation. Furthermore, even if the management on the board complete the detailed plan and announce the restructuring after the entity's year end, but before its financial statement are approved by the board, provision for the restructuring should not be made.

IAS 37 specifies precisely the requirement for a commitment at the year end and makes it clear that even for a sale or termination, the binding sale agreement or the formal plan must exist at the balance sheet date for an obligation to arise.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Example :- The board of directors of ABC Inc. at their meeting held on December 15, 20X1, decided to close down the entity’s international branches and shift its international operations and consolidate them with its domestic operations. A detailed formal plan for winding up the international operations was also formalized and agreed by the board of directors in that meeting. Letters were sent out to customers, suppliers, and workers soon thereafter. Meetings were called to discuss the features of the formal plan to wind up international operations, and representatives of all interested parties were presenting those meetings.

Do the actions of the board of directors create a constructive obligation that needs a provision for restructuring?

The conditions prescribed by IAS 37 are :-

§There should be detailed formal plan of restructuring;

§Which should have raised valid expectations in the minds of those affected that the entity would carry out the restructuring by announcing the main features of its plans to restructure.

The board of directors did discuss and formalize a formal plan of winding up the international operations. This plan was communicated to the parties affected and created a valid expectation in their minds that ABC Inc. will go ahead with its plans to wind up international operations. Thus there is a constructive obligation that needs to be provided at year-end.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Onerous Contract

Onerous Contract is a contract where the costs involved with fulfilling the terms and conditions of the contract are higher than the amount of economic benefit received. The standard requires that where an entity has a contract that is onerous, provision should be made for the present obligation that arises under the contract. Many contract can be cancelled without any compensation being paid to the other contracting party and clearly, as no obligation can arise in this type of situation, such contract cannot be onerous.

Contract that typically fall into this area include leases of property particularly where the property is being sublet. For example :- Where a company has a head lease on a property it has a continuing obligation to pay the landlord for the rents due under the lease. However if the property is vacant, the company may not be able to recover any of that cost in the future, unless it can find a sub-lessee for the unoccupied premises.

Executory Contract are excluded from IAS 37. Executory contract is a contract under which neither party has performed any of its obligation or under which both parties have partially performed their obligation to an equal extent. Take – or – Pay contracts are example of executory contracts.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Example:- XYZ Inc. is getting ready to move its factory from its existing location to a new industrial free zone specially created by the government for manufacturers. To avail itself of the preferential licensing offered by the local governmental authorities as a reward for moving into the free trade zone and the savings in costs that would ensue (since there are no duties or taxes in the free trade zone).

XYZ Inc. has to move into the new location before the end of the year. The lease on its present location is non-cancelable and is for another two years from year-end. The obligation under the lease is the annual rent of Rs.100,000.

Advise XYZ Inc. what amount, if any, it needs to provide at year-end toward this lease obligation.

The lease agreement is an executory onerous contract because after moving to the new location, XYZ Inc. would derive no economic benefits from the existing factory building but would still need to pay rent under the agreement since the lease is non-cancelable. Thus the unavoidable costs exceed the benefits expected under the lease contract. Based on the annual lease obligation under the lease agreement, the total amount needed to be provided at year-end is the present value of the total commitment under the lease = PV of [Rs.100,000 × 2 (years)].

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CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

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CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

The standard requires that before a separate provision for an onerous contract can be made, an entity should recognize any impairment that has occurred on assets “dedicated to that contract”.

Example :- A). Contract not onerous :- A company has a contract to purchase one million units of gas at Rs.23 per unit and the current market price for a similar contract is Rs.16 Per unit. The gas will be used in generating electricity and the electricity will be sold at a profit. In this case the economic benefits from the contract include the benefits to the entity of using the gas in its business and because the electricity that is produced can be sold at a profit, the contract is not onerous.

B). Impairment of Assets:- However, the gas is used to generate electricity, the high cost of the gas assumed that the electricity is sold at a loss and entity makes an overall operating loss. In this case, the standard to carry out an impairment test on the CGU that generates the electricity and write down any assets that are impaired. To the extent that there is still a loss after the assets have been fully written down, the balance sheet should be provided for as a provision for an onerous contract.

C). Sale to 3rd Party at below Purchase Price:- If entity wants to exit the purchase contract they have to pay Rs.6 Per unit. In this case company has paying extra Rs. 7 per unit. Therefore a provision should be made for the onerous element of Rs. 6 per unit. Being the lower of the cost of fulfilling the contract and the penalty cost.