- 12 Marks
FR – L2 – Q47 – Provisions and Contingencies
Question
ACCOUNTING TREATMENT
You have been asked to advise on the appropriate accounting treatment for the following situations arising in the books of various companies. The year end in each case can be taken as 31 December 20X4 and you should assume that the amounts involved are material in each case.
(a) At the year-end there was a debit balance in the books of a company for GH¢15,000, representing an estimate of the amount receivable from an insurance company for an accident claim. In February 20X5, before the directors had agreed the final draft of the published accounts, correspondence with lawyers indicated that GH¢18,600 might be payable on certain conditions.
(b) A company has an item of equipment which cost GH¢400,000 in 20W8 and was expected to last for ten years. At the beginning of the 20X4 financial year the book value was GH¢280,000. It is now thought that the company will soon cease to make the product for which the equipment was specifically purchased. Its recoverable amount is only GH¢80,000 at 31 December 20X4.
(c) On 30 November, a company entered into a legal action defending a claim for supplying faulty machinery. The company’s solicitors advise that there is a 20% probability that the claim will succeed. The amount of the claim is GH¢500,000.
(d) An item has been produced at a manufacturing cost of GH¢1,800 against a customer’s order at an agreed price of GH¢2,300. The item was in inventory at the year-end awaiting delivery instructions. In January 20X5 the customer was declared bankrupt and the most reasonable course of action seems to be to make a modification to the unit, costing approximately GH¢300, which is expected to make it marketable with other customers at a price of about GH¢1,900.
(e) At 31 December, a company has a total potential liability of GH¢1,000,400 for warranty work on contracts. Past experience shows that 10% of these costs are likely to be incurred, that 30% may be incurred but that the remaining 60% is highly unlikely to be incurred.
Required
For each of the above situations outline the accounting treatment you would recommend and give the reasoning of principles involved. The accounting treatment should refer to entries in the books and/or the year-end financial statements as appropriate.
Answer
ACCOUNTING TREATMENTS
(A) IAS 37 Provisions, Contingent Liabilities and Contingent Assets states that contingent gains should not be recognised as income in the financial statements. The company has a debit balance already in its books which indicates that it must be reasonably certain that at least part of the claim will be paid. This element of the claim then is probably not a contingency at all. The remaining part (the difference between the GH¢15,000 and the GH¢18,600) is, and should be disclosed and not accrued.
(b) IAS 16 Property, Plant and Equipment requires, that the carrying amount of property, plant and equipment should be reviewed periodically in order to assess whether the recoverable amount has fallen below the carrying amount. Where it has, the property, plant and equipment should be written down to the recoverable amount through the statement of profit or loss as an expense. In this case this would result in the recognition of an expense of GH¢200,000. (280,000 – 80,000).
It may be the case that the amounts involved are so significant as to warrant separate disclosure in the statement of profit or loss under IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.
(c) IAS 37 states that contingent liabilities should not be recognised. Though a provision should be made for amounts where the company has an obligation to pay them.
The question in this case is whether or there is an obligating event within the context of IAS 37. On balance it seems inappropriate to recognise a provision in respect of this amount but the possible liability should be disclosed as a contingent liability.
(i) the nature of the contingency
(ii) the uncertainties surrounding the ultimate outcome
(iii) the likely effect, i.e. GH¢500,000 loss less likely tax relief.
(d) IAS 2 Inventories requires that inventories be stated at the lower on cost and net realisable value. Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.
In this case, cost is GH¢1,800 and net realisable value is GH¢1,600
(e) The company should set up a provision for GH¢100,040, i.e. should accrue for the 10% probable liability. It should disclose the possible liability under contingent liabilities. The disclosure is as noted in (c) except that the financial effect is GH¢300,120 (30% × GH¢1,000,400). The balance should be ignored as it is a remote contingent liability.
Tutorial note
In (c) above it is not appropriate to provide for 20% receivableGH¢500,000, i.e. GH¢100,000. This would only be appropriate where the event is recurring many times over.
In (e) it is appropriate to use the percentages provided, as warranty work is provided for.
- Tags: Contingent Liabilities, Financial Statements, IAS 16, IAS 2, IAS 37, Impairment, Inventories, Legal Claims, Provisions, Warranty
- Level: Level 2
- Uploader: Samuel Duah