[et_pb_section bb_built=”1″ admin_label=”Header – All Pages” transparent_background=”off” background_color=”#1e73be” allow_player_pause=”off” inner_shadow=”off” parallax=”off” parallax_method=”off” make_fullwidth=”off” use_custom_width=”off” width_unit=”on” make_equal=”off” use_custom_gutter=”off” custom_padding=”0px||0px|” next_background_color=”#000000″ custom_padding_tablet=”50px|0|50px|0″ custom_padding_last_edited=”on|desktop” global_module=”1221″][et_pb_row admin_label=”row” global_parent=”1221″ make_fullwidth=”off” use_custom_width=”off” width_unit=”on” use_custom_gutter=”off” custom_padding=”||5px|” allow_player_pause=”off” parallax=”off” parallax_method=”on” make_equal=”off” parallax_1=”off” parallax_method_1=”off” background_position=”top_left” background_repeat=”repeat” background_size=”initial”][et_pb_column type=”4_4″][et_pb_post_title global_parent=”1221″ title=”on” meta=”off” author=”on” date=”on” categories=”on” comments=”on” featured_image=”off” featured_placement=”below” parallax_effect=”on” parallax_method=”off” text_orientation=”left” text_color=”light” text_background=”off” text_bg_color=”rgba(255,255,255,0.9)” module_bg_color=”rgba(255,255,255,0)” use_border_color=”off” border_color=”#ffffff” border_style=”solid” custom_padding=”10px|||” parallax=”on” background_color=”rgba(255,255,255,0)” /][/et_pb_column][/et_pb_row][/et_pb_section][et_pb_section bb_built=”1″ fullwidth=”off” specialty=”off” transparent_background=”off” allow_player_pause=”off” inner_shadow=”off” parallax=”off” parallax_method=”off” custom_padding=”30px||0px|” make_fullwidth=”off” use_custom_width=”off” width_unit=”on” make_equal=”off” use_custom_gutter=”off” background_color=”#1e73be” prev_background_color=”#000000″ next_background_color=”#ffffff” custom_padding_tablet=”0px||0px|” global_module=”1228″][et_pb_row global_parent=”1228″ make_fullwidth=”off” use_custom_width=”off” width_unit=”on” use_custom_gutter=”off” custom_padding=”30px||0px|” allow_player_pause=”off” parallax=”off” parallax_method=”off” make_equal=”off” parallax_1=”off” parallax_method_1=”off” column_padding_mobile=”on” background_position=”top_left” background_repeat=”repeat” background_size=”initial”][et_pb_column type=”4_4″][et_pb_text global_parent=”1228″ background_layout=”light” text_orientation=”left” use_border_color=”off” border_color=”#ffffff” border_style=”solid” background_position=”top_left” background_repeat=”repeat” background_size=”initial”]
[breadcrumb]
[/et_pb_text][/et_pb_column][/et_pb_row][/et_pb_section][et_pb_section bb_built=”1″ fullwidth=”off” specialty=”off” transparent_background=”off” allow_player_pause=”off” inner_shadow=”off” parallax=”off” parallax_method=”off” padding_mobile=”off” make_fullwidth=”off” use_custom_width=”off” width_unit=”on” make_equal=”off” use_custom_gutter=”off” gutter_width=”3″ custom_padding_tablet=”0px||0px|” custom_padding_last_edited=”on|desktop” prev_background_color=”#1e73be” next_background_color=”#000000″][et_pb_row][et_pb_column type=”4_4″][et_pb_toggle admin_label=”Index” _builder_version=”3.0.106″ open=”off” title=”Index”]
Section 21: Provisions and Contingencies.
21.1.1 Extract from FRS 102 – Section 21.1-21.3.
21.1.2 OmniPro comment – Scope.
21.2 Initial recognition and subsequent measurement
21.2.1 Extract from FRS 102 – Section 21.4-21.11.
21.2.2.1 Conditions required to recognise a provision.
21.2.2.1.1 a) Present obligation as a result of a past event
21.2.2.1.1.1 Legal obligation.
21.2.2.1.1.2 Constructive obligation.
21.2.2.1.1.2.2 Refunds Policy.
21.2.2.1.3.1 Changes in income tax system.
21.2.2.1.3.2 Provision required for a future date.
21.2.2.1.3.3 Difficulty is assessing if a present obligation on a result of a past event exists.
21.2.2.1.3.4 Profits on disposal of fixed assets excluded.
21.2.2.1.3.5 Reimbursement by a third party for costs.
21.2.2.1.3.6 Weighted Probabilities.
21.2.2.1.2 b) Probability of transfer of economic benefits.
21.2.2.1.3 c) Obligation can be reliably measured.
21.2.2.1.4 Present value and the discount rate to be used.
21.2.2.1.5 Change in estimate and discount rates.
21.3.1. Extract from FRS 102 – Section 21.10-21.11A.
21.3.2 OmniPro comment – Onerous contracts.
21.4.1 Extract from FRS 102 – Section 21.11B.
21.4.1.1 OmniPro comment – Future operating losses.
21.5.1 Extract from FRS 102 – Section 21.11C-21.11D.
21.5.2 OmniPro comment – restructuring.
21.5.2.1 Definition and examples.
21.5.2.2 Restructuring and a constructive/legal obligation.
21.5.2.2.1 Examples that illustrate a detailed restructuring plan.
21.5.2.2.2 Examples of items that may be included in restructuring provision.
21.5.2.2.3 Examples of items that may not be included in restructuring provision.
21.6.1 Extract from FRS 102 – Section 21.12.
21.6.2.1 Contingent liability – definition and when it arises.
21.6.2.1.1 Exception to non-recognition of contingent liabilities.
21.6.2.3 Contingent liability examples.
21.7.1 Extract from FRS 102 – Section 21.13.
21.7.2 OmniPro comment – Contingent assets.
21.8 Decommission costs/ reinstatement/dilapidation provision. 21.9 Remediation provision. 21.10 Disclosures.
21.10.1 Disclosures about provisions.
21.10.1.1 Extract from FRS 102 – Section 21.14.
21.10.1.2 OmniPro comment – Disclosures about provisioning.
21.10.1.2.1 Extract from accounting policy note – Provisions.
21.10.1.2.2 Remediation provision/environmental provision accounting policies.
21.10.1.2.3 Extract from notes to the financial statements – Provisions.
21.10.2 Disclosures about contingent liabilities.
21.10.2.1 Extract from FRS 102 – Section 21.15.
21.10.2.2 OmniPro comment – Contingent liability disclosures.
21.10.2.2.1 Accounting policy disclosure – Contingencies.
21.10.3 Disclosures about contingent assets.
21.10.3.1 Extract from FRS 102 – Section 21.16.
21.10.3.2.1 Accounting policy – Contingent assets.
21.10.4 Prejudicial disclosures.
21.10.4.1 Extract from FRS 102 – Section 21.17.
21.10.4.2 OmniPro comment – Prejudicial disclosures.
21.10.4.2.1 Extract from notes to the financial statements showing prejudicial disclosure.
21.10.5 Disclosure about financial guarantee contracts.
21.10.5.1 Extract from FRS 102 – Section 21.17.
21.10.5.2 OmniPro comment – Financial guarantee contract disclosures.
21.10.5.2.1 Financial guarantee contract example disclosures.
[/et_pb_toggle][/et_pb_column][/et_pb_row][et_pb_row][et_pb_column type=”3_4″][et_pb_text admin_label=”Main Body Text” text_orientation=”justified” use_border_color=”off” border_color_all=”off” module_alignment=”left” _builder_version=”3.17.6″]
21.2 Initial recognition and subsequent measurement
21.2.1 Extract from FRS 102 – Section 21.4-21.11
21.4 An entity shall recognise a provision only when:
(a) the entity has an obligation at the reporting date as a result of a past event;
(b) it is probable (i.e. more likely than not) that the entity will be required to transfer economic benefits in settlement; and
(c) the amount of the obligation can be estimated reliably.
21.5 The entity shall recognise the provision as a liability in the statement of financial position and shall recognise the amount of the provision as an expense, unless another section of this FRS requires the cost to be recognised as part of the cost of an asset such as inventories or property, plant and equipment.
21.6 The condition in paragraph 21.4(a) means that the entity has no realistic alternative to settling the obligation. This can happen when the entity has a legal obligation that can be enforced by law or when the entity has a constructive obligation because the past event (which may be an action of the entity) has created valid expectations in other parties that the entity will discharge the obligation. Obligations that will arise from the entity’s future actions (i.e. the future conduct of its business) do not satisfy the condition in paragraph 21.4(a), no matter how likely they are to occur and even if they are contractual. To illustrate, because of commercial pressures or legal requirements, an entity may intend or need to carry out expenditure to operate in a particular way in the future (for example, by fitting smoke filters in a particular type of factory). Because the entity can avoid the future expenditure by its future actions, for example by changing its method of operation or selling the factory, it has no present obligation for that future expenditure and no provision is recognised.
Initial measurement
21.7 An entity shall measure a provision at the best estimate of the amount required to settle the obligation at the reporting date. The best estimate is the amount an entity would rationally pay to settle the obligation at the end of the reporting period or to transfer it to a third party at that time.
(a) When the provision involves a large population of items, the estimate of the amount reflects the weighting of all possible outcomes by their associated probabilities. Where there is a continuous range of possible outcomes, and each point in that range is as likely as any other, the mid-point of the range is used.
(b) When the provision arises from a single obligation, the individual most likely outcome may be the best estimate of the amount required to settle the obligation. However, even in such a case, the entity considers other possible outcomes. When other possible outcomes are either mostly higher or mostly lower than the most likely outcome, the best estimate will be a higher or lower amount. When the effect of the time value of money is material, the amount of a provision shall be the present value of the amount expected to be required to settle the obligation. The discount rate (or rates) shall be a pre-tax rate (or rates) that reflect(s) current market assessments of the time value of money and risks specific to the liability. The risks specific to the liability shall be reflected either in the discount rate or in the estimation of the amounts required to settle the obligation, but not both.
21.8 An entity shall exclude gains from the expected disposal of assets from the measurement of a provision.
21.9 When some or all of the amount required to settle a provision may be reimbursed by another party (e.g. through an insurance claim), the entity shall recognise the reimbursement as a separate asset only when it is virtually certain that the entity will receive the reimbursement on settlement of the obligation. The amount recognised for the reimbursement shall not exceed the amount of the provision. The reimbursement receivable shall be presented in the statement of financial position as an asset and shall not be offset against the provision. In the statement of comprehensive income (or in the income statement, if presented) the expense relating to a provision may be presented net of the amount recognised for a reimbursement.
Subsequent measurement
21.10 An entity shall charge against a provision only those expenditures for which the provision was originally recognised.
21.11 An entity shall review provisions at each reporting date and adjust them to reflect the current best estimate of the amount that would be required to settle the obligation at that reporting date. Any adjustments to the amounts previously recognised shall be recognised in profit or loss unless the provision was originally recognised as part of the cost of an asset (see paragraph 21.5). When a provision is measured at the present value of the amount expected to be required to settle the obligation, the unwinding of the discount shall be recognised as a finance cost in profit or loss in the period it arises.
21.2.2 OmniPro comment
21.2.2.1 Conditions required to recognise a provision
Section 21.4 of FRS 102 details the conditions required for a provision to be included in the financial statements. We will look at each of these separately below. Refer to the decision tree at 21.6.2.2 which illustrates whether a provision, contingent liability disclosure or non-disclosure is required based on the rules of Section 21 of FRS 102. In addition refer to the asset decision tree at 21.7.2.1.
21.2.2.1.1 a) Present obligation as a result of a past event
Present obligation as a result of a past event – legal obligation or a constructive obligation
Section 21.6 of FRS 102 makes it clear that a provision is required where there is no realistic alternative to settling the obligation – which can happen due to there being a legal or constructive obligation.
21.2.2.1.1.1 Legal obligation
A legal obligation is usually quite easy to identify and prove. The legal obligation has to arise from a past event. Examples of legal obligations would be:
- Provision of warranties for products sold where this is documented in the sales agreement
- Obligation arising from non-cancellable operating leases
- Legal obligation as a result of negligence on the entity’s behalf
- Legal requirement under the laws of the country. Note provision only required at the balance sheet date where the law has been substantively enacted at the reporting date. A provision will only be required at that reporting date where the law applies retrospectively.
21.2.2.1.1.2 Constructive obligation
A constructive obligation is defined in FRS 102 glossary. The key point here is that it must result from a past event. A constructive obligation derives from an entity’s actions:
- By 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;
AND
- As a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.
Constructive obligations will usually require judgement so all facts and circumstances will need to be reviewed. The key point is that it has created expectations of third parties and/or they cannot withdraw from it. Examples of constructive obligations include:
- Retailers with a policy of providing cash refunds to customers even where the goods are neither faulty or damaged. Note the policy would have to be applied consistently.
- Provision for vouchers issued but not redeemed which are in excess of the stated policy, where the entity e.g. hotel has had a past practice of honoring vouchers which have well past the date for redemption
- Published policies which are available to all parties to see which is over and above what is required by law
- Any communication that has been made to outside parties which the entity cannot realistically withdraw from as they have created an expectation of outside parties. For example, a decision by a board of directors to carry out a large restructuring is not a constructive obligation as the board can turn back on its decision as it has not communicated to other external parties. However where the management communicate this to all interested parties including employee representative or a public announcement has been made, a constructive obligation exists as they cannot realistically withdraw.
- Restructuring provisions
21.2.2.1.1.2.1 Warranties
Example 1: Warranties (as extracted from Appendix to FRS 102 Section 21A.4)
A manufacturer gives warranties at the time of sale to purchasers of its product. Under the terms of the contract for sale, the manufacturer undertakes to make good, by repair or replacement, manufacturing defects that become apparent within three years from the date of sale. On the basis of experience, it is probable (i.e. more likely than not) that there will be some claims under the warranties.
- Present obligation as a result of a past obligating event – The obligating event is the sale of the product with a warranty, which gives rise to a legal obligation. The past event is the sale of the product to the customer.
- An outflow of resources embodying economic benefits in settlement: – Probable for the warranties as a whole to be paid as the company has a history of warranty claims so they are expected.
- Measured reliably – as the company has a history of past warranty claims it can measure the provision reliably.
Conclusion: The entity recognises a provision for the best estimate of the costs of making good under the warranty products sold before the reporting date.
In 20X0, goods are sold for CU1,000,000. Experience indicates that 90 per cent of products sold require no warranty repairs; 6 per cent of products sold require minor repairs costing 30 per cent of the sale price; and 4 per cent of products sold require major repairs or replacement costing 70 per cent of sale price. Therefore estimated warranty costs are:
|
CU1,000,000 X 90% X 0 = CU0 CU1,000,000 X 6% X 30% = CU18,000 CU1,000,000 X 4% X 70% = CU28,000 Total CU46,000 |
The expenditures for warranty repairs and replacements for products sold in 20X0 are expected to be made 60 per cent in 20X1, 30 per cent in 20X2, and 10 per cent in 20X3, in each case at the end of the period. Because the estimated cash flows already reflect the probabilities of the cash outflows, and assuming there are no other risks or uncertainties that must be reflected, to determine the present value of those cash flows the entity uses a ‘risk-free’ discount rate based on government bonds with the same term as the expected cash outflows (6 per cent for one-year bonds and 7 per cent for two-year and three-year bonds). Calculation of the present value, at the end of 20X0, of the estimated cash flows related to the warranties for products sold in 20X0 is as follows:
| Year | Expected cash payments (CU) | Discount rate |
Discount factor |
Present Value (CU) |
|
| 1 |
60% CU46,000 |
27,600 | 6% |
0.9434 (at 6% for 1 year) |
26,038 |
| 2 |
30% CU46,000 |
13,800 | 7% |
0.8734 (at 7% for 2 years) |
12,053 |
| 3 |
10% CU46,000 |
4,600 | 7% |
0.8163 (at 7% for 3 years) |
3,755 |
| Total | 41,846 |
The entity will recognise a warranty obligation of CU41,846 at the end of 20X0 for products sold in 20X0. The journal required is to debit cost of sales and credit provisions.
NOTE: if in this example, the company also sold extended warranty above the standard warranty, any revenue from the sale is deferred and recognised over the extended warranty period.
21.2.2.1.1.2.2 Refunds Policy
Example 2: Refunds policy (as extracted from Appendix to FRS 102 Section 21A.5)
A retail store has a policy of refunding purchases by dissatisfied customers, even though it is under no legal obligation to do so. Its policy of making refunds is generally known.
Present obligation as a result of a past obligating event – The obligating event is the sale of the product, which gives rise to a constructive obligation because the conduct of the store has created a valid expectation on the part of its customers that the store will refund purchases.
An outflow of resources embodying economic benefits in settlement – Probable that a proportion of goods will be returned for refund based on past experience.
Conclusion: The entity recognises a provision for the best estimate of the amount required to settle the refunds.
21.2.2.1.3 Past events
As per Section 21.4 (a) of FRS 102 it is necessary that the obligation has arisen from past events i.e. events that occurred at or before the reporting date. The past event in the examples above was the sale of the products. Sometimes a past event giving rise to the obligation increases over a period of time (e.g. a sand-pit/quarry where there is an obligation to reinstate the land to its original condition). In this case a provision would be adjusted each year for the cost of the extra restoration work to establish the material taken out to its original condition.
The obligation cannot arise as a result of future actions. Any obligations that will arise from an entity’s future action no matter how likely they are to occur i.e. conduct of business do not create the need for a provision as it does not meet criteria in Section 21.10 of FRS 102 Examples given in the appendix to the standard is the requirement to fit smoke filters in the future due to legal and commercial pressures. In this scenario as the entity can avoid the expense of fitting smoke filters by changing the method in which it operates, it therefore has no obligation at the reporting date as a result of a past event so no provision should be booked.
21.2.2.1.3.1 Changes in income tax system
Example 3: Staff retraining as a result of changes in the income tax system (as extracted from Appendix to FRS 102 Section 21A.8)
The government introduces changes to the income tax system. As a result of those changes, an entity in the financial services sector will need to retrain a large proportion of its administrative and sales workforce in order to ensure continued compliance with tax regulations. At the end of the reporting period, no retraining of staff has taken place.
Present obligation as a result of a past obligating event – The tax law change does not impose an obligation on an entity to do any retraining. An obligating event for recognising a provision (the retraining itself) has not taken place. The entity could hire new staff who are already trained in order to avoid this cost.
Conclusion: The entity does not recognise a provision.
If the law changes in the future, this may create for a requirement for a provision where an action has been taken to get an entity to accept a liability or an entity accepts a liability.
21.2.2.1.3.2 Provision required for a future date
Example 4: Provision required for a future date
Company A operated a waste management plant for many years. Due to the chemicals used in the operation, the land on which the plant operates has been contaminated which has impacted the quality of the water supply. The company does not have to legally correct this contamination. At 31 December 2014, the company decides that it is not going to accept liability and on this basis no provision is required as the entity does not have a constructive or legal obligation.
At 31 December 2015, in order to maintain goodwill with the locals and as is consistent with plants with similar issues around the world, the entity makes a public announcement that it will implement procedures to clean up the contaminated land over the next number of years. At 31 December 2015, a provision is required to be booked for the best estimate of the cost as the entity has a constructive obligation as it has communicated to interested parties that it will make good any damage.
21.2.2.1.3.3 Difficulty is assessing if a present obligation on a result of a past event exists
There are instances where it is difficult to assess whether in fact there is a present obligation as a result of a past event present because the entity may determine that there is no obligation as the entity was not at fault or in a legal case the responsibility of the entity has not been established. In these cases it is likely a contingent obligation exists (and disclosure is required only) or where the chances of the plaintiff being successful with proceeding is remote in which case no disclosure is required. In assessing whether a provision exists an assessment needs to made based on evidence available and advice from legal council as to whether it is more likely than not, possible or remote and the outcome of this thought process will determine whether a provision should be booked, a disclosure included (contingent liability as possible outflow of economic benefits or reliable estimate cannot be made) or no disclosure included (likelihood deemed remote). In assessing the evidence Section 32 – Events after the end of the reporting period, states that settlement of a court case or further evidence as to its likely outcome which occurs after period end might indicate the existence of an obligation at the reporting date.
Example 5: Court case where difficulty assessing whether present obligation exists (Extracted from Section 21.9 of FRS 102)
A customer has sued Entity X, seeking damages for injury the customer allegedly sustained from using a product sold by Entity X. Entity X disputes liability on grounds that the customer did not follow directions in using the product. Up to the date the board authorised the financial statements for the year to 31 December 20X1 for issue, the entity’s lawyers advise that it is probable that the entity will not be found liable. However, when the entity prepares the financial statements for the year to 31 December 20X2, its lawyers advise that, owing to developments in the case, it is now probable that the entity will be found liable.
(a) At 31 December 20X1
Present obligation as a result of a past obligating event: On the basis of the evidence available when the financial statements were approved, there is no obligation as a result of past events as the entity sees that the customer was at fault.
Conclusion: No provision is recognised. The matter is disclosed as a contingent liability unless the probability of any outflow is regarded as remote.
(b) At 31 December 20X2
Present obligation as a result of a past obligating event: On the basis of the evidence available, there is a present obligation. The obligating event is the sale of the product to the customer.
An outflow of resources embodying economic benefits in settlement: Probable.
Conclusion: A provision is recognised at the best estimate of the amount to settle the obligation at 31 December 20X2, and the expense is recognised in profit or loss. It is not a correction of an error in 20X1 because, on the basis of the evidence available when the 20X1 financial statements were approved, a provision should not have been recognized at that time.
NOTE: had management believed at 31 December 20×1 that the likelihood of a transfer of economic benefits were remote, no disclosure would be required.
21.2.2.1.3.4 Profits on disposal of fixed assets excluded
Section 21.8 of FRS 102 makes it clear, that any gains from the expected disposal of assets are excluded from the measurement of the provision. Instead this is recognised on the actual disposal of the asset. These should always be excluded from the provision. However, losses on disposal should be incorporated into a provision where relevant. Even where the disposal is relating to restructuring due to closure provision, the profit on the disposal of the premises itself cannot be included.
21.2.2.1.3.5 Reimbursement by a third party for costs
As per Section 21.9 of FRS 102 where costs are covered by insurance, the reimbursement should only be recognised as a separate asset where it is virtually certain that it will be received. The reimbursement can be shown net in the profit and loss. Note the max amount that can be recognised cannot exceed the provision. Note the netting in the profit and loss would not be allowed where the client is joint and severally liable.
Example 6: reimbursement by a third party
A case has been taken against company A by an employee for personal injury. Company A is insured for such claims. At year end the company believes the conditions for a provision to be recognised applies. The provision calculated is CU100,000, this includes estimated fees of CU5,000. The company is covered in full under its insurance policy other than for fees. The likelihood of receiving the proceeds is certain as the insurer has to cover this. At year end the company would recognise an asset for CU95,000 on the balance sheet and set this against the provision posted in the P&L so as to show a net debit in the profit and loss of CU5,000 which relates to the legal fees which are not reimbursed.
If in the above example there was an issue whereby the insurance company felt they may not pay, the asset would not be recognised.
21.2.2.1.3.6 Weighted Probabilities
Section 21.7.(a) of FRS 102 makes it clear where the provision includes a large population of items, the estimate must reflect the weighting of all possible outcomes by their associated probabilities. See illustration of same at 21.2.2.1.1.2.1
21.2.2.1.2 b) Probability of transfer of economic benefits (Section 21.4 (b) FRS 102)
Section 21 does not define what is meant by probable but in practice as was the case under old GAAP this is taken to mean more likely than not or greater than a 50% chance. Once it is not probable then no provision is required to be booked in the year end financial statements. However where it is less than probable, it may or may not require disclosure.
Where the transfer of economic benefits is not probable then it can only be possible or remote.
Where the transfer is possible then it would generally fall into the category of a contingent liability. A contingent liability only requires disclosure but does not require recognition. See contingent liability section below for further discussion.
Where the transfer is remote then no disclosure or recognition is required under the standard. See contingent liability section below for further discussion.
21.2.2.1.3 c) Obligation can be reliably measured (Section 21.4 (c) FRS 102)
Before a provision can be recognised it must be able to be reliably measured. Section 21.7 of FRS 102 deals with the method in which estimation uncertainty should be dealt with. See example 1 at 21.2.2.1.1.2.1 for an illustration how uncertainty can be incorporated into the provision so as to determine a mid-point estimate using a weighting of all possible outcomes.
Example 7: determining most likely outcome where a single obligation (Section 21.7 (b) FRS 102)
A case has been taken against Company A and the company will have to pay damages of CU500,000. Company A believes it is 60% likely that they will have to pay this. Therefore at year end a provision of CU500,000 is required which may need to be present valued where the time value of money is significant. No probabilities are applied to this rate as there is only one possible outcome.
Example 8: Estimating a provision (Section 21.7 (b) FRS 102)
Where there is only a single obligation, then the best estimate to settle this should be utilised (the most probable outcome is used).
In order to obtain a reliable estimate it may be appropriate to discuss with legal counsel to determine the likelihood of success or failure and the expected payout based on their experience. This will require judgements and all facts should be looked at. As stated above in assessing the estimate management look at events after the reporting period to assess if this provides better evidence of the amount to be provided or if it is to be provided.
In the very unlikely event that a reliable estimate cannot be measured, then this would be disclosed as a contingent liability. See discussion on contingent liability at 21.6.2
21.2.2.1.4 Present value and the discount rate to be used
Section 21.7 of FRS 102 requires where material to present value the future cash flows on initial recognition. This is more often to be material where dilapidation, decommissioning and environmental clean up provisions are to be included.
In these particular cases, the amount recognised as a provision is the present values. As with any provision the credit side of the transaction is obviously posted to the provision but where the debit is posted depends on the circumstances as stated in Section 21.10 of FRS 102. Where a provision is recognised for dilapidation, decommissioning and environmental clean up the debit side will be posted to fixed assets and will be depreciated over the life of the requirement for the provision or as the entity gets the benefit from using the property over its life. In all other cases the debit side would be posted to the profit and loss. Where the debit is posted in the profit and loss will be determined if the expense is exceptional in nature or not. If it is exceptional an entity may include it as an exceptional item in the profit and loss or if not include it within operating costs. See example 1 at 21.2.2.1.1.2.1 and example 9 at 21.2.2.1.5 for how the present value should be determined.
21.2.2.1.4.1 Discount rate
Section 21.7 (b) of FRS 102 states a pre-tax discount rate should be used that reflects current market assessments of the time value of money and the risk specific to the liability. The risk specific to the liability should be in the discount rate used or the cash flows. The easiest way to incorporate risk is to include the risk in the cash flows using a pre-tax risk free discount rate as it is very hard to adjust the discount rate for risk.
The tax-free discount rate would usually be a government bond yield rate which is supported by the example in Section 21 replicated in example 1 at 21.2.2.1.1.2.1 Where there are a number of years where the cash flows expire then a number of discount rates may need to be applied. See example 1 at 21.2.2.1.1.2.1 for application of the discount rates.
One other point that needs to be considered is whether to incorporate inflation into the discount rate (i.e. to use a real discount rate) or to incorporate inflation into the cash flows (and use the nominal discount rate). The decision taken has an impact on yearly adjustments that gets posted to finance costs and the adjustment that gets posted to operating expenses. If we take example 9 at 21.2.2.1.5, and instead of assuming the CU200,000 initially incorporated inflation but instead this represents the CU200,000 expected settlement before inflation the CU200,000 would have to be adjusted for inflation as follows: CU200,000 * 1.04^4= CU243,101. The calculation below would then incorporate this figure when using the discount rate.
21.2.2.1.4.1.1 Unwinding of the discount
The unwinding of the discount throughout the provisions life is posted to the profit and loss within finance costs as stated in Section 21.11 of FRS 102. See example 9 at 21.2.2.1.5 of the application for unwinding the discount rules.
21.2.2.1.5 Change in estimate and discount rates
As stated in Section 21.7 of FRS 102, an entity should recognise a provision at the best estimate of the amount required to settle the obligation. By its nature the provision is an estimate, where there is a change in estimate of the provision this is corrected prospectively in line with Section 10 – Accounting policies. The effect of the change in estimate is posted to operating expenses in the profit and loss or to wherever the original provision was posted as stated in Section 21.11 of FRS 102. See example 9 for application of this change in estimate.
Also where the risk free discount rate changes over the life of the provision due to a material move in the yield on government bonds, this is corrected prospectively and as with a change in estimated cash flows it is posted to operating expenses in the profit and loss.
Example 9: Present valuing a provision, change in estimate/cash flow and change in discount rate
For Company A a provision at the start of year 1 is required for CU200,000 after the effects of inflation with respect to a legal case taken against the company. The case is scheduled to finish at the end of year 4. The risk free discount rate for a government bond for four years at the date of inception is 4.5%. At the end of year 2, the estimated payout is CU210,000 before the effects of inflation. At the end of year 3, the risk free discount rate fluctuated to 4%.
See below how these would be accounted for:
| Year | Opening Provision | PV Original Provision at year end from inception using 4.5% discount rate* | PV revised provision at end of year 2 at discount rate of 4.5% ** | PV revised provision at year end from end of year 3 at discount rate of 4% *** |
| Start of year 1 | 167,712* | |||
| 1 | 167,712 |
175,259 (167,712*1.045) |
n/a | n/a |
| 2 | 175,259 |
183,146 (175,259*1.045) |
192,303** | n/a |
| 3 | 183,146 |
191,388 (183,146*1.045) |
200,957 (192,303*1.045) |
201,923*** |
| 4 | 191,388 |
200,000 (191,388*1.045) |
210,000 (200,957*1.045) |
210,000 (201,923*1.04) |
| *CU200,000*((1/1.045^4)) | ||||
| **CU210,000*((1/1.045^2)) | ||||
| ***CU210,000*((1/1.04^1)) | ||||
Note 1: Narrative for change in estimate
Following the change in estimate at the end of year 2 the difference of CU9,157 (i.e. the difference between the carrying amount under the original estimate of CU183,146 at the end of year 2 as detailed above and the present value of the revised estimate of CU210,000 which was CU192,303), would be charged as an operating expense item. The difference of CU7,887 between the opening balance under the original provision at the end of year 1 of CU175,259 and the closing balance under the original provision at the end of year 2 of CU183,146 prior to the calculation of the provision for the new estimate represents the unwinding of the discount.
Note 2: Narrative for change in discount rate
Following the change in discounts rate at the end of year 3 the difference of CU966 (the difference between the carrying amount under the revised estimate of CU200,957 at the end of year 3 as detailed above and the present value of the revised amount using the 4% discount rate of CU201,923), would be charged as an operating expense item. The difference of CU8,654 between the opening balance under the revised provision at the end of year 2 of CU192,303 and the closing balance under the revised provision at the end of year 3 of CU200,957 prior to the calculation of the provision incorporating the new discount rate represents the unwinding of the discount.
Therefore the journals required throughout the four year period is as follows:
Year 1
| CU | CU | |
| Dr Operating Expenses | 167,712 | |
| Cr Provision | 167,712 |
Being journal to reflect the initial recognition of the provision at its present value
| CU | CU | |
|
Dr Finance Cost (CU175,259-CU167,712) |
7,547 | |
| Cr Provision | 7,547 |
Being journal to reflect the unwinding of the discount
Year 2
| CU | CU | |
|
Dr Finance Cost (CU183,146-CU175,259) |
7,887 | |
| Cr Provision | 7,887 |
Being journal to reflect the unwinding of the discount
| CU | CU | |
|
Dr Operating Expenses (CU192,303-CU183,146) |
9,157 | |
| Cr Provision | 9,157 |
Being journal to reflect the catch up for the change in estimate
Year 3
| CU | CU | |
|
Dr Operating Expenses (CU201,923-CU200,957) |
966 | |
| Cr Provision | 966 |
Being journal to reflect the catch up for the change in discount rate
Year 4
| CU | CU | |
| Dr Finance Cost (CU210,000-CU201,923) | 8,077 | |
| Cr Provision | 8,077 |
Being journal to reflect the unwinding of the discount
[/et_pb_text][/et_pb_column][et_pb_column type=”1_4″][et_pb_toggle _builder_version=”3.0.106″ title=”Practical Examples” open=”off”]
Examples
Example 3: Staff retraining as a result of changes in the income tax system..
Example 4: Provision required for a future date.
Example 5: Court case where difficulty assessing whether present obligation exists.
Example 6: reimbursement by a third party.
Example 7: determining most likely outcome where a single obligation
Example 8: Estimating a provision.
Example 9: Present valuing a provision, change in estimate/cash flow and change in discount rate.
Example 12: Onerous supply contract
Example 13: Future operating losses.
Example 14: Closure of a division: no implementation before end of reporting period.
Example 15: Closure of a division: communication and implementation before end of reporting period.
Example 16: Restructuring provision – no formal plan.
Example 17: Contingent liability – remote.
Example 18: Contingent liability – possible.
Example 20: Contingent assets.
Example 21: Financial guarantees.
Example 22: Decommissioning reinstatement costs
Example 23: Reinstatement provision on property which is held on operating lease.
Example 24: Dilapidation requirement
Example 27: Extract from accounting policy and notes to the financial statements.
Example 28: Extract from accounting policy and notes to the financial statements.
Example 29: Extract from notes to the financial statements showing prejudicial disclosure.
Example 30: Extract from notes to the financial statements.
[/et_pb_toggle][/et_pb_column][/et_pb_row][/et_pb_section]