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Provisions, contingent assets and contingent liabilities – IAS 37

Week 5MN20018

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Off Balance Sheet Financing – Substance over Form Substance

Has a transaction occurred Giving rise to a new asset or liability Giving rise to a change in an existing

asset or liability Rights

Access to benefits Evidenced by exposure to risks Likelihood of risks arising

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Substance over form

Typical examples:

Consignment stocks

Sale and repurchase agreements

Debt factoring

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Consignment stocks Legal title retained by consignor

Consider economic risks and benefits

Likelihood of stock being returned Past experience Contractual penalty clauses

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Sale and repurchase agreements Vendor retains control of the asset

Asset remains in use

Substance not that of normal sale

Retain on balance sheet of vendor

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Sale and repurchase agreements

Substance is that of finance arrangement Money borrowed on security of asset Repurchase amount will include interest Separate out the interest element Report interest in Income Statement Report as a liability in the balance sheet

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Debt factoring

Factoring may be:

Without recourseOr With recourse

Sale of debts without recourse

Any bad debts are suffered by factor

Treat cash received from factor as settlement of debts

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Provisions & Contingencies Provisions

Affect income statement & balance sheet Contingencies

No affect Can be disclosed as note May not even be disclosed at all

Provisions Liability of uncertain timing or amount Increase in provision recognised in IS as expense Liability created Provisions are by nature uncertain so Timing and amount has to be estimated

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Recognition Used to be able to use provisions to manipulate

accounts Eg loss making business creating provision to cause

large loss in 1 year Gradually reduce provision in subsequent years to

offset losses/show profits IAS 37 prevents this Company should have present obligation arising

from past event Must be probable an outflow of resources embodying

economic benefits will be required to clear the obligation

Probable = more likely than not to occur Group of small obligations can be lumped together

as a class of obligations Should be reliable estimate of amount of obligation

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Non-recognition Provision not recognised unless Obligatory event exists – present obligation

from past event Settlement of obligation is legally

enforceable Eg obligation to make good environmental

damage Constructive obligation – event creates valid

expectation in 3rd party Eg a retail store that has a long-standing

policy of allowing customers to return merchandise within, say, a 30-day period

Or decommissioning nuclear power stations

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Measurement & Review Measurement of provision = Best estimate of expenditure required Amount should be estimate before tax If large number of events – expected value

based on range of outcomes & probabilities Should take account of risks & uncertainties

but not use excessive prudence & overstate provisions

Reviewing provision At every balance sheet date & adjust to reflect

best current estimate If provision is long-term & time value of money

is material - should be stated at present value

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Specific applications - 1 Future operating losses Cannot create provision for this – no

obligating event & no present obligation Specifically outlawed by IAS 37 Onerous contracts Unavoidable costs of meting contract are

> than expected economic benefits Provision should be recognised Lowest cost of exiting contract Ie cost of carrying out contract or Cost of penalty for failure to complete

contract

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Specific applications - 2 Restructuring costs Incurred when company

Sells/closes line of business Closes business location in a country/region of

another country Changes management structure substantially Carries out fundamental reorganisation materially

affecting nature/focus of operations Provision for restructuring costs only allowed if

recognition criteria apply i.e. Detailed & formal plan of restructuring exists

outlining expected number/location of employees to be compensated, expenditures to be undertaken & timing of them

Should have raised expectation in individuals affected that reorganisation will occur

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Contingent liabilities Possible obligations that arise from past

events & whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events that are not wholly within the company’s control

Or present an obligation arising out of past events that is not recognised as a provision because

Not probable outflow of resources needed to settle obligation

Obligation cannot be measured satisfactorily

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Contingent liabilities So contingent liability is Possible obligation not yet confirmed Present obligation that does not meet

all criteria for recognition as a provision

Therefore not recognised as liability If CL is not remote - possibility

disclose as note If CL is remote - do not disclose

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Contingent Asset Arises from past events but its

existence confirmed by occurrence/non-occurrence of uncertain future events not in the company’s control.

Eg compensation from a law suit Do not recognise as an asset When realisation of income/asset

become virtually certain then recognise

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Disclosures Reconciliation for each class of provision:

Opening balance Additions Used (amounts charged against the provision) Released (reversed) Unwinding of the discount Closing balance A prior year reconciliation is not required

For each class of provision, a brief description of: Nature Timing Uncertainties Assumptions Reimbursement

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Post balance sheet events – IAS 10 Events which could be favourable or

unfavourable that occur after the balance sheet date but before accounts are authorised

2 types of events… Adjusting event: An event after the balance

sheet date that provides further evidence of conditions that existed at the balance sheet

including an event that indicates that the going concern assumption in relation to the whole or part of the enterprise is not appropriate.

Non-adjusting event: An event after the balance sheet date that is indicative of a condition that arose after the balance sheet date.

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Treatment Adjust financial statements for

adjusting events Do not adjust for non-adjusting

events If an entity declares dividends after

the balance sheet date, the entity shall not recognise those dividends as a liability at the balance sheet date

That is a non-adjusting event

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Going Concern Issues Arising After Balance Sheet Date

An entity shall not prepare its financial statements on a going concern basis if management determines after the balance sheet date either that it intends to liquidate the entity or to cease trading, or that it has no realistic alternative but to do so

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Disclosure Non-adjusting events should be

disclosed if they are of such importance that non-disclosure would affect the ability of users to make proper evaluations and decisions

Required disclosure is the nature of the event and an estimate of its financial effect or a

statement that a reasonable estimate of the effect cannot be made

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Disclosure A company should update disclosures that

relate to conditions that existed at the balance sheet date to reflect any new information that it receives after the balance sheet date about those conditions.

Companies must disclose the date when the financial statements were authorised for issue and who gave that authorisation

If the enterprise's owners or others have the power to amend the financial statements after issuance the enterprise must disclose that fact

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IAS 24 - Related party disclosures Objective of IAS 24 To ensure that an entity's financial

statements contain the disclosures necessary to draw attention to the possibility that its financial position and profit or loss may have been affected by the existence of related parties and by transactions and outstanding balances with such parties

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Who Are Related Parties? Parties are considered to be

related if one party has the ability to

control the other party or to exercise significant

influence or joint control over the other party in making financial and operating decisions

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Related Entity A party is related to an entity if: (a) directly, or indirectly through one or

more intermediaries, the party: (i) controls, is controlled by, or is under

common control with, the entity (this includes parents, subsidiaries and fellow subsidiaries)

(ii) has an interest in the entity that gives it significant influence over the entity or

(iii) has joint control over the entity (b) the party is an associate of the entity (c) the party is a joint venture in which

the entity is a venturer

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Related Entity A party is related to an entity if: (d) the party is a member of the key management

personnel of the entity or its parent (e) the party is a close member of the family of

any individual referred to in (a) or (d) (f) the party is an entity that is controlled, jointly

controlled or significantly influenced by or for which significant voting power in such entity resides with, directly or indirectly, any individual referred to in (d) or (e) or

(g) the party is a post-employment benefit plan for the benefit of employees of the entity, or of any entity that is a related party of the entity

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Not related Examples where a party is not related: two enterprises simply because they have a

director or key manager in common two venturers who share joint control over a joint

venture providers of finance, trade unions, public utilities,

government departments and agencies in the course of their normal dealings with an enterprise

a single customer, supplier, franchiser, distributor, or general agent with whom an enterprise transacts a significant volume of business merely by virtue of the resulting economic dependence

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Related Party Transactions

A related party transaction is a transfer of resources

services or obligations between related parties

regardless of whether a price is charged

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Disclosure The amount of the transactions. The amount of outstanding

balances, including terms and conditions and guarantees

Provisions for doubtful debts related to the amount of outstanding balances

Expense recognised during the period in respect of bad or doubtful debts due from related parties

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Types of transactions that would be disclosed if they are with a related party

Purchases or sales of goods Purchases or sales of property and other assets Rendering or receiving of services Leases Transfers of research and development Transfers under licence agreements Transfers under finance arrangements (including

loans and equity contributions in cash or in kind) Provision of guarantees or collateral Settlement of liabilities on behalf of the entity or

by the entity on behalf of another party

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IAS 32 – Financial Instruments – Disclosure & Presentation Objective

of the standard

Objective to enhance financial statement users' understanding of the significance of financial instruments to an entity's financial position, performance, and cash flows

Does so by Clarifying the classification of a financial

instrument issued by an enterprise as a liability or as equity

Prescribing the accounting for treasury shares (a company's own repurchased shares)

Prescribing strict conditions under which assets and liabilities may be offset in the balance sheet

Requiring a broad range of disclosures about financial instruments, including information as to their fair values

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No-one here just us shares We will deal with SHARES only When a company issues a financial instrument it should

classify as Financial Liability (sometimes asset) Equity Equity Instruments

Ordinary shares Some preference shares Share warrants (right to purchase shares in future

at fixed price) Financial Liabilities

Trade payables Bank loans Bonds (loan stock/debentures) Some preference shares

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and preference shares

Preferences shares Entitle shareholder to a

dividend before ordinary shareholders

Usually fixed amount Redeemable Irredeemable

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Equity or financial liability? Or both (compound financial instrument)

Key factor – extent to which company obliged to make future repayments

Required to redeem share = future obligation redeemable element = financial liability dividends = financial liability or deduction of equity

Cumulative shares dividend element = financial liability

Irredeemable non-cumulative = Equity Convertible bonds have 2 elements Financial liability + equity – therefore

compound financial instrument

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Compound instruments illustration

Convertible debentures

1 January 20X0 1,000 £100 5% issued at par

1 January 20X5 Convert into 50 ordinary shares

per £100 OR redeem at par

Interest rate on similar debentures is 6%

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Compound instruments illustration

Value of debt

Present value of redemption payment £74,726Present value of interest (5 years)

£21,062Value of debt £95,788Value of equity proceeds £ 4,212

Par value £100,000

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Interest, dividends, gains & losses All 4 relating to a financial liability should

be recognised as an expense (in IS) Dividends to equity shareholders debit

directly to equity Transaction costs of equity transactions

= debit to equity net of tax benefit Note divis recognised in Fin Statements

as deduction from equity only If dividend paid

before BS date since previous BS date

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Distributable Profit Profits not distributed until

profit/gain realised If company makes a loss should be

allowed to pay divis if has sufficient accumulated profits

Capital from shareholders is not distributable

Reserves Capital reserves not distributable

(revaluation reserve/share premium) Revenue reserves are distributable

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Share issues Share issues Increase cash/bank/assets by cash raised less

issue costs Share capital increased by nominal value of shares Share premium increased by cash raised – par

value – issue costs Bonus issue In bonus issue Company converts some reserves to share capital Issues new shares to existing share holders in

proportion to existing shareholdings If there is share premium it can be reduced If not (or insufficient) use reserves

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Own share buy back - 1 Can repurchase own shares and cancel them But creditors must be protected Therefore: transfer from accumulated profit to

capital reserves…. Purchase cost of shares DR CR Par value share capital Bank Share premium Accumulated profit Capital maintenance DR CR Accumulated profit Capital reserves

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Own share buy back - 2 As purchase price probably > par value Dr excess top share premium, but restricted to

lowest of 3 amounts share premium originally received when shares

issued current balance on share premium actual premium on redemption

Transfer to capital reserve = par value of shares purchased + cancelled

If repurchase financed by new issue of preference shares treated as equity

Transfer to capital reserve reduced by mount of new shares issued

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Redeemable shares

As company under obligation to buy back in future

Obligation = financial liability