Provisions FAR24 – PROVISIONS RELATED STANDARDS: PAS 37 – PROVISIONS, CONTINGENT LIABILITIES & CONTINGENT ASSETS TOPIC OUTLINE LECTURE NOTES DEFINITION A provision is present obligation of uncertain timing or uncertain amount. Characteristics of Provisions Uncertainty of the amount of the liability as well as the timing of its settlement differentiates provisions from other types of liabilities. Please be minded that the word uncertainty does not include uncertainty of the existence of obligations. The past event that leads to a present obligation is called an obligating event. The present obligation may be legal or constructive. A legal obligation is an obligation arising from a contract, legislation or other operation of law. A constructive obligation is an obligation that is derived from an entity's actions where: . The entity has indicated to other parties that it will accept certain responsibilities by reason of an established pattern of past practice, published policy, or a sufficiently specific current statement. a. And as a result the entity has created a valid expectation on the part of other parties that it will discharge those responsibilities. A provision may be the equivalent of an estimated liability or a loss contingency that is accrued because it is both probable and measurable. In some instances, the exact payee of estimated liabilities cannot be identified or determined. RECOGNITION PAS 37, paragraph 14, states that a provision shall be recognized as liability under the following conditions: 1. 2. 3. The entity has a present obligation as a result of a past event. It is probable that an outflow of economic benefits shall be required to settle the obligation. The amount of the obligation can be measured reliably. PROVISIONS, CONTINGENT LIABILITIES & CONTINGENT ASSETS Likeliness to Happen (U.S. GAAP) More than 95% Ranges of Outcome Treatment if LIABILITY Treatment if ASSET Provisions (Accrue) Accrue as Asset Contingent Asset (Disclosed in Notes to FS Contingent Liability (Disclosed in Notes to FS Do Nothing Do Nothing Virtually Certain 51% - 95% Probable 5% - 50% Possible Less than 5% Remote MEASUREMENT The amount recognized as a provision should be the best estimate of the expenditure required to settle the present obligation at the end of reporting period. The best estimate is the amount that an entity would rationally pay to settle the obligation at the reporting date or to transfer it to a third party at that time. NOTE: Generally, the best estimate is the MOST LIKELY OUTCOME of the obligation. Scenario Large Population (Distributed Probability) Continuous range of possible outcomes and each point in that range is as likely as any other Best Estimate Expected Value Midpoint OTHER MEASUREMENT CONSIDERATIONS 1. RISK & UNCERTAINTIES - The risks and uncertainties that inevitably surround many events and circumstances shall be taken into account in reaching the best estimate of a provision. It shall be taken into account by multiplying the amount of provision to RISK ADJUSTMENT FACTOR. PRESENT VALUE - Where the effect of the time value of money is MATERIAL, the amount of provision shall be the present value of the expenditures expected to be required to settle the obligation. 3. FUTURE EVENTS - Future events that affect the amount required to settle an obligation shall be reflected in the amount of a provision where there is SUFFICIENT OBJECTIVE EVIDENCE that they will occur. 4. EXPECTED DISPOSAL OF ASSETS - Gains from expected disposal of assets shall NOT BE TAKEN INTO ACCOUNT in measuring a provision. 5. REIMBURSEMENT - Where some or all of the expenditure required to settle a provision is expected to be reimbursed by another party, the reimbursement shall be recognized when it is virtually certain that reimbursement will be received if the entity settles the obligation. 2. The reimbursement shall be treated as a separate asset and not "netted" against the estimated liability for the provision. However, the related income can be offset to the expense generated by the estimated liability. 6. CHANGES IN PROVISION - Provisions shall be REVIEWED AT EACH REPORTING DATE and adjusted to reflect the current best estimate. 7. FUTURE OPERATING LOSSES - Provision shall NOT BE RECOGNIZED for future operating losses. 8. ONEROUS CONTRACT - An onerous contract is a contract in which the unavoidable costs of meeting the obligation under the contract exceed the economic benefits expected to be received under the contract. If an entity has an onerous contract, the present obligation under the onerous contract shall be recognized and measured as a provision. The amount to be recognized as provision is the lower amount between the cost of fulfilling the contract and the compensation or penalty arising from failure to fulfil the contract. RECORDING OF PROVISIONS Generally, provisions are recorded by debiting the expense account and crediting the estimated liability account. Expense or Loss xx Estimated Liability xx EXCEPTION: If the provision is directly attributable to a certain asset, it is debited as cost of the asset. (i.e. estimated dismantling cost for PPEs and estimated restoration cost for wasting assets) Asset xx Estimated Liability xx COMMON TYPES OF PROVISIONS Types of Provisions Lawsuit or Court Cases Decommissioning Cost (c) Present Obligation Arises When? Upon causing damage or harm Upon imposition of provision of a law or contract Warranties (b) Premiums (a) Guarantee Restructuring (d) Upon Sale Upon default of party guaranteed by the entity (1) The entity has a detailed formal plan (2) The entity has raised valid expectation in the minds of those affected that the entity will carry out the restructuring by starting to implement the plan and announcing its main features to those affected by it. PREMIUMS LIABILITY (a) Premiums are articles of value such as toys, dishes, silverware, and other goods and in some cases cash payments, given to customers as result of past sales or sales promotion activities. FREQUENTLY ASKED QUESTIONS 1. 2. Premiums expense for the year (based on accrual of expense) Estimated premiums liability at the end of the year Accrual of expense is computed as: (No. of premiums expected to be distributed x net cost) Actual expense is computed as: (Actual premiums distributed x net cost*) * (Cost less reimbursement from customers) WARRANTIES LIABILITY (b) Home appliances like television sets, stereo sets, ratio sets, refrigerators and the like are often sold under guarantee or warranty to provide free repair service or replacement during a specified period if the products are defective. Such entity policy may involve significant costs on the part of the entity if the products sold prove to be defective in the future within the specified period of time. Accordingly, at the point of sale, a constructive obligation arises and a liability is incurred. FREQUENTLY ASKED QUESTIONS (1) Warranty expense for the year (based on accrual of expense) (2) Estimated warranty liability at the end of the year NOTE: Before accruing warranty liability at year-end, consider if estimated liability are still valid, that is, are still probable to be settled in the next period (i.e. if warranties have expiration) DECOMMISSIONING LIABILITY (c) The cost of abandonment or decommissioning an asset after full exhaustion of its economic benefits is will result to a provision known as decommissioning liability. If there is an increase in the balance of decommissioning liability, the journal entry is: Asset or Impairment Loss Estimated Liability xx xx If there is a decrease in the balance of decommissioning liability, the journal entry is: Estimated Liability Asset xx xx RESTRUCTURING PROVISION (d) PAS 37 defines restructuring as a "program that is planned and controlled by management and materially changes either the scope of a business of an entity or the manner in which that business is conducted". A restructuring provision shall include only direct expenditures arising from the restructuring, meaning, those expenditures that are necessarily entailed by the restructuring and not associated with the ongoing activities of the entity. For example, salaries and benefits of employees to be incurred after operations cease and that are associated with the closure of the operations shall be included in the amount of the restructuring provision. PAS 37 specifically excludes the following expenditures from the restructuring provision: (a) Cost of retraining or relocating continuing staff. (b) Marketing or advertising program to promote the new entity image. (c) Investment in new system and distribution network. PRESENTATION AND DISCLOSURE Provisions or estimated liabilities may be presented as current or non-current liability. Among those that are presented as current liabilities are premiums liability and warranties liability. On the other hand, those that are presented as non-current liabilities include decommissioning liabilities. (2) For each class of provisions, the timing, assumptions used, nature, uncertainties and reimbursement. (1) Reconciliation showing the beginning balances, ending balances, additions and deduction for each class of provision. DISCLOSURE REQUIREMENTS
