- 15 Marks
Question
a. IAS – 37 applies to all provisions and contingencies apart from those covered by the specific requirement of other standards.
Therefore, provisions differ from other liabilities because there is uncertainty about timing or amount of the future cashflow required to settle the liability.
Required:
- Explain the criteria for recognition of provisions in the financial statements and distinguish between provisions and contingent liabilities.
(6 Marks)
b. The following activities took place in THREE different companies:
- Otapiapia Plc: A Rat Trap Company based in Nigeria has just secured exportation of rat killers to South Africa. The advertising slogan of the rat killers is “KILL the BLACKS.” A South African anti-racist movement with a representative in Nigeria is claiming N15,000,000 from the company as damages because the advertising slogan allegedly compromises the dignity of black people. The company’s legal representative believes that the success of the claim will depend on the judge who presides over the case. They estimate, however, that there is a 70 percent probability that the claim will be thrown out and a 30 percent probability that it will succeed.
- Ire-Akari Motors Plc: A Nigerian company that specialises in the manufacture of “made-in-Nigeria cars.” During the current financial year, 100 cars have been completed and sold. During testing, a defect was found in their steering mechanism. All 100 customers that bought the cars were duly informed of the defect and were told to bring their cars back to have the defects repaired at no cost. All the customers have indicated that this is the only remedy they require. The estimated cost of the recall is N10.5m. The manufacturer of the steering mechanism, a quoted company with sufficient funds, has accepted responsibility for the defect and has undertaken to reimburse Ire-Akari Motors Plc for all costs that it might incur.
- Abeokuta Electricity Company Plc: This company sold a number of electricity transformers with a warranty in the year ended December 31, 2015. At the beginning of the year, the provisions for warranty stood at N5,625,000. A number of claims have been settled during the period for N3,000,000. At the year-end, there were unsettled claims for 300 customers. Experience is that 40% of the claims submitted do not fulfil warranty conditions and can be defended at no cost. The average cost of settling other claims will be N52,500 each.
Required: Explain how the matters in (b)(i) to (b)(iii) above should be accounted for in the financial statements of the three companies using figures to illustrate your points where appropriate.
(9 Marks)
Answer
a. Criteria for Recognition of Provisions and Differences Between Provisions and Contingent Liabilities
Recognition Criteria (IAS 37):
- Present Obligation: There must be a present obligation (legal or constructive) as a result of a past event.
- Probable Outflow of Resources: It is probable that an outflow of economic benefits will be required to settle the obligation.
- Reliable Estimate: A reliable estimate of the amount of the obligation can be made.
If any of these conditions is not met, a provision cannot be recognized.
Distinction Between Provisions and Contingent Liabilities:
- Provisions: Recognized as liabilities in the financial statements if the above criteria are met, as they represent a present obligation with probable outflow and measurable amount.
- Contingent Liabilities: Not recognized as liabilities because they are either:
- Possible obligations depending on future events not in control of the entity, or
- Present obligations that do not meet the criteria for recognition (e.g., unlikely outflow or unreliable estimate).
b(i). Otapiapia Plc
- Analysis:
- The legal case represents a potential obligation due to the advertisement.
- The probability of an outflow (settlement) is only 30%, meaning the claim may not succeed.
- Treatment: As there is a high probability (70%) that the claim will be dismissed, no provision should be recognized. However, a contingent liability may be disclosed, describing the nature of the claim and probability, unless the risk is deemed remote.
b(ii). Ire-Akari Motors Plc
- Contingent Liability:
- The company has a present obligation to repair the defective cars, with an estimated cost of N10.5m.
- The conditions for a provision are met:
- Present obligation (acknowledged defect).
- Probable outflow (repair costs).
- Reliable estimate (N10.5m).
- Recognition: Recognize a provision for N10.5m in the financial statements by debiting Profit or Loss and crediting Provision for Product Recall.
- Contingent Asset:
- The steering mechanism manufacturer has agreed to reimburse the repair costs, creating a probable asset.
- Recognition: Recognize a contingent asset of N10.5m, as the reimbursement is virtually certain. Debit Contingent Asset and credit Profit or Loss with N10.5m.
b(iii). Abeokuta Electricity Company Plc
- Warranty Provisions:
- The company has an ongoing obligation under the warranty for its transformers.
- Based on historical data, 40% of claims can be defended at no cost, and 60% require settlement at N52,500 each.
- Calculations:
- Total Claims: 300
- Claims Fulfilled by Warranty (60% of 300):
- Cost of Settling Claims:
- Claims Settled During Year: N3,000,000
Provision Calculation:
- Beginning Balance: N5,625,000
- Less: Claims Settled (N3,000,000)
- Add: Provision for Outstanding Claims (N9,450,000)
- Ending Provision Balance: N12,075,000
- Recognition: The ending provision balance of N12,075,000 should be recognized in the Statement of Financial Position, with details provided in a note on the warranty provisions.
- Tags: Contingencies, Financial Statements, IAS 37, Liability, Provisions, Recognition, Warranty Claims
- Level: Level 2
- Uploader: Theophilus