slide 12.1 alan melville, international financial reporting, 3rd edition, © pearson education...

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Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011

Chapter 12 - PROVISIONS AND EVENTS AFTER

THE REPORTING PERIOD(IAS37 and IAS10)

ACTG 6580

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Definition of a Provision (IAS37)

• The entity has a present obligation (legal or constructive) as a result of a past event

• It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation

• A reliable estimate can be made of the amount of the obligation.

IAS37 defines a provision as "a liability of uncertain timing or amount" and states that a provision should be recognized when all of the following conditions are satisfied:

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Obligating Events

a) The obligation is legally enforceable, or

b) The event has given rise to a "constructive obligation", where the entity has created a valid expectation that it will discharge the obligation, even though this is not legally enforceable.

A past event which leads to a present obligation is an "obligating event". For a past event to be an obligating event, the entity must have no realistic alternative but to settle the obligation created by the event. This will be the case if:

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Measurement of a Provision

• If the effect of the time value of money is material, the amount of a provision should be calculated as the present value of the expenditure required to settle the obligation.

• Future events that may affect the amount required to settle an obligation should be taken into account when measuring a provision, so long as there is sufficient objective evidence that these events will occur.

The amount of a provision should be the best estimate of the expenditure required to settle the obligation concerned.

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Specific Applications of IAS37

• Future operating losses. Provisions should not be recognized for future operating losses.

• Onerous contracts. An onerous contract is one "in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it". The present obligation under such a contract should be measured and recognized as a provision.

• Restructuring costs. A provision for restructuring costs (e.g. the costs of a major reorganization) should be recognized only if the general recognition criteria of IAS37 are satisfied.

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Contingent Liabilities

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 the recognition criteria for a provision are not satisfied.

IAS37 defines a contingent liability as:

Contingent liabilities should not be recognized but should instead be disclosed in the notes, unless the possibility of an outflow of economic benefits is remote.

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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".

Contingent assets should not be recognized but should be disclosed in the notes if the inflow of economic benefits is judged to be probable.

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Progress on Convergence• The Boards both have current agenda items related to provisions and contingencies. The

IASB’s objectives in this area are:– To address inconsistencies with other IFRS– To achieve global convergence of accounting standards.– To improve measurement of liabilities in IAS 37

• An IFRS working draft proposing a new IFRS to replace IAS 37 was issued in February 2010. The new IFRS will apply to all liabilities that are not within the scope of other standards.

– The proposed new IFRS would remove the requirement under IAS 37 for recognizing a liability when “it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation” (IAS 37, paragraph 14(b)).

– The result is that a company would recognize a liability for the amount it would rationally pay to be relieved of an obligation that can be reliably measured. The intent is to focus management on judging whether the company has an obligation rather than predicting the likely outcome.

– This proposed change will create a bigger difference between US GAAP and IFRS. • The IASB has postponed this project to finish the convergence projects (this project is not

part of the Memorandum of Understanding (MOU)).

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Progress on Convergence

• The FASB has a project on its agenda to improve loss contingency disclosures.

– The FASB issued an ED, Disclosure of Certain Loss Contingencies, on June 5, 2008, and an ED of a proposed Accounting Standards Update (ASU), Contingencies (Topic 450): Disclosure of Certain Loss Contingencies, on July 20, 2010.

– The proposed ASU would expand and require new, enhanced disclosures about certain loss contingencies.

– This proposed change will create a bigger difference between US GAAP and IFRS.

• The FASB does not anticipate issuing the ASU during 2012.

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ContingenciesLoss Contingency – Definition of Probable and Range

IFRS

► Probable is defined as “more likely than not” (more than a 50% chance of occurring).

► The midpoint of the range is used to measure the provision.

US GAAP

► Defines probable as “likely” (this has been generally interpreted as greater than a 70% chance of occurring)

► Where there is a continuous range of possible outcomes and each point in the range is as likely as any other to occur, under ASC 450-20-30-1, the minimum amount in the range is used to measure the provision.

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Example 1: An entity sells webcams 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. The company has only recently started operations and thus cannot estimate what percentage of webcams will likely be returned. They do know that if defects were detected in all products sold, repair costs would range from $2 million for minor repairs to $4 million for major repairs.

Range of Possible Outcomes Example

► Assuming all other criteria are met, how much should the entity book related to warranty repairs using US GAAP and IFRS?

► Show any required journal entries.

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Example 1 solution:

US GAAP

The minimum point of the range, $2.0 million, should be recorded.

Warranty expense $2,000,000Warranty liability $2,000,000

IFRS

The midpoint of the range, $3.0 million, should be recorded.

Warranty expense $3,000,000Warranty liability $3,000,000

Since the entity only had a range to work with, the treatment using the two sets of standards is different. If no particular outcome within the range is better than another, then for US GAAP the entity would book the minimum of the range, whereas for IFRS the entity would book the midpoint range.


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Example 2: Use the same facts in example 1, except now assume the entity is able to perform an analysis on the historical data of returns and estimates (based on historical data), finding that 75% of the goods sold will have no defects, 20% of the goods sold will have minor defects and 5% of the goods sold will have major defects.


► Assuming all other criteria are met, how much should the entity book related to warranty repairs using US GAAP and IFRS?

► Show any required journal entries.

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Example 2 solution:

For both US GAAP and IFRS, $600,000 should be recorded. The most likely outcome is $600,000 explained as follows: (20% of $2 million for minor repairs = $400,000) + (5% of $4 million for major repairs = $200,000) + (75% without defects and, therefore, no impact on the estimate).

Warranty expense $600,000Warranty liability $600,000

Probable Liability Example

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Disclosure Requirements of IAS37

• Carrying amount at the beginning and end of the period• Additional provisions or increases made in the period• Amounts used and amounts reversed during the period• Brief description.

For each class of provision that is recognised in the financial statements:

• A brief description of each contingent liability (unless the possibility of an outflow of benefits is remote) and an estimate of its financial effect.

• A brief description of each contingent asset (if an inflow of benefits is probable) and an estimate of its financial effect.

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Events After the Reporting Period – Subsequent Events (IAS10)

Events after the reporting period are defined as "those events, favorable and unfavorable, that occur between the end of the reporting period and the date when the financial statements are authorized for issue".

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Subsequent Events PeriodDate through which subsequent events are evaluated

IFRS► Subsequent events are evaluated

through the date that the financial statements are “authorized for issue.” The authorization date is prior to the filing date. Depending on an entity’s corporate governance structure and statutory requirements, authorization may come from management or a board of directors.

► Requires disclosure of the date the financial statements were authorized for issuance.

US GAAP► Subsequent events are evaluated

through the date that the financial statements are issued (for SEC filers) or are available to be issued (in the case of non-SEC filers). For SEC filers, the issuance date is also the date that the financial statements are filed with the SEC.

► SEC filers are not required to disclose the date the financial statements were issued, however, such disclosure is required for a non-public company.

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Adjusting Events and Non-adjusting Events

• Adjusting events. Adjusting events are those "that provide evidence of conditions that existed at the end of the reporting period".

• Non-adjusting events. Non-adjusting events are "those that are indicative of conditions that arose after the reporting period".

• Financial statements should be adjusted to reflect adjusting events that occur after the reporting period.

• Material non-adjusting events should be disclosed in the notes to the financial statements.

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Example 3 - The Hilo Company (Hilo), a public company in the United States, is considering adopting IFRS in 2011 or 2012. The Board met on February 20, 2011, and voted to accept the final financial statements and authorized management to file the financial statements with the SEC on February 28, 2011.

Date Through Which Subsequent Events are Evaluated Example

► Under IFRS, would Hilo record the subsequent event described above similarly to US GAAP?

On February 23, 2011, a decision was reached in a lengthy lawsuit against Hilo, whereby the amount of the judgment against Hilo exceeded the recorded accrued liability by $5.0 million. Because the conditions on which the judgment was rendered existed at December 31, 2010, Hilo decided that this was an adjusting event and recorded an additional expense and accrual as of December 31, 2010, to reflect the judgment. Thus, the financial statements in the annual report to shareholders, as filed with the SEC, reflected this subsequent event.

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Example 3 solution:

No. Subsequent events under US GAAP are evaluated through the date that the financial statements are issued (filed for SEC purposes) or are

available to be issued, which in this example is February 28, 2011.

Under IFRS, subsequent events are only evaluated through the date of authorization of the financial statements, which in this example is February 20, 2011. In that regard, since there might not have been a review of the subsequent events after February 20, 2011, the additional expense accrual may not have been recorded under IFRS. Thus, there could have been a difference of $5.0 million (pretax) in income due to the difference between US GAAP and IFRS.

Date Through Which Subsequent Events are Evaluated Example

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Example 4:

Assume the same facts as in example 3 above. Hilo is drafting its subsequent events footnote. Through which date should it disclose that subsequent events procedures have been performed under US GAAP and IFRS?

a. The date the Board voted to accept the financial statements and authorized management to file (February 20, 2011).

b. The date of the decision on the lawsuit (February 23, 2011).

c. The date that Hilo’s management filed the financial statements with the SEC (February 28, 2011).

d. None of the above.

Disclosure of Date to Which Subsequent Events are Evaluated

Example

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Example 4 solution:

US GAAP:

d. Public companies (those filing with the SEC) are not required to disclose the date through which subsequent events have been performed.

IFRS:

a. IFRS requires disclosure of the date that the financial statements were authorized for issuance.

Disclosure of Date to Which Subsequent Events are Evaluated

Example

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Example 5: On January 15, 2011, the Kona Company’s (Kona) Board of Directors declared a 10% stock dividend to all shareholders of record on January 31, 2011. The fair value of the stock as of January 15, 2011, was $40 per share. As of January 31, 2011, Kona had not finalized the completion of the 2010 financial statements and as of December 31, 2010, shareholders’ equity was as follows:

Non-adjusting Events ExampleStock dividends after the balance sheet date

Common sock, 1,000,000 shares, par value $10 per share

$10,000,000

Additional paid-in capital 20,000,000

Retained earnings 50,000,000

$80,000,000

► What is the effect of the stock dividend on Kona’s 2010 financial statements under US GAAP and IFRS?

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Example 5 solution:US GAAP:

The 10% stock dividend would be reflected as of December 31, 2010, and capital stock would have been increased by $1,000,000.

(10% x 1,000,000 shares = 100,000 shares x $40 fair value = $4,000,000)

The journal entry to record the stock dividend as of December 31, 2010, would be as follows:

Retained earnings $4,000,000Paid-in capital

$1,000,000Additional paid-in capital

3,000,000

IFRS:

There would be no adjustment to the December 31, 2010, financial statements because this would be recognized as a 2011 event.

Non-adjusting Events Example

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