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School of Accounting ACCT3563: Issues in Financial Reporting and Analysis

Homework solutions Provisions, Contingent Liabilities and Accounting for Employee Benefits

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Exercise 8.1 (in class) 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. 1. Liability: this event falls within the reporting period and the amount and timing are certain. 2. Provision: 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. 3. No provision or liability: the amount is a future cost. 4. No provision or liability: no present obligation to overhaul the machine – Kasey Ltd could decide to sell the machine or not repair it. 5. 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 measurement.

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Exercise 8.3 Recognising a provision The government introduces a number of changes to the goods and services (value-added) tax system. As a result of these changes, Welles Ltd, a manufacturing company, will need to retrain a large proportion of its administrative and sales workforce to ensure compliance with the new tax regulations. At the end of the reporting period, no retraining of staff has taken place. Required Should Welles Ltd provide for the costs of the staff training at the end of the reporting period? The question here is whether a present obligation as a result of a past obligating event exists. There is no obligation because no obligating event (retraining) has taken place. Therefore, no provision is recognised. 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. No present obligation: no provision. No legal nor constructive liability. 2. Present obligation exists; contamination of the land is the past event; 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. There is a legal liability. 3. 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. There is a constructive liability.

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Exercise 8.11 (in class) Calculation of a provision In May 2022, Savoir Ltd relocated an employee from head office to an office in another city. As at 30 June 2022, the end of Savoir Ltd’s reporting period, the costs were estimated to be $44  000. Analysis of the costs is as follows. Costs for shipping goods

$

4 000

Airfare Temporary accommodation costs (May and June)

8 000 6 000

Temporary accommodation costs (July and August)

8 000

Reimbursement for lease break costs (paid in July; lease was terminated in May) Reimbursement for cost of living increases (for the period 15 May 2022 – 15 May 2023)

3 000 15 000

Required Calculate the provision for relocation costs for Savoir Ltd’s financial statements as at 30 June 2022. Assume that AASB 137/IAS 37 applies to this provision and that the effect of discounting is immaterial. Savoir Ltd relocated an employee from Savoir Ltd head office location to another city. The employee moved to the other city during May 2022. As at 30 June 2022 (Savoir Ltd’s reporting date) the costs were estimated to be $44 000. An analysis of the costs and the amounts to be included as part of a provision, is as follows: Note that the obligating event is the relocation of the employee, which occurred before 30 June 2022. Costs for shipping goods $4 000 Include (assume goods shipped before 30 June 2022) Airfare 8 000 Include (assume employee flew in May 2022) Temporary accommodation costs (May and June) 6 000 Include Temporary accommodation costs (July and August) 9 000 Exclude - Future costs Reimbursement for lease break costs (paid in July; 3 000 Include; obligating event lease was terminated in May) occurred in May 2022 Reimbursement for cost of living increases 15 000 Include $1 875 ($15 000/12 x 1.5 (for the period 15 May 2022-18 May 2023) months) for May and June 2022; remainder are future costs Total amount provided should therefore be $22 875.

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Exercise 8.14 (in class) Wizards Ltd, a listed company, is a manufacturer of confectionery and biscuits. The end of its reporting period is 30 June. Relevant extracts from its financial statements at 30 June 2023 are shown. Current liabilities Provisions Provision for warranties

$630 000*

Non‐current liabilities Provisions Provision for warranties

240 300*

Non‐current assets Plant and equipment At cost Accumulated depreciation

$ 2 000 000 600 000

Carrying amount

1 400 000

* Note that there is an error in the textbook. These are the correct numbers. Assume that the opening balance in the provision account at 1 July 2022 was zero. Plant and equipment has a useful life of 10 years and is depreciated on a straight‐‐line basis. Note 36 — contingent liabilities Wizards is engaged in litigation with various parties in relation to allergic reactions to traces of peanuts alleged to have been found in packets of fruit gums. Wizards strenuously denies the allegations and, as at the date of authorising the financial statements for issue, is unable to estimate the financial effect, if any, of any costs or damages that may be payable to the plaintiffs. The provision for warranties at 30 June 2023 was calculated using the following assumptions (there was no balance carried forward from the prior year). Estimated cost of repairs — products with minor defects Estimated cost of repairs — products with major defects Expected % of products sold during FY 2023 having no defects in FY 2024 Expected % of products sold during FY 2023 having minor defects in FY 2024

$3 000 000 $9 000 000 80% 15%

Expected % of products sold during FY 2023 having major defects in FY 2024

5%

Expected timing of settlement of warranty payments — those with minor defects

All in FY 2024

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Expected timing of settlement of warranty payments — those 40% in FY 2024, 60% in FY with major defects 2025 Discount rate 6%. The effect of discounting for FY 2024 is considered to be immaterial. During the year ended 30 June 2024, the following occurred. (a) In relation to the warranty provision of $860 000 at 30 June 2023, $350  000 was paid out of the provision. Of the amount paid, $250  000 was for products with minor defects and $100  000 was for products with major defects, all of which related to amounts that had been expected to be paid in the 2024 financial year. (b) In calculating its warranty provision for 30 June 2024, Wizards made the following adjustments to the assumptions used for the prior year. Estimated cost of repairs — products with minor defects Estimated cost of repairs — products with major defects Expected % of products sold during FY 2024 having no defects in FY 2025 Expected % of products sold during FY 2024 having minor defects in FY 2025 Expected % of products sold during FY 2024 having major defects in FY 2025 Expected timing of settlement of warranty payments — those with minor defects Expected timing of settlement of warranty payments — those with major defects Discount rate

No change $6 000 000 80% 15% 5% All in FY 2025 25% in FY 2025, 75% in FY 2026 No change. The effect of discounting for FY 2024 is considered to be immaterial.

(c) Wizards determined that part of its plant and equipment needed an overhaul — the conveyor belt on one of its machines would need to be replaced in about May 2025 at an estimated cost of $250  000. The carrying amount of the conveyor belt at 30 June 2023 was $140  000. Its original cost was $200  000. (d) Wizards was unsuccessful in its defence of the peanut allergy case and was ordered to pay $1  500  000 to the plaintiffs. As at 30 June 2024, Wizards had paid $800  000. (e) Wizards commenced litigation against one of its advisers for negligent advice given on the original installation of the conveyor belt referred to in (c) above. In April 2024 the court found in favour of Wizards. The hearing for damages had not been scheduled as at the date the financial statements for 2024 were authorised for issue. Wizards estimated that it would receive about $425  000. (f) Wizards signed an agreement with BankSweet to the effect that Wizards would guarantee a loan made by BankSweet to Wizards’ subsidiary, CCC Ltd. CCC’s loan with BankSweet was $3  200  000 as at 30 June 2024. CCC was in a strong financial

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position at 30 June 2024. Required Prepare the relevant extracts from the financial statements (including the notes) of Wizards Ltd as at 30 June 2024, in compliance with AASB 137/IAS 37 and related accounting standards. Include comparative figures where required. Show all workings separately. Perform your workings in the following order. 1. Calculate the warranty provision as at 30 June 2023. This should agree with the financial statements provided in the question. 2. Calculate the warranty provision as at 30 June 2024. 3. Calculate the movement in the warranty provision for the year. 5. Determine whether the unpaid amount owing as a result of the peanut allergy case is a liability or a provision. 1. (80% x $0) + (15% x $3 000 000) + (5% x $9 000 000)

= = =

$0 $450 000 $450 000 $900 000

Timing: FY 2024: $450 000 + (40% x $450 000)

= =

$450 000 $180 000 $630 000 (current portion)

FY 2025: + (60% x $450 000 discounted at 6% [for 2 years]) = $270 000/1.1236* $240 300 (non-current portion) 2 * rounded to 4 decimal places (1 + 0.06) = 1.1236 (the PV discount factor is therefore calculated as 1/1.1236 = 0.8900) Therefore total provision = $630 000 + $240 300 = $870 300 2. (85% x 0)

$0

+ (15% x 3 000 000)

$450 000

+ ( 5% x 6 000 000)

$300 000 $750 000

Timing: FY 2025: $450 000 + (25% x $300 000)

$450 000 $ 75 000 $525 000 (current portion)

FY 2026: + (75% X $300 000 discounted at 6% [for 2 years]) = $225 000/1.1236 $200 250 (non-current portion)

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Total new provision for FY 2024 = $525 000 + $200 250 = $725 250 Balance of provision from FY 2023 payable in FY 2025

*$270 000 (current portion) $995 250

*$270 000 = 60% of $450 000 (major defects) Current portion = $795 000 ($525 000 + $270 000) Non-current portion = $200 250 3. Opening balance $870 300 Plus: Increase in the provision $725 250 Less: Amounts used during the year ($350 000) Less: Unused amounts reversed during the year ($280 000)

Plus: Increase in discounted amount arising from the passage of time Closing balance

$29 700 $995 250

[$630 000 expected to be paid in FY2024, $350 000 was actually paid] [$270 000 – $240 300]

5. The unpaid amount of $700 000 ($1 500 000 - $800 000 already paid) owing as a result of the peanut allergy case, should be included as part of trade and other payables as there is no uncertainty regarding timing or amount of settlement and hence it is not a provision.

Exercise 8.15 (In class) In June 2021 Great Southern Ltd built a submarine under a contract with the Australian Navy. The contract required Great Southern Ltd to provide a one-year warranty. The accountant was unsure how to measure the warranty because the design of the submarine differed from those previously built by Great Southern Ltd. The trainee accountant was asked to obtain more information, so she asked some engineers for their advice on the expected cost of servicing the warranty. The trainee’s report is summarised below. Engineers’ estimates and accompanying explanations Worst-case scenario Best-case scenario

$ 1 000 000 $ 200 000

Most probable scenario

$

500 000

Quote from a Japanese company to take on the warranty

$

700 000

Recommendation: The provision for warranty should not be recognised because it is too difficult to measure. The accountant needs to decide whether to recognise a provision for warranty and, if so, how to measure it.

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Required 1. Describe two principles from AASB 137/IAS 37 that are relevant to the accountant’s decision. 2. Use the principles identified in 1, above, to evaluate the trainee accountant’s recommendation. 3. Describe an accounting policy to account for the provision for warranty. 4. Explain how the policy that you proposed in 3, above, is consistent with AASB 137/IAS 37. 5. Identify assumptions made in the exercise of judgement in proposing an accounting policy for the warranty. 1. Any of the following. 

  

Definition of a liability AASB 137, paragraph 10: a present obligation arising from a past event, settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Recognition criteria of provision AASB137, paragraph 14 (a-c) – present obligation as a result of a past event, the outflow or resources if probable and a reliable estimate can be made of the amount of the obligation. A provision should be measured as the best estimate of the expenditure required to settle the obligation at the end of the reporting period (AASB 137, paragraph 36). The best estimate of a provision is the amount that an entity would rationally pay to settle an obligation or transfer it to another party (AASB 137, paragraph 37).

Some student may draw on AASB 137, paragraph 40 which states that the most likely outcome may be the best estimate where a single obligation is being measured, but it is necessary to consider other possible outcomes. However this is more of a statement of what might be, rather than a principle that provided guidance. 2. The trainee’s policy fails to recognise a liability for the warranty, thus understating expenses and liabilities. The policy does not correctly apply the recognition criteria because an estimate is available. The trainee has taken the view that there is too much measurement uncertainty so that nonrecognition is justified by AASB 137. i.e., it fails the recognition criteria and meets the second limb of the definition of a contingent liability, and should thus not be recognised. However, it is not necessary that the amount be known with certainty. The issue is whether it can be measured reliably. 3. Recognise a provision for warranty when the submarine is sold and measure it at the best estimate of the expenditure required to settle it, which is the most probable estimate. (An alternative answer is to measure it at the best estimate of the amount the entity would need to pay to transfer it to another party.) 4. The warranty satisfies the definition of a liability because a present obligation to service a warranty has arisen from the sale of a submarine. Settlement of the warranty is expected to result in an outflow of at least $200 000. The recognition criteria are satisfied because there is a present obligation, as stated above, an outflow is probable, based on all available evidence or

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advice from engineers, and it can be measured reliably. The justification of reliable measurement depends on which measurement is adopted and the assumptions made. For example, if measuring at the $700 000, the reliability is ascertained from the existence of a quote. If measuring at $500 000, the reliability is only as good as the engineers’ estimates. 5. Answers will vary with the policy. If proposing measurement at $700 000, there is an assumption that Great Southern Ltd would reasonably pay the Japanese company $700 000 to transfer the obligation. If proposing to measure the provision at $500 000, the assumption would be that Great Southern Ltd would not pay the Japanese company $700 000 to transfer the obligation. It further assumes that the engineers’ estimate of the most probable amount is sufficiently reliable and in accordance with AASB 137, paragraph 38 with respect to having considered the range of other possible outcomes.

Ethics Case: Ship Ahoy Shipping Co Ltd (in class) You are the newly appointed deputy chief-accountant at Ship Ahoy Shipping Co Ltd. You review of the company’s accounts for the past 10 years, and you observe the following data:

Year

Profits (losses) from shipping ($’000s)

Investment income ($’000s)

Shipping + Annual debit Investment or (credit) to Income($’000s) Provision for Ship Modernisation ($’000s)

Reported Net Profit ($’000s)

A

B

A+B

C

A+B+C

2009

900

500

1400

(565)

837

2010

(780)

452

(328)

995

668

2011

(450)

435

(15)

740

725

2012

(380)

422

42

736

779

2013

(425)

404

(21)

794

773

2014

(538)

261

(277)

1008

731

2015

(540)

267

(273)

901

629

2016

(334)

559

225

513

737

2017

(95)

452

357

372

729

2018

(427)

385