ZeePedia buy college essays online


Advanced Financial Accounting

<<< Previous PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS Next >>>
 
img
Advance Financial Accounting (FIN-611)
VU
LESSON # 28
IAS ­ 37 PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT
ASSETS
DEFINITIONS:
The following terms are used in this Standard with the meanings specified:
Liability:
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. Definition of liability can be divided into three parts:
Present obligation
Arising from the past event
Probable outflow of resources in future
Provision:
A provision is a liability of uncertain timing or amount. For a provision following
points must be kept in mind:
Present obligation
Arising from the past event
Probable outflow of resources in future
Amount can be estimated reliably.
Provision is created for two motives:
One to reduce Assets
Second to create a liability against losses
Provision that is created for reduction in assets is of two types:
1. Provision against receivables (also known as contra to receivables ­
Provision for doubtful debts)
2. Provision against the expiry of economic benefits of fixed assets
(Provision for depreciation/amortization).
IAS 37 does not talk about the provisions created to reduce the carrying amount of
assets. It only talks about the provision that is created to recognize a liability against
probable losses.
140
img
Advance Financial Accounting (FIN-611)
VU
Obligation Event:
An obligating event is an event that creates a legal or constructive obligation that
results in an entity having no realistic alternative but to settle that obligation.
Legal Obligation:
A legal obligation is an obligation that derives from:
a) A contract (through its explicit or implicit terms);
b) Legislation; or
c) Other operations of law.
Constructive Obligation:
A constructive obligation is an obligation that derives from an entity's actions where:
a) By an established pattern of past practice, published policies or a sufficiently
specific current statement, the entity has indicated to other parties that it will
accept certain responsibilities.
b) As a result, the entity has created a valid expectation on the part of those other
parties that it will discharge those responsibilities.
Contingent Liability:
A contingent liability is:
a) 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 entity; or
b) A present obligation that arises from past events but is not recognized because:
i.
It is not probable that an outflow of resources embodying economic
benefits will be required to settle the obligation.
ii.
The amount of the obligation cannot be measured with sufficient
reliability;
Contingent Assets:
A contingent asset is 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 entity.
Treatment of Liabilities, Accruals & Provisions:
Liabilities can be categorized as:
141
img
Advance Financial Accounting (FIN-611)
VU
1. Certain liability
example is Creditors against supplies
2. Virtually certain liability
example is Accruals against expenses
3. Uncertain liability
example is Provision against expected losses
Liabilities
Accruals
Provisions
(certain)
(virtually certain)
(uncertain)
Present
Present obligation
Present obligation
Status
obligation
Arising from
Past events
Past events
Past events
Outflow of
resources
Probable
Probable
Probable
embodying
economic benefits
Uncertain
(However
a
Measurement of
Certain
Virtually certain
amount
reliable  estimate
can be made)
Dr.
Loss
Dr. Expense
Dr. Purchases
(Expenses)
Accounting
Cr.
treatment
Cr. Creditors
Cr. Provision for
Accrual/Owings
the Loss
Virtually certain:
Something that involve a minor degree of estimation. An example of such would be
the amount payable in Utility Bills. The expense on the bill is for one month; however
the meter is read a couple of days after the month including charges for those extra
days as well.
Identifying Contingent Liabilities:
Following table will help to identify whether the obligation is a contingent liability
or not in accordance with the definition of IAS 37.
Case 1
Case 2
Case 3
Possible
Present obligation
Present obligation
Status
obligation
Arising from
Past events
Past events
Past events
Will be confirmed
Outflow of
resources
upon
the
Probable
Not probable
embodying
occurrence
or
142
img
Advance Financial Accounting (FIN-611)
VU
economic benefits
non-occurrence of
future events, not
in the control of
the entity
a] Future events
a] Probability is
not remote
are not remote
be  b] Probability is
Cannot
Amount
measured reliably  remote
b] Future events
are remote
a]  Disclosed  in
a]  Disclosed  in
notes
notes
Accounting
Disclosed in notes
treatment
b] Not disclosed
b] Not disclosed in
in notes
notes
Accounting Requirements for recognizing Liabilities and Assets:
Recognizing liabilities and assets means to record relevant accounting heads in the
books of accounts. IASB frame work and relevant Accounting Standards provide
guidelines for recognizing liabilities and assets at different stages.
Following table will explain that which type of liabilities and assets will be treated in
what way.
Stage
Liabilities
Assets
Recognize
Recognize
Certain
Virtually certain
Recognize
Recognize
(Accruals/Owings)
Uncertain
Do not recognize
(Probable/Provisio
Recognize
Disclose only
n)
Do not recognize
Contingent
Do nothing
Disclose only
Remote
Do nothing
Do nothing
Do nothing:
`Do nothing' means that the event is to be ignored while preparing the financial
statements. Even a disclosure of the same is not required in the notes to the accounts.
143
img
Advance Financial Accounting (FIN-611)
VU
Recognizing different transactions/events in Accordance with IAS 37:
Expense/Loss
Measurement
of
Status/Recognize
Accounting entry
amount
as
(Status)
Certain
Identified as
Dr. Expense
(Invoice/supporti
Liability
present
ng
documents
Cr. Payable
obligation
based)
Virtually certain
Dr. Expense
Identified as
(Invoice/supporti
Accrued liability
Cr.
present
ng documents
obligation
Accrual/Owings
based)
Uncertain
(amount can be
Dr.
Expense
Identified as
estimated reliably
(Loss)
present
Provision liability
with
probable
Cr. Provision for
obligation
outflow
of
loss
resources)
Uncertain
(amount can not
be
estimated
Identified as
reliably although
Contingent
No
entry.
present
there
is
a
liability
Disclose only
obligation
probability
of
outflow
of
resources)
Uncertain
(without
any
Identified as
Contingent
No
entry.
present
probability
of
liability
Disclose only
obligation
outflow
resources)
Uncertain
(possible outflow
of resources are
Unidentified
Contingent
No
entry.
(possible
based on future
liability
Disclose only
obligation)
events  not  in
control  of  the
entity)
Unidentified
No  entry.
No
(remote
Uncertain
No recognition
disclosure
obligation)
144
img
Advance Financial Accounting (FIN-611)
VU
Accrued
Provision
Contingent
Contingent
Contingent
Creditors
Expense
liability
liability
liability
liability
Liability
Virtually
Certain
Uncertain
Uncertain
Uncertain
Possible
certain
1: Present
X
obligation
2: Arising
from past
events
3:
Probable
outflow of
resources
X
embodying
economic
benefit in
future
4: Reliable
estimation
As per
As per
of the
iouprev
-/
Invoice
X
-
amount
s
X/
received
(can be
Invoice
measured
reliably)
Losses
against
Expense
warranty
No entry
No entry
No entry
5: Expense/Resources
A/C
Dr.
only
only
only
Accounting
Provision  disclosure  disclosure  disclosure
Payable A/C
Accrual
treatment
for is required is required is required
A/C
Warranty
Cr.
Provisions and Other Liabilities:
Provisions can be distinguished from other liabilities such as trade payables and
accruals because there is uncertainty about the timing or amount of the future
expenditure required in settlement. By contrast:
a) Trade payables are liabilities to pay for goods or services that have been
received or supplied and have been invoiced or formally agreed with the
supplier; and
145
img
Advance Financial Accounting (FIN-611)
VU
b) Accruals are liabilities to pay for goods or services that have been received or
supplied but have not been paid, invoiced or formally agreed with the supplier,
including amounts due to employees (for example amounts relating to accrued
vacation pay).
Although it is sometimes necessary to estimate the amount or timing of accruals, the
uncertainty is generally much less than for provisions. Accruals are often reported as
part of trade and other payables, whereas provisions are reported separately.
Relationship between Provisions and Contingent Liabilities:
This Standard distinguishes between:
a) Provisions ­ which are recognized as liabilities (assuming that a reliable
estimate can be made) because they are present obligations and it is probable
that an outflow of resources embodying economic benefits will be required to
settle the obligations; and
b) Contingent liabilities ­ which are not recognized as liabilities because they are
either:
i.
Possible obligations, as it has yet to be confirmed whether the entity has
a present obligation that could lead to an outflow of resources
embodying economic benefits; or
ii.
Present obligations that do not meet the recognition criteria in this
Standard (because either it is not probable that an outflow of resources
embodying economic benefits will be required to settle the obligation, or
a sufficiently reliable estimate of the amount of the obligation cannot be
made).
RECOGNITION:
Provisions:
A provision shall be recognized when:
a) An entity has a present obligation (legal or constructive) as a result of a past
event;
b) It is probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; and
c) A reliable estimate can be made of the amount of the obligation.
If these conditions are not met, no provision shall be recognized.
Present Obligation:
In rare cases it is not clear whether there is a present obligation. In these cases, a past
event is deemed to give rise to a present obligation if, taking account of all available
146
img
Advance Financial Accounting (FIN-611)
VU
evidence, it is more likely than not, that a present obligation exists at the balance sheet
date.
In almost all cases it will be clear whether a past event has given rise to a present
obligation. In rare cases, for example in a law suit, it may be disputed either whether
certain events have occurred or whether those events result in a present obligation. In
such a case, an entity determines whether a present obligation exists at the balance
sheet date by taking into account of all available evidence, including for example, the
opinion of experts. The evidence considered includes any additional evidence
provided by events after the balance sheet date. On the basis of such evidence:
a) Where it is more likely than not, that a present obligation exists at the balance
sheet date, the entity recognizes a provision (if the recognition criteria are met);
and
b) Where it is more likely that no present obligation exists at the balance sheet
date, the entity discloses ability, unless the possibility of an outflow of resources
embodying economic benefits is remote.
Past Events:
A past event that leads to a present obligation is called an obligating event. For an
event to be an obligating event, it is necessary that the entity has no realistic
alternative to settling the obligation created by the event. This is the case only:
a) Where the settlement of the obligation can be enforced by law; or
b) In case of a constructive obligation, the event creates valid expectations in other
parties that the entity will discharge the obligation.
Probable Outflow of Resources Embodying Economic Benefits:
For a liability to qualify for recognition there must be not only a present obligation but
also the probability of an outflow of resources embodying economic benefits to settle
that obligation. For the purpose of this Standard, an outflow of resources or other
event is regarded as probable if the event is more likely than not to occur i.e. the
probability that the event will occur is greater than the probability that it will not.
Where it is not probable that a present obligation exists, an entity discloses a
contingent liability, unless the possibility of an outflow of resources embodying
economic benefits is remote.
Reliable Estimate of the Obligation:
The use of estimates is an essential part of the preparation of financial statements and
does not undermine their reliability. This is especially true in the case of provisions,
which by their nature are more uncertain than most other balance sheet items.
147
img
Advance Financial Accounting (FIN-611)
VU
Contingent Liabilities:
An entity shall not recognize a contingent liability. A contingent liability is disclosed
unless the possibility of an outflow of resources embodying economic benefits is
remote.
Contingent liabilities may develop in a way not initially expected. Therefore, they are
assessed continually to determine whether an outflow of resources embodying
economic benefits has become probable. If it becomes probable that an outflow of
future economic benefits will be required for an item previously dealt with as a
contingent liability, a provision is recognized in the financial statements of the period
in which the change in probability occurs (except in the extremely rare circumstances
where no reliable estimate can be made).
Example-1:
Extract from Notes to the Accounts:
a) Guarantees issued by banks on behalf the company;
b) Claims against the company were not acknowledged as debt by the company.
As the management is confident that the matter would be settled in her favor;
consequently no provision has been made in the financial statements in respect
of the disputed liabilities.
Contingent Assets:
An entity shall not recognize a contingent asset. Contingent assets usually arise from
unplanned or other unexpected events that give rise to the possibility of an inflow of
economic benefits to the entity. An example is a claim that an entity is pursuing
through legal processes, where the outcome is uncertain.
Contingent assets are not recognized in financial statements since this may result in
the recognition of income that may never be realized. However, when the realization
of income is virtually certain, then the related asset is not a contingent asset and its
recognition is appropriate.
A contingent asset is disclosed where an inflow of economic benefits is probable.
Example-2:
The company has filed a suit against SA Ltd. claming damages amounting to Rs.
600,000. The legal advisors of the company are of the opinion that the company will
win the case.
148
img
Advance Financial Accounting (FIN-611)
VU
MEASUREMENT:
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 estimates of outcome and financial effect are determined by the judgment of the
management of the entity, supplemented by experience of similar transactions and in
some cases, reports from independent experts. The evidence considered includes any
additional evidence provided by events after the balance sheet date.
Example-3:
An entity sells goods with a warranty under which customers are covered for the cost
of repairs of any manufacturing defects that become apparent within the first six
months after purchase. If minor defects were detected in all products sold, repair costs
of Rs. 1 million would result. If major defects were detected in all products sold, repair
costs of Rs. 4 million would result. The entities past experience and future expectations
indicate that, for the coming year, 75 percent of the goods sold will have no defects, 20
percent of the goods sold will have minor defects and 5 percent of the goods sold will
have major defects. In accordance with 3.1.4.2, an entity assesses the probability of an
outflow for the warranty obligations as a whole.
The expected value of the cost of repairs is:
(75% of Nil) + (20% of Rs. 1 m) + (5% of Rs. 4 m) = Rs. 400,000.
CHALLANGES IN PROVISION:
Provision shall be reviewed at each balance sheet date and adjusted to reflect the
current best estimate. If it is no longer probable that an outflow of resources
embodying economic benefits will be required to settle the obligation, the provision
shall be reversed.
USE OF PROVISIONS:
A provision shall be used only for expenditures for which the provision was originally
recognized.
Only expenditures that relate to the original provision are set against it. Setting
expenditures against a provision that was originally recognized for another purpose
would conceal the impact of two different events.
Example-8:
A damage claim of Rs. 15 million for breach of contract has been served on the
company. The company's legal counsel is of the view that it is probable that the
damages will be awarded to plaintiff. So, the company makes a provision. In the next
149
img
Advance Financial Accounting (FIN-611)
VU
year the case is decided in the favor of the plaintiff. The company has to pay Rs. 12
million. Another suit filed against the company is also decided in this year. The
company has to pay Rs. 2 million in respect of this case.
Required:
How will you account for above two payments?
Solution:
i.
The first payment of Rs. 12 million shall be charged to provision and remaining
provision should be reversed.
Provision for claim
15,000,000
Cash
12,000,000
Profit & Loss (Reversal of provision)
3,000,000
ii.
The second payment of Rs. 2 million shall be charged to P & L Account
separately.
Damages Expenses (P & L A/c)
2,000,000
Cash
2,000,000
Application of the Recognition and Measurement Rules:
Future Operating Losses:
a) Provisions shall not be recognized for future operating losses.
b) Future operating losses do not meet the definition of a liability and the general
recognition criteria set out for provisions.
c) An expectation of future operating losses is an indication that certain assets of
the operation may be impaird. An entity tests these assets for impairment under
IAS-36 Impairment of Assets.
Onerous Contracts:
If an entity has a contract that is onerous, the present obligation under the contract
shall be recognized and measured as a provision.
150
Table of Contents:
  1. ACCOUNTING FOR INCOMPLETE RECORDS
  2. PRACTICING ACCOUNTING FOR INCOMPLETE RECORDS
  3. CONVERSION OF SINGLE ENTRY IN DOUBLE ENTRY ACCOUNTING SYSTEM
  4. SINGLE ENTRY CALCULATION OF MISSING INFORMATION
  5. SINGLE ENTRY CALCULATION OF MARKUP AND MARGIN
  6. ACCOUNTING SYSTEM IN NON-PROFIT ORGANIZATIONS
  7. NON-PROFIT ORGANIZATIONS
  8. PREPARATION OF FINANCIAL STATEMENTS OF NON-PROFIT ORGANIZATIONS FROM INCOMPLETE RECORDS
  9. DEPARTMENTAL ACCOUNTS 1
  10. DEPARTMENTAL ACCOUNTS 2
  11. BRANCH ACCOUNTING SYSTEMS
  12. BRANCH ACCOUNTING
  13. BRANCH ACCOUNTING - STOCK AND DEBTOR SYSTEM
  14. STOCK AND DEBTORS SYSTEM
  15. INDEPENDENT BRANCH
  16. BRANCH ACCOUNTING 1
  17. BRANCH ACCOUNTING 2
  18. ESSENTIALS OF PARTNERSHIP
  19. Partnership Accounts Changes in partnership firm
  20. COMPANY ACCOUNTS 1
  21. COMPANY ACCOUNTS 2
  22. Problems Solving
  23. COMPANY ACCOUNTS
  24. RETURNS ON FINANCIAL SOURCES
  25. IASBíS FRAMEWORK
  26. ELEMENTS OF FINANCIAL STATEMENTS
  27. EVENTS AFTER THE BALANCE SHEET DATE
  28. PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS
  29. ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS 1
  30. ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS 2
  31. BORROWING COST
  32. EXCESS OF THE CARRYING AMOUNT OF THE QUALIFYING ASSET OVER RECOVERABLE AMOUNT
  33. EARNINGS PER SHARE
  34. Earnings per Share
  35. DILUTED EARNINGS PER SHARE
  36. GROUP ACCOUNTS
  37. Pre-acquisition Reserves
  38. GROUP ACCOUNTS: Minority Interest
  39. GROUP ACCOUNTS: Inter Company Trading (P to S)
  40. GROUP ACCOUNTS: Fair Value Adjustments
  41. GROUP ACCOUNTS: Pre-acquistion Profits, Dividends
  42. GROUP ACCOUNTS: Profit & Loss
  43. GROUP ACCOUNTS: Minority Interest, Inter Co.
  44. GROUP ACCOUNTS: Inter Co. Trading (when there is unrealized profit)
  45. Comprehensive Workings in Group Accounts Consolidated Balance Sheet