Accounting for Liabilities- complete.pdf
- 1. Accounting for Liabilities (LKAS 37) FN 1113: FINANCIAL ACCOUNTING INTAKE 39 - SEMESTER 01, 2022 1 Prof. Athula Manawaduge
- 2. Learning Outcomes At the completion of this chapter, you should be able to: • Define liabilities, provision, and contingent liabilities; • Identify how the provisions should be recognized, measured and disclosed; and • Identify information to be disclosed about the contingent liabilities in the financial statements 2
- 6. Liabilities As per the requirements of Sri Lank Accounting Standards (LKASs/SLFRSs), many types of liabilities are presented on the face of the statement of financial position. • Provisions (LKAS 37) • Contingent Liabilities (LKAS 37) • Financial Liabilities (LKAS 32 and 39) Examples: Bank overdrafts, Trade payables, Loans, Debentures issued, Redeemable preference shares issued • Statutory Obligations Examples: EPF Payables, ETF Payables, VAT & Tax Payables • Deferred Obligations Examples: Deferred Tax Liability Out of these types, Provisions and Contingent Liabilities are discussed in this lecture. 6
- 7. Liabilities • A present obligation of the entity to transfer an economic resource as a result of past events (Conceptual Framework for Financial Reporting, 2018) • Accordingly, the following three characteristics are available in any liability. 1. There is a present obligation 2. Requires to transfer an economic resource 3. It arises as a result of past events. 7
- 8. Provisions • A liability of uncertain timing or amount. • A provision should be recognized when: – an 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; and – a reliable estimate can be made of the amount of the obligation. 8
- 9. Present Obligation Legal obligation may arise due to; • operations of contractual law (Ex. Provision for product warranty) ; • operation of provisions in parliament acts (Provision for income tax); or • operations of other law (Ex. Provision for compensation for a case file against the company by a customer) 9
- 10. Present Obligation (Contd.) Constructive obligations may arise due to, • established pattern of past practice, published policies or a sufficiently specific current statement, the enterprise has indicated to other parties that it will accept certain responsibilities; and • valid expectations created by enterprise on the part of those other parties that it will discharge those responsibilities Ex. Provision for environmental conservation in the absence of legal obligation to do so. 10
- 11. Probable Outflow of Economic Benefits • Outflow of resources or other event is regarded as probable if the event is more likely to occur than not to occur. • In other words, the probability that the event will occur is greater than the probability that it will not. • When there are a number of similar obligations (for example, product warranties and similar contracts) the probability that an outflow will be required in settlement is determined by considering the class of obligations as a whole. • In contrast, where a single obligation is being measured, the individual most likely outcome may be the best estimate of the liability. 11
- 12. Reliable Estimate of the Obligation • In most cases reliable estimate can be made for an event when: –Present Obligation and –Probable Outflow of Economic Benefits exists. • In the rare case where no reliable estimate can be made, a liability exists that cannot be recognized. In such situations, the liability is required to be disclosed as a contingent liability. 12
- 13. Activity 1 -Similar Obligation Quicksilver PLC sells toasters. Toasters are sold with a six-month warranty that covers the costs of repairing any manufacturing defects that become apparent within six-months of purchase. If minor defects are detected in all products sold, repair costs of Rs.1, 050,000 would be incurred. If major defects are detected in all products sold, repair costs of Rs.6, 500, 000 would result. Based on past experience and future expectations, Quicksilver PLC is able to estimate that 80 per cent of all toasters sold will have no defects, 12 per cent of goods sold will have minor defects, and 8 per cent will have major defects. Required: a) Identify the expected cost of repairs and b) prepare the journal entry to record it. 13
- 14. ANSWER - Similar Obligation Expected cost of Repair 1, 050,000 x 12% = xxxx 6, 500, 000 X 8% = xxxxx Total = xxxxx ……………………………………..… Dr ……. …………………………………………. Cr ……… (Provision for warranty expense on toasters) 14
- 15. ANSWER Expected cost of Repair 1,050,000*.12 +6,500,000*0.08= 646,000 Warranty expense (P/L) Dr 646,000 Provision for warranty expense Cr 646,000 (Provision for warranty expense on toasters) 15
- 16. Activity 2-Single & Similar Obligation The following issues have arisen during the preparation of Silver PLC‟s draft financial statements for the year ended 31 March 2020. Silver PLC has two potential liabilities to assess. 1) The first is an outstanding court case concerning a customer claiming damages for losses due to faulty components supplied by the company. 2) The second is the provision required for product warranty claims against 100,000 units of retail goods supplied with a one-year warranty. The estimated outcomes of the two liabilities at the reporting date are as follows: Required: Briefly explain how each of the above transactions should be treated and provide journal entries to record them in the financial statements of Silver PLC for the year ended 31 March 2020 16 (1) Court case (2) Product warranty claims 10% chance of no damages awarded 70% of sales will have no claim 70% chance of damages of Rs.6 million 20% of sales will require a repair of Rs.250 per each unit 20% chance of damages of Rs.4 million 10% of sales will require a repair of Rs.1200 per each unit
- 17. Answer The two provisions must be calculated on different bases because LKAS 37 Provisions, Contingent Liabilities and Contingent Assets distinguishes between a single obligation (the court case) and a large population of items (the product warranty claims). For the court case the most probable single likely outcome is normally considered to be the best estimate of the liability, i.e. Rs.6 million. The Rs.6 million will be an expense for the year ended 31 March 2020 and recognized as a provision. Legal expenses Dr 6,000,000 Provision for court case Cr 6,000,000 (Recognition of provision for court case) 17
- 18. Answer The provision for the product warranty claims should be calculated on an expected value basis: 1. (70% x100, 000 x 0) = 0 2. (20% x100, 000 x Rs.250) = 5,000,000 3. (10% x 100,000 x Rs.1200) = 12,000,000 Total = 17,000,000 This will also be an expense for the year ended 31 March 2020 and recognized as a current liability. Warranty expenses Dr 17,000,000 Provision for Product warranty Cr 17,000,000 (Recognition of provision for product warranty) 18
- 19. Measurement • The amount recognized as a provision should be the best estimate of the expenditure required to settle the obligation that existed at the reporting date. • If the time value of money is material, the amount of a provision should be the present value of the expenditure required to settle the obligation (Refer Example 1 & 2). • Provisions should be reviewed at the end of each reporting date and adjusted to reflect the best estimate. 19
- 20. Example 1: PPE - Measurement at Recognition The cost of an item of PPE comprises of; I. Purchase price II. Directly attributable cost in bringing the asset to the location and condition III. The initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located.
- 21. Example 2: Right-of-use Asset - Measurement at Recognition The cost of the right-of-use asset comprises: The lease liability, Down payment Initial direct costs incurred by the lessee Estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset and restoring the site 21
- 22. Activity 4 - Measurement Baxter PLC is a manufacturing company specializing in making Rubber products for which company purchased and installed a machine at a cost of Rs 10 million on 1 April 2019 . The company started its operations on 1 April 2019. The manufacturing process produces toxic chemicals which pollute the nearby environment. In order to be eligible for the renewal of the operating licence in five years, legislation requires that a clean-up operation must be undertaken by Silver PLC on 31 March 2024. This has an estimated cost of Rs.5 million. Silver PLC’s applicable interest rate is 12% per annum. Discounting factor at 12% in five years time has a present value of 0.567 and in four years time has a present value of 0.635. Required: 1. Prepare the journal entries to record the above liabilities in the financial statements of Baxter PLC for the year ended 1 April 2019 and 31 March 2020 as per LKAS 37 2. Provide the extracts of Statement of Financial position as at 31 March 2020 and Statement of Profit or Loss and Other Comprehensive Income for the year ended 31 March 2020 with respect to the above provision. 22
- 23. Answer 23 01 April 2019 Provision to be recognized 5,000,000 x 0.567 = 2,835,000 Machine Dr 2,835,000 Provision for cleaning up site Cr 2,835,000 (To recognize the cost of cleaning up the site) 31 March 2020 Total Provision to be recognized as at 31st March 2020 5,000,000 x 0.635= 3,175,000 P/L Account (3,175,000 – 2,835,000 = 340,000) Dr 340,000 Provision for cleaning up site Cr 340,000 (To recognize increase in provision for cleaning up site)
- 24. Answer Extracts from Statement of Financial Position as at 31 March 2020 (Rs) Non-Current Liabilities Provision for Clean-up 3,175,200 (5,000,000*0.567+340,200) 24 Extracts of Statement of Profit or Loss and Other Comprehensive Income For the year ended 31 March 2020 (Rs) Finance Expenses Finance cost of cleanup (5,000,000*.567*.12) 340,200
- 25. Provisions(Contd.) Disclosures • The carrying amount at the beginning and end of the period; • Additional provisions made in the period, including increases to existing provisions; • Amounts used (i.e. incurred and charged against the provision) during the period; • Unused amounts reversed during the period; and • The increase during the period in the discounted amount arising from the passage of time and the effect of any change in the discount rate. 25
- 26. Contingent Liabilities • a possible obligation Ex. legal case filed by one of the employees against the company claiming that the dismissal is unfair. At the reporting date the case is being heard by the court and the professional advice indicates the outcome of the case is unpredictable at the moment 26
- 27. Contingent Liabilities(Contd.) • a present obligation but is not recognized because: – it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; • Ex. a guarantee provided to a finance provider for a loan taken out by another entity where default on that loan is uncertain as at the reporting date or – the amount of the obligation cannot be measured with sufficient reliability. • Ex. a claim for damages against the entity, where the entity is defending the claim even though professional advice indicates the defense is unlikely to succeed, and the amount of the claim cannot be measured reliably as at the reporting date 27
- 28. Contingent Liabilities(Contd.) Disclosures a brief description of the nature of the contingent liability and, where practicable: – an estimate of its financial effect – an indication of the uncertainties relating to the amount or timing of any outflow; and – the possibility of any reimbursement 28
- 29. Activity 5 -Contingent Liability and Provision During the year ending 31.03.2019, Mark PLC whose reporting period ends on 31 March each year guarantees the bank overdraft of Thomson PLC. At the time of providing the guarantee, Thomson PLC was in a sound financial position. During the year ending, 31.03.2020, trading conditions changed to the extent that Thomson PLC incurred substantial losses. Required: How would Mark PLC report the guarantee provided to Thomson PLC in its financial statements ending 31.03.2019 and 31.03 2020? 29
- 30. Answer At 31st March 2019 it is unlikely that an outflow of resources embodying economic benefits will occur. Hence no provision is recognized. However, the guarantee is disclosed as a contingent liability. At 31 March 2020 it is probable that an outflow of resources embodying economic benefits will occur. A provision for the best estimate of the obligation must be recognized. 30
- 31. Explain how the following scenarios should be treated in the financial statements with reference to the LKAS 37. A. ABC PLC is a Sri Lankan firm, which specializes in the production of engineering products and related development activities. Just before the end of a year, the company received a notice of a legal case from one of its competitors. The case is related to potential infringement of the competitor’s patent. The in-house legal council discussed the case with the ABC PLC’s management and based on the available information concluded that the lawsuit was possible. However, there was not enough information to estimate the potential liability. B. A research agency is in a dispute with a client company, where the latter has accused that the former has infringed its copyright for a genetic material and is seeking damages of Rs.100 million. Further, a case has been filed in this respect against the research agency and it is being heard in the high court. C. On 12.12.2019, Puma PLC decided to outsource a division of their Painting Department. On 20.12.2019, a detailed plan for the outsourcing of the division was agreed by the company, and redundancy notices were sent to the staff of the division. The Puma PLC’s reporting period ends on 31.12.2019 31 Activity 6 -Contingent Liability and Provision
- 32. The treatment in the financial statements with reference to the LKAS 37. (a) As per LKAS 37, this has to be disclosed as a contingent liability. • This is a present obligation and there is a possibility of outflow of resources embodying future economic benefits • However, company is not in a position to make a provision, as reliable estimate of amount required to settle cannot be made. Hence become a contingent liability. (a) As per LKAS 37, this has to be disclosed as a contingent liability. • There is a possible obligation which would be arisen from the case, alleging that the research agency has infringed copyright in its use of genetic material. • However, the existence of the obligation will be depended on the outcome of the case under consideration. Hence become a contingent liability. (a) As per LKAS 37, Provision has to be made to the best estimated amount required to compensate employees for losing their job. 32 Activity 6 -Contingent Liability and Provision
- 33. 33 Figure 9.1: Decision Tree Yes Start Present obligation as an obligating event? Reliable estimate? Probable outflow? Provision Possible obligation? Remote? Disclose as a contingent liability Do nothing No No No No No Yes Yes Yes Yes