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22420 Self Study Topic 6 SELF STUDY CHECKLIST Chapter 8– Liabilities Comprehension Questions 1 Present value concept 3 Characteristics of a provision 5 Present obligation concept 6 Recognition criteria for a provision 7 Contingent liability to provision Application and Analysis Exercises Ex 8.1 Classification – Liability/ Provision/Contingent liability Ex 8.2 Recognising a provision Ex 8.5 Recognising a provision

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22420 Self Study Topic 6 Chapter 9 – Employee Benefits Comprehension Questions 1 Concept of paid absence 2 Accumulating and Non-Accumulating sick leave 3 Vesting and Non-vesting sick leave 9 Measurement of long service leave Application and Analysis Exercises Ex 9.4 Accounting for accumulated sick leave Ex 9.5 Accounting for non-accumulating sick leave Ex 9.6 Accounting for annual leave Ex 9.20 Accounting for long service leave

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22420 Self Study Topic 6 Chapter 8:

Provisions, contingent liabilities and contingent assets

Comprehension questions 1. How is present value related to the concept of a liability? AASB 137/IAS 37 (paragraph 42) requires that the risks and uncertainties surrounding the events and circumstances should be taken into account in reaching the best estimate of a provision. AASB 137/IAS 37 requires provisions to be discounted to present value where the effect of discounting is material (paragraph 45). The discount rate used must be a pre-tax rate that reflects the time value of money and the risks specific to the liability. To avoid doublecounting, where the estimates of future cash flows have been adjusted for risk then the discount rate should not also reflect the particular risk (paragraph 47). In practical terms it is often difficult to determine reliably a liability-specific discount rate. Usually entities use a rate available for a liability with similar terms and conditions or, if a similar liability is not available, a risk-free rate for a liability with the same term (for example a government bond1 with a five-year term may be used as the basis for a company’s specific liability with a five-year term) and this rate is then adjusted for the risks pertaining to the liability in question. 3

What are the characteristics of a provision?

The characteristics of a provision are that it is a liability where there is uncertainty as to either the timing of settlement or the amount to be settled. When measuring a provision, the amount to be recognised should be the best estimate of the consideration required to settle the present obligation at the end of the reporting period. The fact that it is difficult to measure a provision and that estimates have to be used does not mean that the provision is not reliably measurable. 5

What is the key characteristic of a present obligation?

The key characteristic of a present obligation is if the entity has no realistic alternative but to make the sacrifice of economic benefits to settle the obligation. This may be the case for example, if an entity makes a public announcement that it will match dollar for dollar the financial assistance provided by other entities to bushfire victims, and because of custom and moral obligations, there is no realistic alternative but to provide the financial assistance. In rare cases it may not be clear whether there is a present obligation. In such cases, a past event is deemed to give rise to a present obligation if, taking account of all available evidence, it is more likely than not that a present obligation exists at the reporting date (AASB 137/IAS 37, paragraph 15)

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22420 Self Study Topic 6 6. What are the recognition criteria for provisions? The recognition criteria for provisions are contained in AASB 137/IAS 37 (paragraph 14). A provision should be recognised when: (a) an entity has a present obligation (legal or constructive) as a result of a past event; (b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and (c) a reliable estimate can be made of the amount of the obligation. A constructive obligation is an obligation that derives from an entity’s actions where: (a) by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and (b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities

7

At what point would a contingent liability become a provision?

Contingent liabilities need to be continually assessed to determine whether or not they have satisfy the definition of a iability and therefore should be recognised on the Statement of Financial Position. This is done by considering whether the recognition criteria for liabilities have been met.

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22420 Self Study Topic 6 Exercise 8.1

Distinguishing between liabilities, provisions and contingent liabilities

Kasey Ltd’s financial statements are authorised for issue on 24 August 2022. Required Identify whether each of the following would be a liability, a provision or a contingent liability, or none of the above, in the financial statements of Kasey Ltd as at the end of its reporting period of 30 June 2022. 1. An amount of $42,000 owing to Pigz Ltd for services rendered during May 2022. 2. Long service leave, estimated to be $350,000, owing to employees in respect of past services. 3. Costs of $12, 000 estimated to be incurred for relocating an employee from Kasey Ltd’s Head Office location to another city. The staff member will physically relocate during July 2022. 4. Provision of $40,000 for the overhaul of a machine. The overhaul is needed every 5 years and the machine was 5 years old as at 30 June 2022. 5. Damages awarded against Kasey Ltd resulting from a court case decided on 26 June 2022. The judge has announced that the amount of damages will be set at a future date, expected to be in September 2022. Katz Ltd has received advice from its lawyers that the amount of the damages could be anything between $50,000 and $2 million. SOLUTION Classification 1 Liability 2

Provision

3

No provision or liability

4

No provision or liability

5

Contingent liability

Explanation This event falls within the reporting period and the amount and timing are certain The amount and timing are uncertain: it is unclear how long employees will continue to serve in Kasey Ltd and this affects whether or not they become eligible for long service leave. The amount is a future cost. Paragraph 18 of AASB 137 states that financial statements deal with the financial position of an entity at the end of its reporting period and not its possible position in the future. The only liabilities recognised in an entity’s statement of financial position are those that exist at the end of the reporting period. No present obligation to overhaul the machine – Kasey Ltd could decide to sell the machine or not repair it. Reference to paragraph 18 of AASB 137 is also relevant here as financial statements deal with the financial position of an entity at the end of its reporting period and not its possible position in the future. Therefore, no provision is recognised for costs that need to be incurred to operate in the future This is a present obligation and the obligating event has occurred, therefore it is a liability; however the amount cannot be reliably measured as the estimated range is too great. Therefore, this should be disclosed as a contingent liability, being a liability that fails the recognition criterion of reliable Page 5 of 12

22420 Self Study Topic 6 measurement. Exercise 8.2 Recognising a provision When should liabilities for each of the following items be recorded in the accounts of the business entity? 1. 2. 3. 4.

Acquisition of goods by purchase on credit Salaries Annual bonus paid to management Dividends

SOLUTION 1 When the goods are delivered (the obligating event for the purchaser is the receipt of the goods). 2 When the services are rendered by the employee (the obligating event for the employer is when the employees provide their services). 3 When the conditions for receiving the bonus are met and the amount can be reliably measured. See also AASB 119/IAS 19 paragraphs 19-24. 4 When the dividends are declared (appropriately authorised and no longer at the discretion of the entity). See also AASB 110/IAS 10 paragraphs 12 and 13

Exercise 8.5 Recognising a provision In each of the following scenarios, explain whether or not Margot Ltd would be required to recognise a provision. 1. As a result of its plastics operations, Margot Ltd has contaminated the land on which it operates. There is no legal requirement to clean up the land, and Margot Ltd has no record of cleaning up land that it has contaminated. 2. As a result of its plastics operations, Margot Ltd has contaminated the land on which it operates. There is a legal requirement to clean up the land. 3. As a result of its plastics operations, Margot Ltd has contaminated the land on which it operates. There is no legal requirement to clean up the land, but Margot Ltd has a long record of cleaning up land that it has contaminated. 1 2

3

No present obligation: no provision. Present obligation exists as there is a legal requirement to clean up the land; the contamination of the land represents the past event; it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation( ie money spent to undertake the clean up; and assume that a reliable estimation of the cleaning costs can be made. Therefore a provision should be recognised. There is a constructive obligation, which is construed from Margot Ltd’s past actions; it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and assume that a reliable estimation of the cleaning costs can be made. Therefore a provision should be recognised.

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22420 Self Study Topic 6 Chapter 9 Employee benefits Comprehension questions 1. What is a paid absence? Provide an example. Refer to section 9.2. Paid absence refers to an employee entitlement to be paid during certain absences from work . Examples include sick leave and annual leave (usually 4 weeks a year, more in some companies and industries). 2. What is the difference between accumulating and non-accumulating sick leave? How does the recognition of accumulating sick leave differ from the recognition of non-accumulating sick leave? Refer to section 9.2.4. Accumulating sick leave may be carried forward to a future period if the employee has not taken the leave in the current period. Non-accumulating sick leave may not be carried forward to a future period. A liability must be recognised for accumulating sick leave when the employee renders services that increase the entitlement. The liability is measured as the amount that the entity expects to pay. If the leave is non-vesting, the amount recognised is affected by the probability that the leave will be taken. 3. What is the difference between vesting and non-vesting sick leave? How does the recognition of vesting sick leave differ from the recognition of non-vesting sick leave? Refer to section 9.2.4. If sick leave is vesting, the employee is entitled to cash settlement for unused leave. If sick leave is non-vesting, the employee has no entitlement to cash settlement of unused leave. The employer recognises a liability for accumulating sick leave, measured as the undiscounted amount expected to be paid. The entity will have good reason to expect that all vested accumulating sick leave will be paid. However, if sick leave is not vesting, a liability is recognised for proportion of accumulated sick leave that the entity expects to be taken by its employees.

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22420 Self Study Topic 6 9. Identify and discuss the assumptions involved in the measurement of a provision for long service leave. Assess the consistency of these requirements with the fundamental qualitative characteristics of financial information prescribed by the conceptual framework. Refer to section 9.6. Accounting for long service leave requires estimation of when the leave will be taken, projected salary levels and the proportion of employees who will continue in the entity’s employment long enough to become entitled to long service leave. It is necessary to make assumptions about when employees will take long service leave, which may be any time after they become entitled. The estimation of the timing of when leave will be taken affects estimates of projected salaries and wages and the discounting of the defined benefit. The estimation of projected salary levels may be affected by assumptions about the rate of inflation as well as promotion. The likelihood of promotion may differ among different categories of employees, such as engineers, graduate trainees and unskilled workers. The proportion of employees who will become entitled to long service leave may vary from one location to another, and is usually considered to be increasing with the period of past employment. Employees who are approaching entitlement are assumed to be less likely to leave before their long service leave vests, because the loss of long service leave entitlement would be viewed as a cost of changing employment. The fundamental qualitative characteristics of financial information prescribed by the Conceptual Framework are relevance and faithful representation. The liability for long service leave is required to be measured as the present value of the amount expected to be paid to settle the obligation. The focus on future cash flows required to settle the obligation reflects the fundamental characteristic of relevance because users of financial statements need information with which to assess the entity’s prospects for future not cash inflows (Conceptual Framework, paragraph OB4). However, the estimation of future cash flows introduces measurement uncertainty that can detract from faithful representation. The use of historical patterns of employee retention and actuarial estimates can enhance the faithful representation of liabilities for long service leave.

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22420 Self Study Topic 6 Exercise 9.4 Accounting for sick leave- accumulating Magpie Ltd has 80 employees who each earn a gross wage of $120 per day. In an attempt to reduce absenteeism, Magpie Ltd introduced a new workplace agreement providing all employees with entitlement to 5 days of non-vesting, accumulating sick leave per annum, effective from 1 July 2021. Under the previous workplace agreement, all sick leave was non-cumulative. During the year ended 30 June 2022, 240 days of paid sick leave were taken by employees. It is estimated that 70% of unused sick leave will be taken during the year ended 30 June 2023 and that 30% will not be taken at all. Required Prepare a journal entry to recognised Magpie Ltd’s liability, if any, for sick leave at 30 June 2022. (LO2) Date 30 June 2022

Account Wages and salaries expense

Debit

Provision for sick leave (Accrual of sick leave: 70% x (80 x 5 – 240) x $120 = $13,440)

Exercise 9.5

Credit 13,440 13,440

Accounting for sick leave- non- accumulating

Omu Ltd has 220 employees who each earn a gross wage of $145 per day. Omu Ltd provides 5 days of paid non-accumulating sick leave for each employee per annum. During the year, 160 days of paid sick leave and 20 days of unpaid sick leave were taken. Staff turnover is negligible. Required Calculate the employee benefits expense for sick leave during the year and the amount that should be recognised as a liability, if any, for sick leave at the end of the year. Employee benefits for sick leave during the year (ie expense for the period): 160 days x $145 per day = $23,200. Omu Ltd should not recognise a liability for sick leave because it is non-accumulating.

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22420 Self Study Topic 6 Exercise 9.6 Accounting for annual leave Burung Ltd provides employees with 4 weeks (20 days) of annual leave for each year of service. The annual leave is accumulating and vesting up to a maximum of 6 weeks. Thus, all employees take their annual leave within 6 months after the end of each reporting period so that it does not lapse. Burung Ltd pays a loading of 17.5% on annual leave; that is, employees are paid an additional 17.5% of their regular wage while taking annual leave. Refer to the following extract from Burung Ltd’s payroll records for the year ended 30 June 2022. ** Loading is like a bonus on top of your normal base salary/rate Increase in entitlement Wage/day

AL 1 July 2021 (days)

(days)

AL taken (days)

Chand

$150

8

20

15

Kettle

$115

5

20

12

Sander

$140

4

20

10

Zhou

$100

6

20

15

Employee

Required Calculate the amount of annual leave that should be accrued for each employee. (LO2) 1 Employee Chand Kettle Sander Zhou

2 Wage per day $150 $115 $140 $100

3 Change in AL entitlement 8+20-15 5+20-12 4+20-10 6+20-15

4 AL 30/6/22 in days 13 13 14 11

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5= 2 * 4* 1.175 AL accrual 2,291 1,757 2,303 1,293

22420 Self Study Topic 6 Exercise 9.20 Accounting for long service leave Oca Ltd provides long service leave for its retail staff. Long service leave entitlement is determined as 13 weeks of paid leave for 10 years of continued service. The following information is obtained from Oca Ltd’s payroll records and actuarial reports for its retail staff at 30 June 2022. Unit credit (years)

% Expected to become entitled

No. of employees

Annual salary per employee

No. of years until vesting

Yield on HQ corporate bonds

1

80

20

$45,000

9

10%

2

70

30

$45,000

8

9%

3

50

50

$45,000

7

9%

4

30

60

$45,000

6

9%

Additional information  The estimated annual increase in retail wages is 1% p.a. for the next 10 years, reflecting expected inflation.  The provision for long service leave for retail staff at 30 June 2021 was $22 ,000.  No employees were eligible to take long service leave during the year ended 30 June 2022. Required Prepare the journal entry to account for Oca Ltd’s provision for long service leave at 30 June 2022. (LO6) Step 1:Estimate the number of employees who are expected to become eligible for long service leave. Years of service

% expected to become entitled

Total employees

Eligible employees ** Rounded **

B

C

D= B*C

A

1 2 3 4

20% 30% 50% 60%

80 70 50 30

16 21 25 18

Step 2:Estimate projected salaries = Current salary x Eligible employees x (1 + inflation rate)n, with n being the respective period until LSL vests in years. Years of Period service Eligible Current Inflation until Projected employees salary rate LSL vests salaries $ $ 1 16 45,000 0.01 9 787,453 2 21 45,000 0.01 8 1,023,300 3 25 45,000 0.01 7 1,206,152 4 18 45,000 0.01 6 859,831 16 * 45,000 * (1.01)9 = 787,453

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22420 Self Study Topic 6 Step 3: Determine the accumulated bene...