IAS 37 explains how to determine when an obligating event has occurred in connection with a restructuring. IAS 37 also applies to provisions for restructuring when there is a discontinued operation. Where a restructuring meets the definition of a discontinued operation in IFRS 5, additional disclosures might be required.

Definition

A ‘restructuring’ is:

“A programme that is planned and controlled by management, and materially changes either:

(a) the scope of a business undertaken by an entity; or

(b) the manner in which that business is conducted.”

IAS 37 gives some examples of situations that fall within the restructuring definition:

• The sale or termination of a line of business.
• The closure of business locations or the relocation of business activities.
• Changes in management structure.
• Fundamental re-organisations that have a material effect on the nature and focus of the entity’s operations.

Applying the recognition criteria

A restructuring provision is recognised only when an obligating event has arisen. The obligation for a restructuring is often constructive. A constructive restructuring obligation arises only when both of the conditions below exist:

• A detailed formal plan for the restructuring, which identifies at least:
• the business or part of a business concerned;
• the principal locations affected;
• the location, function and approximate number of employees who will be compensated for terminating their services;
• the expenditures that will be undertaken; and
• when the plan will be implemented.
• A valid expectation, in those affected, that the entity will carry out the restructuring by starting to implement that plan or announcing its main features to those affected by it.

Evidence demonstrating that an entity has started to implement a restructuring plan includes:

• Dismantling plant;
• Selling assets;
• Public announcement of the plan’s main features.

Third party expectation

A constructive obligation arises from a public announcement only when it raises a valid expectation in employees (or their representatives), customers, suppliers or others affected by it in a ‘sufficiently specific manner’ that the entity has no alternative but to discharge its responsibilities.

The announcement must therefore address the main features of the restructuring plan in a sufficiently specific manner to raise a valid expectation that the entity will carry out the restructuring.

Is an announcement of an intention sufficient to recognise a restructuring provision? Entity A’s management has prepared a plan for a re-organisation of its operations. The board has approved the plan, which involves closing ten of entity A’s 50 retail outlets. Management will conduct further analysis before deciding which outlets to close. Management has announced its intentions publicly and believes that this has given rise to a valid expectation for those affected. Should a provision for restructuring costs be recognised? No, a provision for restructuring should not be recognised. A constructive obligation arises only when an entity has both a detailed formal plan for restructuring and makes an announcement of the plan to those affected by it. The plan does not provide sufficient detail (for example, the principal locations affected) that would permit recognition of a constructive obligation.

Do individual employees have to be notified to recognise a restructuring provision? An entity is planning a head office restructuring. The year-end is 31 March 20X1. The entity announced the restructuring, including the functions and the number of employees likely to be affected, before the year end (say, in January 20X1). But there is a 90-day consultation period, so individual employees were not notified by the year end. Can the entity provide for the restructuring costs at 31 March 20X1? IAS 37 states that a public announcement of a detailed plan to restructure constitutes a constructive obligation to restructure only if it is made in such a way and in sufficient detail (that is, setting out the main features of the plan) that it gives rise to valid expectations in other parties – such as customers, suppliers and employees (or their representatives) – that the entity will carry out the restructuring. Our view is that it is not necessary for individual employees to have been notified at the year-end. The notification of employee representatives could create a constructive obligation. It will be necessary to consider what is involved in the specific consultation. For example, the announcement will create a constructive obligation if the negotiation is about terms rather than something that could change the entity’s plans (which have already been announced in detail).

Board decision

A management or board decision to restructure taken before the balance sheet date does not, in itself, give rise to a constructive obligation.

Implications of a management announcement of restructuring after balance sheet date An entity has prepared a formal plan for a re-organisation involving site closures and redundancies. The plan has been approved by the board at the year-end, but the entity will not implement or announce the re-organisation until after the year end. There is no constructive obligation, even if there is an announcement after the entity’s year-end but before its financial statements are approved. The announcement is a non-adjusting post balance sheet event and there was no commitment to restructure at the year-end. The entity could change its plans completely after the year end. A constructive obligation would exist if the entity has raised a valid expectation in those affected by beginning to implement the re-organisation by the end of the year (for example, by scrapping the plant or informing employees and suppliers of the re-organisation), despite the absence of a formal announcement.

A board decision and a formal plan might be all that is necessary to give rise to an obligation in some territories. This might also occur, for example, where the board includes worker representatives and management representatives.

Circumstances in which board approval crystallises the obligation Where employees have been consulted about the restructuring, and the restructuring plan has been developed with their participation, board approval will crystallise an obligation when the decision has been made and it has been communicated to the entity’s employees. An obligation might also arise from a board decision where negotiations for the sale of part of the business have been agreed with a purchaser, but the contract is subject to board approval, because the agreement will be unconditional once the decision is made.

Restructuring time-frame

Many entity re-organisations take several years to complete. Some or all of the re-organisation might not be an obligation at the first-year end following a board decision if the entity is realistically able to change its plans. It is unlikely that the plan will raise a sufficiently valid expectation on the part of others that the entity is committed to restructuring in these circumstances.

A restructuring that takes a long time to implement A retailer has a significant number of small retail outlets and it has decided to consolidate its retailing activities into a smaller number of larger outlets. The time taken to execute the plan will depend on a number of factors, some of which will be outside the entity’s control (for example, the availability of suitable retail outlets of the appropriate size and location). The time taken to execute the plan might affect whether there is an obligation from which the entity cannot realistically withdraw. Management should assess each phase of the plan to determine whether the initial or subsequent announcements contain sufficient detail and are sufficiently certain to create a constructive obligation. The costs of some restructuring programmes might therefore be charged to profit or loss over a number of accounting periods.

Identification of employees to be terminated under a restructuring plan Generally, it is not necessary for the plan to be so detailed that it identifies which individual employees will be leaving. However, it must be sufficiently detailed that those employees in the employee groups affected by the restructuring plan have a valid expectation that either they or their colleagues in the group will be affected. the expenditures that will be undertaken; and when the plan will be implemented.

Binding sale agreement

An obligation to sell exists only when there is a binding sale agreement evidencing a commitment to sell part of the business. An entity has an obligation for restructuring related to the sale only when it has found a purchaser and signed an unconditional contract. The unconditional sale agreement must be signed before the year-end for an obligation to arise at the year-end.

It might be necessary to consider the carrying value of the cash generating unit to which the operations relate in the period between the board decision and the unconditional contract, particularly if management expects a loss on disposal.

The sale of an operation might be a small part of a larger restructuring, in which case a constructive obligation might arise for other aspects of the restructuring plan before a formal sale agreement has been reached.

Costs of restructuring

A restructuring provision should include only the direct expenditures arising from the restructuring, which are those that are both: necessarily entailed by the restructuring; and not associated with the ongoing activities of the entity.

Retraining or relocating continuing staff, marketing, or investment in new systems and distribution networks should not be included in a restructuring provision. This is because these costs relate to the future conduct of the business; they do not represent an obligation arising from a past event.

Entity is demonstrably committed to only part of a restructuring plan When a restructuring plan will take quite a long time to be completed, it is possible that the entity may be demonstrably committed to earlier actions in the plan but not to later actions in the plan. In such circumstances, a provision should be recognised only for those actions to which the entity is committed (i.e. the earlier actions in the restructuring plan).

Entity to have raised a valid expectation in those affected by a restructuring plan at the end of the period The requirement for the existence of a valid expectation in those affected relates to the situation at the end of the reporting period. The fact that implementation has commenced by the date that the financial statements are authorised for issue does not, by itself, provide evidence that a present obligation existed at the end of the reporting period.

Relocation costs – example An entity has decided to relocate one of its employees. The employee is aware of the impending move. No provision should be recognised until the relocation occurs, because the relocation relates to the ongoing activities of the business.

Lease termination – example (entities that have not yet adopted IFRS 16) An entity has developed a detailed formal plan for restructuring a business, and has announced the key features of the restructuring to all affected by it in a manner that meets the criteria of IAS 37. The entity has not yet adopted IFRS 16. As part of the restructuring, the entity has entered into an oral agreement (i.e. a commitment has been established) with the landlord to terminate a lease and pay a settlement fee of CU1 million to the landlord. The settlement fee represents a direct cost resulting from the restructuring. The entity does not expect to be able to sublet the property; therefore, CU1 million represents the minimum expected obligation. A provision should be recognised for the CU1 million settlement fee for the lease because a valid expectation has been created between the lessor and lessee that the lease will be terminated. The entity has a constructive restructuring obligation because it has publicly announced the plan to restructure. Such an announcement gives rise to valid expectations in other parties (e.g. the lessor) that the entity will carry out the restructuring, which includes the termination of the lease. Note: For entities that have adopted IFRS 16 (effective for annual periods beginning on or after 1 January 2019, with earlier application permitted), termination penalties are dealt with as part of the lease liability under that Standard.

Costs that are generally included in, and those generally excluded from, a restructuring provision A restructuring provision might include the following: ·        Expenditure necessarily entailed by the restructuring and not associated with the ongoing activities of the business. ·        Costs of making employees redundant (although the treatment of redundancy costs is governed by IAS 19). ·        Costs of terminating leases and other contracts that arise directly from the restructuring. ·        Contractual obligations that would continue after the restructuring with no economic benefit to the entity. ·        The costs of contracts that become onerous contracts as a result of the restructuring. The following table distinguishes between costs that are generally included in, and those generally excluded from, a restructuring provision: Description of costs Included Excluded Reason for exclusion Voluntary redundancies. ✓ Compulsory redundancies, if the target for voluntary redundancies is not met. ✓ Lease cancellation fees for a factory that will no longer be used. ✓ Relocation of employees and related equipment from a factory (to be closed) to a factory that will continue to be used. ✓ Costs associated with ongoing activities. Relocation incentive for employees. ✓ Costs associated with ongoing activities. Retraining of remaining employees. ✓ Costs associated with ongoing activities. Recruitment costs for a new manager. ✓ Costs associated with ongoing activities. Stay-on bonuses ✓ Costs associated with ongoing activities. Marketing costs to develop a new corporate image. ✓ Costs associated with ongoing activities. Investments in a new distribution network. ✓ Costs associated with ongoing activities. Future identifiable operating losses, up to the date of a restructuring. ✓ Costs associated with ongoing activities. Impairment write-down of certain property, plant and equipment. ✓ The impairment provision should be accounted for in accordance with IAS 36. Consulting fees to identify future corporate strategies and organisational structures. ✓ Costs associated with ongoing activities. Costs of relocating inventory and equipment that will be used at another location. ✓ Costs associated with ongoing activities. Acquisition integration costs (for example, integrating the combining entities’ computer systems). ✓ Costs associated with ongoing activities.

Employee termination benefits are often lump-sum payments, but can also include enhancement of pensions and salary until the end of a specified period if the employee renders no further service that provides economic benefits to the entity.

What is the unit of account when assessing onerous contracts? This FAQ applies to entities that are applying IAS 17 to account for leases. The unit of account for the onerous contract is the entire contract. An onerous contract provision should only be made when the unavoidable costs exceed the expected benefits from the contract as whole. For example, an entity would not recognise an onerous contract provision if a rented property was temporarily closed for renovation. It might be appropriate, in limited circumstances, to split an operating lease into several component parts, to assess whether there is an onerous contract. Splitting a contract might be appropriate where: ·        The components are clearly identifiable and separable under the operating lease contract. An entity might consider whether the single contract could reasonably at inception have been agreed as a number of separate contracts. Any interdependency between the components of the contract would indicate that the contract is not separable. ·        The unavoidable costs and future economic benefits can be allocated, on a reliable basis, to the different components of the contract.

Onerous contracts

An onerous contract is a contract under which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. The present obligation under an onerous contract is recognised and measured as a provision.

Identification of onerous contracts It is not appropriate to test for an onerous contract only by comparing the value of the goods or services to be received or provided with the amount to be paid or received. A mere fall in price does not necessarily mean that a contract is onerous. Instead, the test of whether a contract is onerous focuses on how the goods or services that are the subject of the contract will be used within the business. Depending on the facts and circumstances, a contract may or may not relate to a cash-generating unit (CGU) and this will affect the determination as to whether the contract is onerous. For example, a contract to buy goods or services that will be used by a CGU is directly related to that CGU. Such a contract will be assessed as onerous if the cost of the items purchased causes the CGU to report a loss or increases the loss to be reported by the CGU. It does not necessarily follow that a CGU reporting a loss has an onerous contract or contracts. Rather, it will always be necessary to consider individual contracts to assess whether the unavoidable costs of meeting the obligations under any contract exceed the economic benefits expected to be received under it. Onerous contracts may arise when an entity prepares financial statements on a basis other than that of a going concern. In those circumstances, contracts that would not normally be onerous (e.g. employee contracts) may become onerous. Long-term contracts for the supply of goods or services when costs have risen or current market prices have fallen may be onerous and, if so, a provision is recognised to the extent that future supplies must be made at a loss. No provision is recognised under a contract for the supply of goods which is profitable but at a reduced margin compared to other contracts, because there is no probable net transfer of economic benefits by the reporting entity.

Assessment of whether a revenue contract with variable consideration is onerous In the determination of the transaction price for a revenue contract that includes variable consideration, IFRS 15 requires an estimate to be made of the amount of consideration to which the entity will be entitled (using either an ‘expected value’ or ‘most likely amount’ method). However, that estimate is only included in the transaction price to the extent that it is highly probable that a significant reversal of revenue will not occur when the variability in consideration to be received is resolved. This limitation in the amount of variable consideration recognised is often referred to as ‘the constraint’. When assessing whether a revenue contract with variable consideration is onerous, the estimated economic benefits expected to be received under the contract with the customer should not reflect the variable consideration constraint. The recognition and measurement of onerous contract provisions are subject to the general requirements of IAS 37 and, as such, are based on the entity’s ‘best estimate’ of the (net) expenditure required to settle an obligation. This is not affected by the revenue constraint applied under IFRS 15; in particular, the level of confidence (‘highly probable’) required by the constraint to recognise revenue does not appear in IAS 37.

Recognition and measurement of onerous contracts – example Entity A has entered into a contract with Entity B to supply goods for a fixed price of CU100. Because of price inflation, Entity A’s expenditure to meet its obligations under the contract is expected to be CU120. No other benefits are expected under the contract. Therefore, the contract is considered to be onerous, and a provision should be recognised. Entity A estimates that any compensation or penalties arising from failure to fulfil the contract are equal to the cost of fulfilling the contract (i.e. CU120). At the end of the reporting period, Entity A has commenced negotiations with Entity B with a view to increasing the price at which the goods are supplied under the contract. Entity A expects that Entity B will be willing to agree to such a price increase so as to avoid Entity A ceasing to trade as a result of the losses incurred under the contract (and, consequently, cutting off the source of supply of goods necessary for Entity B’s own business). The onerous contract should be measured based on the contractual terms in existence at the end of the reporting period because that is Entity A’s ‘present obligation’ required to be recognised and measured in accordance with IAS 37. The potential renegotiation of the supply contract between Entity A and Entity B should not be reflected in the amount of provision recognised for the onerous contract. Any future amendment to the terms of the contract would be a change in the obligation resulting in remeasurement of the provision when the amendment occurs. As discussed, IAS 37 states that “future events that may affect the amount required to settle an obligation shall be reflected in the amount of a provision where there is sufficient objective evidence that they will occur”. However, this reference to future events is not to changes in the underlying obligation, but to those future events that are factors in estimating the costs of meeting a present obligation (e.g. developments in the technology used to clean up a site) or in assessing the extent to which a present contractual obligation is onerous (e.g. for entities that have not yet adopted IFRS 16, an expectation of subleasing a vacant property). IAS 37 defines an onerous contract as “a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it“. IAS 37 further states that “the unavoidable costs under a contract reflect the least net cost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it”. Because IAS 37 refers to the net cost rather than the gross cost associated with the contract, the provision for the onerous contract should reflect the costs required to fulfil the contract net of any income that the entity will receive as a consequence of fulfilling the contract. Consequently, Entity A should recognise a provision for the onerous contract equal to the expected loss of CU20 (not for the entire cost of fulfilling the contract of CU120).

Vacant property – example (entities that have not yet adopted IFRS 16) Company X, which has not yet adopted IFRS 16, has an operating lease over a property which it entered into several years ago. The property is now surplus to requirements and Company X has vacated it. The lease has three years to run with an associated expense of CU10,000 per year. Company X believes it may be able to find a tenant to take a sublease of the property but that it might only receive CU8,000 per year from the sublease. Alternatively, the landlord is prepared to terminate the lease, and forgive the future rentals of CU30,000, if Company X makes a termination payment of CU5,500. Because the property has been vacated, and the continuing rentals are not expected to be recoverable from subleasing the property, a provision should be recognised. The provision should represent the best estimate of the expenditure required to settle the obligation at the end of the reporting period. If Company X subleases the property, it expects to pay CU30,000 in lease rentals and receive CU24,000 in sublease rentals, which would leave a deficit of CU6,000 to be provided. However, in this case, the amount the landlord would accept to terminate the lease is CU5,500, which is lower. Accordingly, Company X should recognise an onerous lease provision of CU5,500, irrespective of whether it intends to terminate the lease or enter into a sublease. (For simplicity, this example ignores the time value of money. If the effect of discounting is material, the future rental payments and receipts are discounted to their present value. If the net present value of future rental payments less receipts is less than CU5,500, provision is made for that lower amount.) Note: For entities that have adopted IFRS 16 (effective for annual periods beginning on or after 1 January 2019, with earlier application permitted), onerous contracts relating to leases will generally be accounted for in accordance with that Standard.

Economic benefits expected to be received In our view, the term ‘economic benefits expected to be received’ should usually be construed to include both direct and indirect benefits under the contract. An entity might, for example, knowingly choose to enter into a contract with a customer to supply goods or services to them at a price lower than cost because the seller is obtaining some indirect benefits as well as the cash consideration from the customer. The benefits that might be obtained over the period of such an arrangement might include building a relationship with potential customers or additional know-how about production of the goods or services being supplied. Looking only at direct benefits, this contract would appear to be onerous, but entities often have the commercial reason behind such contracts (for example, marketing strategy that includes ‘loss leader’ pricing).

‘Unavoidable costs’ under a contract are defined as being the least net cost of exiting the contract. This will be the lower of the cost to exit or breach the contract and the cost of fulfilling it.

Whether it is necessary to include overheads to determine whether a contract is onerous and to measure any resulting provision An entity might use a central pool of assets or resources that generate fixed costs and are required to service a number of contracts. Unavoidable costs, are not defined in IAS 37, and IAS 37 does not provide any further guidance on the treatment of overhead costs. In June 2017, the IFRS IC discussed unavoidable costs and issued a tentative agenda decision stating that there are two acceptable readings of the term ‘unavoidable costs’ in the definition of an onerous contract. One view is that unavoidable costs include only incremental costs. This view implies that the overhead costs are not included in the assessment of whether a contract is onerous. In this view, only costs that are incremental and directly related to fulfilling the contract should be included in the assessment of whether a contract is an onerous contract. The other view is that unavoidable costs should include the costs that an entity cannot avoid because it has the contract. In this view, an allocation of overhead costs should be included in the assessment of whether a contract is onerous if such costs arise from activities required to complete the contract. At its September 2017 meeting, the IFRS IC decided not to finalise the tentative agenda decision. The IFRS IC will conduct further research to determine if a narrow scope amendment is needed to clarify IAS 37. Either view of the costs used to determine whether a contract is onerous and to measure any resulting provision is acceptable until the IFRS IC has concluded its deliberations.

An entity should recognise any impairment that has occurred on assets ‘dedicated to that contract’ before an onerous contract provision is recognised.

Assets dedicated to a contract In our view, an asset is only dedicated to a contract if there is a contractual requirement to use a specific asset or no other asset can be used. When there appears to be an onerous contract, assets dedicated to the contract should first be tested for impairment. An onerous contract provision is recognised for any excess of unavoidable costs over expected benefits after the assets have been tested for impairment.

IAS 37 does not apply to executory contracts unless those contracts are onerous (for example, a long-term purchase contract that has a higher unit cost than unit sales price).

Long-term purchase contract The examples that follow illustrate when a contract is onerous, whether dedicated assets need to be impaired, and how payments in relation to various contract terms or termination of contracts should be dealt with in the financial statements. Example 1 – Contract not onerous An entity has a contract to purchase one million units of gas at 23c per unit, giving a contract price of C230,000. The current market price for a similar contract is 16c per unit, giving a price of C160,000. The gas will be used to generate electricity, which will be sold at a profit. The economic benefits from the contract include the benefits to the entity of using the gas in its business and, because the electricity will be sold at a profit, the contract is not onerous. Example 2 – Impairment of assets The contract’s terms and market prices are the same as in example 1. However, the electricity is sold at a loss, and the entity makes an overall operating loss. All of the gas purchased by the entity is used to generate electricity using dedicated assets. The electricity is sold to a wide range of customers. The entity first considers whether the assets used to generate electricity are impaired. To the extent that there is still a loss after the assets have been written down, a provision for an onerous contract should be recorded. Example 3 – Sale to third party at below purchase price The contract terms and market price are the same as in example 1. However, in this example, the entity sells the gas under contract, which it no longer needs, to a third party for 18c per unit (5c below cost). The entity determines that it would have to pay C55,000 to exit the purchase contract. The only economic benefit from the purchase contract costing C230,000 are the proceeds from the sales contract, which are C180,000. Therefore, a provision should be made for the onerous element of C50,000, being the lower of the cost of fulfilling the contract and the penalty cost of cancellation (C55,000). Example 4 – Contract termination costs In the year ended 31 December 20X1, an entity has a contract with a third-party supplier. The entity wishes to terminate this contract in 20X2, even though it will still have two years to run, because it can enter into a cheaper contract with a new supplier. It will incur a charge for terminating the contract. Does the entity have to provide in 20X1 for the contract that it will be exiting in 20X2? A provision should be recognised only if the contract is onerous. If the goods received under the supply contract are sold at a profit, the contract is not onerous and provision should not be made in 20X1. The termination cost should be recognised as incurred in 20X2.

Measuring an onerous contract provision for a contract with a customer When a contract with a customer is onerous, IFRS 15 requires IAS 37 to be applied. IAS 37 requires the present obligation under an onerous contract to be recognised as a provision. The provision would be measured in accordance with IAS 37 as the best estimate of the expenditure required to settle the obligation. This estimate would reflect management’s expectations about the costs of satisfying the obligation less the amount to be received from the customer. The estimated amounts to be received from the customer should take into account the customer’s credit risk, but they would be measured using the guidance in IAS 37 rather than IFRS 9.

Waste electrical and electronic equipment

The European Union’s Directive on Waste Electrical and Electronic Equipment (2002/96/EC) (the ‘WEEE Directive’) regulates the collection, treatment, recovery and environmentally sound disposal of electronic and electrical equipment waste. The IFRS IC issued an interpretation, IFRIC 6, providing guidance on the obligating event in certain circumstances under the WEEE Directive.

IFRIC 6 provides guidance on the recognition, in the financial statements of producers, of liabilities for waste management of WEEE in respect of sales of historical household equipment.

WEEE obligation The WEEE Directive distinguishes between ‘new’ and ‘historical’ waste, and between waste from private households and waste from other sources. New waste relates to products sold on or after 13 August 2005. All equipment sold before that date gives rise to historical waste for the purposes of the WEEE Directive. The WEEE Directive states that the cost of waste management for historical household equipment should be borne by producers of that type of equipment that are in the market during a period as specified in the applicable legislation of each Member State (the ‘measurement period’). The WEEE Directive states that each Member State should establish a mechanism for producers to contribute to costs proportionately (for example, in proportion to their respective market share by type of equipment). [IFRIC 6 para 4]. Individual Member States will have their own interpretation of the WEEE Directive enacted into their law. The WEEE Directive on its own cannot impose any legal obligation on individual producers; it imposes an obligation only on the government/country to transpose it into local law. The detailed requirements associated with the Directive will, therefore, vary from State to State. For example, if local law has not put the obligation to dispose of the WEEE on the producers, entities might not have an obligation under the WEEE Directive but will need to consider whether there is any other legal/constructive obligation. For other jurisdictions, the local law might impose the obligation on producers to dispose of the WEEE but might provide the opportunity for each producer to join – and potentially transfer its obligation to – a collective scheme, or it might require producers to make certain exit payments for withdrawing from the market. In those cases, a provision might be necessary when goods are put on the market. Whether an obligation should be recorded will depend on the specific requirements of the local law. IFRIC 6 only addresses sales of historical household equipment; it does not address new waste or historical waste from sources other than private households. Entities will need to determine appropriate accounting policies for other types of waste in accordance with IAS 37’s general requirements and with IAS 8. The IFRS IC concluded that participation in the market during the measurement period is the obligating event. A liability for waste management costs for historical household equipment does not arise when the products are manufactured or sold. The obligation for historical household equipment is linked to participation in the market during the measurement period, rather than to production or sale of the items to be disposed of, so there is no obligation unless and until an entity participates in the market share during the measurement period. The timing of the obligating event might also be independent of the particular period in which the activities to perform the waste management are undertaken and the related costs incurred. Incurring costs in the performance of the waste management activities is a separate matter from incurring the obligation to share in the ultimate cost of those activities. Example – Determining the obligating event in WEEE (reproduced from IFRIC 6) An entity selling electrical equipment in 20X4 has a market share of 4% for that calendar year. It subsequently discontinues operations, so is no longer in the market when the waste management costs for its products are allocated to those entities with market share in 20X7. With a market share of 0% in 20X7, the entity’s obligation is nil. However, if another entity enters the market for electronic products in 20X7 and achieves a market share of 3% in that period, then that entity’s obligation for the costs of waste management from earlier periods will be 3% of the total costs of waste management allocated to 20X7, even though the entity was not in the market in those earlier periods and has not produced any of the products for which waste management costs are allocated to 20X7.

Levies

A public authority could impose a levy on entities based on measures such as gross revenues for a specified period or on assets or liabilities at a specified date. IFRIC 21 addresses the accounting for a liability to pay a levy recognised in accordance with IAS 37 and the liability to pay a levy whose timing and/or amount is certain. It sets out guidance for recognising an obligation to pay a levy that is not within the scope of other standards (such as income taxes), and it excludes fines or penalties for breaches of the legislation, and payments in exchange for an asset or service. Application of IFRIC 21 to liabilities arising from emission trading schemes is optional. The following transactions are likely to be within the scope of IFRIC 21:

• levies on receipts;
• capital taxes;
• property taxes;
• production taxes;
• non-deductible VAT;
• non-refundable import duties;
• oil pollution tax;
• bank levies; and
• other taxes based on assets, liabilities or physical measures.

One of the difficulties, in considering what items are within the scope of the interpretation, is that ‘levies’ are often given different names, such as tax, rents, royalties, contributions and fees.

Property tax Entities often pay property taxes that are collected to fund public services, such as road maintenance. Question Are such taxes within the scope of IAS 37 and IFRIC 21? Answer Most property taxes are within the scope of IFRIC 21. The application of the interpretation to such taxes will generally require a detailed analysis of the arrangements for each tax, to determine when the obligation is recognised. Some payments might arise from a contractual agreement with the government, or they might be related to specific services received from the government. Such transactions would be outside the scope of IFRIC 21.

Payroll tax An entity pays tax to the government based on wages paid to employees. The amount is due only if annual wages exceed a minimum amount. Question Is this tax within the scope of IAS 37 and IFRIC 21? Answer Levies imposed on employee benefits are not explicitly outside the scope of the interpretation. The scope of IAS 37, however, excludes provisions addressed by another standard. IAS 19 addresses all forms of consideration given by an entity in exchange for service rendered by employees. This includes benefits settled by payments made directly to the employees or to others. The scope of IAS 19 is broad and, as a result, the majority of payroll taxes will be within the scope of IAS 19 and thus fall outside the scope of IAS 37 and IFRIC 21.

Payments to third parties Question Are payments imposed by the government and paid to third parties within the scope of IFRIC 21? Answer The scope of IFRIC 21 applies to levies not only paid to the government but also ‘imposed by’ the government. Such payments to third parties would therefore be within the scope of the interpretation (for example, a television tax paid by households to the national broadcaster).

The obligating event that gives rise to a liability to pay a levy is the activity that triggers the payment of the levy, as identified by the legislation. For example, if the activity that triggers the payment of the levy is the generation of revenues in the current period, but the calculation of that levy is based on revenues generated in a previous period, the obligating event is the generation of revenues in the current period. The generation of revenues in the prior period is necessary, but not sufficient, to create a present obligation.

IFRIC agenda decision on levy with a pro rata and annual activity threshold Following the issuance of IFRIC 21, the Interpretations Committee was asked how paragraph 8 of IFRIC 21 should be interpreted in identifying an obligating event for a levy. The Interpretations Committee discussed regimes in which an obligation to pay a levy arises as a result of activity during a period, but is not payable until a minimum activity threshold (as identified by the legislation) is reached. The threshold is set as an annual threshold, but this threshold is reduced pro rata to the number of days in the year that the entity participated in the relevant activity, if its participation in the activity started or stopped during the course of the year. The Interpretations Committee observed that, in the light of the guidance in paragraph 12 of IFRIC 21, the obligating event for the levy is the reaching of the threshold that applies at the end of the assessment period. The Interpretations Committee noted that there is a distinction between a levy with an annual threshold that is reduced pro rata when a specified condition is met and a levy for which an obligating event occurs progressively over a period of time, as described in paragraph 11 of IFRIC 21; until the specified condition is met, the pro rata reduction in the threshold does not apply.

An entity does not have a constructive obligation to pay a levy that will arise from operating in a future period, even where it is economically compelled to continue operating in that future period, or it prepares its financial statements under the going concern principle. The interpretation is clear that only those obligations arising from past events that exist independently of an entity’s future activities should be recognised as provisions. The going concern assumption is a fundamental basis of preparation of financial statements, and it cannot lead to the recognition of a liability that does not meet the definitions and recognition criteria in IAS 37.

Obligating event: generation of revenue An entity reports annually on 31 December. A levy is triggered in full as soon as an entity generates revenue in 20X1. The levy is calculated based on a certain percentage of revenue generated by the entity in 20X0. The entity generated revenue in 20X0 and, in 20X1, starts to generate revenue on 3 January 20X1. Question What is the obligating event in this case? Answer The obligating event, and thus the activity that triggers the payment of the levy, is the first generation of revenue in 20X1. The generation of revenue in 20X0 is not the activity that triggers the payment of the levy and the recognition of the liability. This is necessary, but not sufficient, for recognition. The amount of revenue generated in 20X0 only affects the measurement of the liability.

Property tax – obligating event: point in time Legislation requires an entity to pay a levy if it owns property on 31 December. The property tax is 1% of the most recent property valuation, payable by the owner of the property on 31 December. The most recent property valuation is from 30 June of the same year. Question When is the liability recognised? Answer The obligating event is ownership of the property on 31 December. The owner of the property has no present obligation to pay the levy during the year, because it could sell the property before 31 December, or the legislation could change. The liability is therefore recognised on 31 December. The date of the property valuation is not relevant. It is only used to measure the liability.

An entity does not have a constructive obligation to pay a levy that will arise from operating in a future period, even where it is economically compelled to continue operating in that future period, or it prepares its financial statements under the going concern principle. The interpretation is clear that only those obligations arising from past events that exist independently of an entity’s future activities should be recognised as provisions. The going concern assumption is a fundamental basis of preparation of financial statements, and it cannot lead to the recognition of a liability that does not meet the definitions and recognition criteria in IAS 37.

Obligating event: operation on a particular date A levy is triggered if an entity is operating at the end of the annual reporting period. The levy is calculated based on total equity in the entity’s statement of financial position at the end of the annual reporting period. The end of the entity’s annual reporting period is 31 December 20X1. Question What is the obligating event that gives rise to a liability to pay the levy? Answer The obligating event is the entity operating at the end of the annual reporting period. Before that point, the entity has no present obligation to pay a levy, even if it is economically compelled to continue to operate in the future.

The same recognition principles apply in interim and annual financial statements. Levy costs are recognised in interim financial statements if, and only if, a present obligation to pay the levy exists at the end of the interim reporting period.

The liability to pay a levy is recognised over time if the obligating event occurs over time. For example, if a levy is triggered as an entity earns revenues in a specific market in the current period, the liability is recognised in the current period as the entity earns those revenues.

Levy triggered if the entity operates as a bank at a specified date (example reproduced from IFRIC 21) Entity C has an annual reporting period that ends on 31 December. A levy is triggered only if entity C operates as a bank at the end of the annual reporting period. The amount of the levy is decided by reference to amounts in entity C’s statement of financial position at the end of the annual reporting period (say, 31 December 20X1). The liability is recognised on 31 December 20X1, because the obligating event, as identified by the legislation, is to operate as a bank at the end of the annual reporting period. Before the end of the annual reporting period, entity C has no present obligation to pay a levy, even if it is economically compelled to continue to operate as a bank in the future. The activity that triggers the payment of the levy, as identified by the legislation, is to operate as a bank at the end of the annual reporting period, which does not occur until 31 December 20X1. The conclusion would not change even if the amount of the liability is based on the length of the reporting period, because the obligating event is to operate as a bank at the end of the annual reporting period. In the interim financial report, the liability is recognised in full in the interim period in which 31 December 20X1 falls, because the liability is recognised in full on 31 December 20X1. The same recognition principles should be applied in the annual financial statements and in the interim financial report.

The same recognition principles apply in interim and annual financial statements. Levy costs are recognised in interim financial statements if, and only if, a present obligation to pay the levy exists at the end of the interim reporting period.

The liability to pay a levy is recognised over time if the obligating event occurs over time. For example, if a levy is triggered as an entity earns revenues in a specific market in the current period, the liability is recognised in the current period as the entity earns those revenues.

Levy triggered progressively as the entity generates revenues (example reproduced from IFRIC 21) Entity A has an annual reporting period that ends on 31 December. A levy is triggered progressively as entity A generates revenues in 20X1. The amount of the levy is determined by reference to revenues generated by entity A in 20X1. In this example, the liability is recognised progressively during 20X1 as the entity generates revenues, because the obligating event, as identified by the legislation, is the generation of revenues during 20X1. At any point in 20X1, entity A has a present obligation to pay a levy on revenues generated to date. Entity A has no present obligation to pay a levy that will arise from generating revenues in the future. In other words, the obligating event occurs progressively during 20X1, because the activity that triggers the payment of the levy, as identified by the legislation, occurs progressively during 20X1. In the interim financial report, entity A has a present obligation to pay the levy on revenues generated from 1 January 20X1 to the end of the interim period. As a result, the liability is recognised progressively over the interim period.

Property tax: over time Legislation requires an entity to pay a levy if it owns property. The obligating event is not specified in the legislation. Entities have a choice of settling the tax either once a year or on a monthly basis. An entity that sells the property during the year would be required to settle the tax for the period up to the sale. Question Would monthly recognition be appropriate? Answer Where the legislation does not specify the obligating event, entities will need to consider a range of factors, including for example payment terms and the impact on the obligation if the property is sold. The consideration of these factors in this case support recognition over time, even though the entity has an option to pay on an annual basis.

Recognition over time? A levy is triggered if an entity is operating at the end of the annual reporting period. The levy is calculated based on total equity in the entity’s statement of financial position at the end of the annual reporting period. The end of the entity’s annual reporting period is 31 December 20X1. The legislation also includes specific provisions for entities that cease business during the year. For those entities, the levy is calculated on a pro rata basis (for example, after six months as 0.5% of total equity, instead of 1% at the end of the year). Question Would this change the recognition pattern for all entities, even those who continue doing business throughout the year? Analysis As explained, the IC discussed a similar issue and noted that, until the specific condition is met, the pro rata reduction in the threshold does not apply. In our example, the entity cannot recognise the liability earlier than on 31 December, unless it ceases business during the year.

Where a levy is triggered once an entity reaches a specified threshold (for example, a minimum amount of revenue), a liability is not recognised until that threshold is reached. This is the case even where the calculation of the levy takes into account amounts generated before the threshold is reached.

Levy triggered if the entity generates revenue above a minimum amount Entity B has an annual reporting period that ends on 31 December. A levy is triggered if an entity generates revenue above C50 million in 20X1. The amount of the levy is calculated by reference to all revenue generated (including the first C50 million of revenue generated in 20X1). Entity B’s revenue reaches the revenue threshold of C50 million on 17 July 20X1. The liability for the payment of the levy related to the first C50 million revenue is recognised on 17 July 20X1 when the threshold is met, because the obligating event for the payment of that amount is the reaching of the threshold. The liability for the payment of the levy related to revenue generated above the threshold is recognised between 17 July 20X1 and 31 December 20X1 as the entity generates revenue above the threshold, because the obligating event is the activity undertaken after the threshold is reached. The amount of the liability is based on the revenue generated to date, including the first C50 million of revenue. In entity B’s interim financial report for 30 June 20X1, no liability for the 20X1 levy is recognised, because the threshold had not been reached by that date.

IFRIC 21 does not address whether the liability to pay a levy gives rise to an asset or an expense. Entities need to apply other standards to determine the accounting for the expense. An entity recognises an asset if it has prepaid a levy but does not yet have a present obligation to pay that levy.

Recognition of an asset under IAS 2 A manufacturing entity imports once a year the raw materials used for production. The import is subject to import duties. Question How should the entity account for these? Answer The definition of the costs to purchase inventories includes non-refundable import duties. Thus, the entity might need to recognise the liability for this levy at the obligating event, which is the date of the import; however, it should recognise the costs as part of the inventory purchased. Subsequently, this forms part of the cost of production and is released as the inventory is sold.

---

Recognition of an asset under IAS 16 Question A government imposes a tax every time a property is purchased. How should the buyer account for this levy? Answer The definition of the purchase price of property, plant and equipment includes non-refundable purchase taxes. IFRIC 21 requires recognition of a liability at the obligating event, which is the date of the transfer of the property. The buyer should recognise the levy as part of the cost of the property, and it should thus recognise the expense over the time during which the property is depreciated.

Changes in provisions

Provisions should be reviewed at the end of each reporting period and adjusted to reflect current best estimates.

Adjustments to provisions arise from three sources:

• revisions to estimated cash flows (both amount and likelihood);
• changes to present value due to the passage of time; and
• revisions of discount rates to reflect prevailing current market conditions.

In the years following the initial measurement of a provision at a present value, the present value will be restated to reflect estimated cash flows being closer to the measurement date. This unwinding of the discount relating to the passage of time should be recognised as a finance cost. The effect of revising estimates of cash flows is not part of this unwinding and should be dealt with as part of any adjustment to the previous provision.

When a provision is no longer required (e.g. if it is no longer probable that a transfer of economic benefits will be required to settle the obligation), the provision should be reversed.

Change in the degree of uncertainty associated with a provision The degree of uncertainty associated with an obligation can change over time. In some cases, an obligation will be recognised initially as a provision due to the uncertainty surrounding the amount payable. Subsequently, after negotiation with the counterparty, an exact amount may be agreed. To the extent that the agreed amount is not settled immediately, it no longer meets the definition of a provision and, therefore, should be reclassified to another appropriate category within liabilities.

Use of provisions

One of the objectives of IAS 37 is to increase the transparency of accounting for provisions and, in particular, to prevent the use of an existing provision to meet a different undisclosed obligation. Accordingly, the Standard requires a provision to be used only for expenditures for which the provision was originally recognised.

The disclosure requirements for provisions, particularly the requirement to identify movements on each class of provision, are intended to reinforce this requirement.

Other practical application of the guidance

The FAQs below illustrate how each of the specific aspects of IAS 37 is likely to apply to different types of transaction in their entirety.

When considering the FAQs below, it is also helpful to consider what would happen if the entity were to stop trading as of its balance sheet date. Would it have an obligation to incur further expenditure? This simple test often gives a very good indication of whether or not an obligation exists that arises from a past event. This is referred to in the paragraphs below as the ‘year-end’ test.

Applying the recognition criteria to litigation Litigation is often used to illustrate how to apply certain aspects of IAS 37. The litigation process can be long and the outcome is sometimes unpredictable. Information relating to the litigation cases can be sensitive. An entity might take legal action against another party or defend an action taken by a third party. Whichever position the entity is in, there will be costs associated with the litigation process (for example, lawyers’ fees and fees for expert witnesses) and finally costs (or proceeds) from either settling the action out of court or arising from the court’s decision. There might also be, for the party losing the action, an insurance claim and potential insurance recoveries if the action was covered by insurance. The entity will need to consider carefully whether there is a present obligation and a probable outflow for which provision is required. The likelihood of settlement might initially be remote, so a contingent liability is not disclosed. Once an action has been started, the outflow might become possible, requiring disclosure, and then probable, requiring a provision to be recognised. The outcome will not be determined until the final judgment has been given. Even then, there might still be uncertainties concerning whether claims against insurers will be successful. The example and paragraphs that follow consider a number of these aspects. Example – Product liability An entity sells an additive for leaded petrol engines, which allows customers to comply with new emissions requirements. Ten customers have claimed that the canisters were faulty and burst open on use, and the additive has burnt their hands. The entity is insured for such liabilities and does not expect to lose any money, even if the claims succeed. Present obligation The entity should first determine whether there is a present obligation. The past event is the sale to the customer of the potentially faulty goods. A present obligation exists if the canisters were faulty. Where the facts are unclear, the entity will determine whether it is probable that there is a present obligation, and this might entail seeking expert advice. In this example, the entity might contend that there is nothing wrong with the canisters and the customers did not follow the entity’s instruction leaflet, which clearly shows how to avoid the reported problem. If it was probable that the canisters were faulty, there is a present obligation and the entity should determine whether there is a probable outflow. Probable outflow of economic benefits Once it has been established that a present obligation exists, it is then necessary to determine whether the outflow of economic benefits is probable. This judgement is based on whether it is more likely than not that there will be an outflow of economic benefits. It might be necessary to seek an expert’s advice to make these assessments. Further information that becomes available between the balance sheet date and the date on which an entity’s financial statements are finalised should be taken into account to determine whether the outflow was probable. Reliable estimate When there is a present obligation and an outflow is probable, the next step is to decide whether the entity can estimate the possible outcomes reliably. Again, the entity might need to seek an expert’s advice. IAS 37 mentions that it is only in extremely rare cases that no reliable estimate can be made. Measurement Once it is determined that a provision should be recognised, the next question is measurement. It is helpful here to consider the simple ‘year-end’ test. If the entity stopped trading at its year end, how much would it have to pay to settle the obligation? The entity will need to consider the risk and uncertainties associated with the case. This will obviously depend on the possible outcome of the claim. For example, if the entity decided that it was going to settle out of court, it would provide for the estimated cost of settlement. Considerations relating to legal cost In our view, no liability for legal costs should be recognised until the lawyers have rendered services. Therefore, legal costs cannot be recognised where the provision for the underlying legal claim is not recognised. However, where management determines that a provision should be recognised for the underlying legal claim, it might be appropriate to include an estimate of future direct and incremental legal costs within the provision if a third party would factor future legal costs into any amount that it charged to take on the obligation. If the entity measured the provision at the amount that it expected to settle with the claimant, provision for future legal costs would not be appropriate (for example, where a claim is expected to be settled shortly after the period end). Insurance recovery A receivable for insurance recovery is recognised where it is virtually certain that it will be received if the entity settles the obligation. If the receipt is not virtually certain, a contingent asset is disclosed. An insurance recovery is typically virtually certain of receipt once it has been accepted by the insurance company. Disclosure In the entity’s financial statements, its provision for this litigation and related receivable for insurance recovery might need to be disclosed. In addition to the movement of this provision, a brief description of the nature, expected timing of settlement and indication of the uncertainties needs to be disclosed. The disclosures required might seriously prejudice the entity’s position in the litigation. In those extremely rare cases, the entity can be exempted from the above disclosure. However, it needs to disclose the general nature of the dispute and the reason why the information has not been disclosed.

Applying the recognition criteria to warranties A warranty is often provided to customers in conjunction with the sale of goods or services. The nature of the warranty can vary for different entities, industries, products or contracts. The warranty obligation can arise either through the operation of the law (contract or statute) or through an entity’s stated policies or practices. If an item sold proves to have been defective at the time of sale (usually based on evidence coming to light within a standard period), the purchaser might have the right to require the seller to rectify the defect or replace the faulty item. Such a warranty is considered to be an ‘assurance-type warranty’ that relates to the condition of the item sold at the date of sale. It is not usually considered separable from the sale of goods. These warranties are accounted for in accordance with IAS 37 if the customer does not have the option to purchase the warranty separately. A service-type warranty goes further than an assurance-type warranty by providing a customer with services in addition to the assurance that the product will function as expected. Service-type warranties are normally sold separately and are considered as a separable component of the transaction. Provision for an assurance-type warranty is recognised at the time of sale on a portfolio basis. The principles included in the example given in IAS 37 are explained below. Example 1 – Product repairs or replacement An entity sells gardening merchandise. It warrants at the time of the sale that it will make good, by repair or replacement, manufacturing defects that become apparent within one year from the date of sale. Its past experience shows that it does receive warranty claims on these products. A provision should be recognised because: ·        A contractual obligation exists. ·        The obligating event is the sale of the product. ·        The costs of repair do not relate to the entity’s future operations. ·        Past experience confirms that it is more likely than not that the obligation will result in an outflow of economic benefits. ·        A reliable estimate of the obligation can be made from the entity’s previous claims experience. The entity would typically use its experience of past claims to estimate the amount of the provision. Example 2 – Insured warranty obligation The facts are the same as in example 1, except that the entity makes a payment to a third-party insurer, which insures the risk. In the event of a claim by a customer, the entity would claim a corresponding amount from the insurer. Provision would be made for the warranty for the reasons given in example 1. The existence of the insurance arrangement does not mean that the entity can ignore the warranty obligation. The customer has recourse directly to the entity for the warranty. The entity, in turn, has a claim on the insurer, but this does not remove the entity’s obligation to its customer. The entity therefore recognises a provision for the warranty obligation. It will also consider whether or not it can recognise a recovery from its insurer. It cannot recognise a separate receivable for such claims, unless it is virtually certain that it will recover in the event that warranty claims are settled. If it is not virtually certain but is probable, the entity should disclose a contingent asset.

Applying the recognition criteria to refunds Many entities have refund policies which go beyond the customers’ rights under consumer law. A number of retailers, for example, give cash refunds for products returned, whether or not they are defective, whereas others make cash refunds even where the customer does not have the receipt showing when the goods were purchased. These policies might have been applied in such a way and for so long that customers expect that they will continue. IAS 37 includes an example which considers how such refund policies should be dealt with: Example 1 – Refund obligations based on past practice A retail entity has a policy of refunding purchases by dissatisfied customers, even where it is under no legal obligation to do so. It has adopted this policy for a number of years, and the policy is well known to its customers. The entity should recognise a provision because: ·        It has a present constructive obligation. ·        The obligating event is the sale of the goods, which has raised a valid expectation on the part of its customers from which the entity cannot realistically withdraw. ·        The obligation does not relate to costs of future operations. ·        Past experience confirms that it is more likely than not that the obligation will result in an outflow of economic benefits. ·        A reliable estimate of the obligation can be made on the basis of past refunds. An entity might sometimes be required to recall faulty goods. The example below considers the implications where goods sold prior to the period end are recalled after the period end. Example 2 – Product recalls A retailer has to make a product recall on goods sold before its year end, because the goods have subsequently been found to be faulty. The recall notice was issued after the year end. Costs of the recall can be recovered from the entity’s supplier under the retailer’s supply contract. Does the retailer need to make a provision at the year-end for the recall costs? Provision for the costs of the recall should be made at the year-end. The obligating event was the sale of the faulty goods, and not the recall notice. At the balance sheet date, the entity has an obligation to recall the faulty goods, there is a probable outflow and the obligation can be measured reliably. How should the retailer account for the recovery from the supplier? Recovery of the costs from the supplier can only be recorded if it is virtually certain that the costs will be recovered in the event that the recall expenditure is incurred. If it is not virtually certain (for example, if there was some doubt as to the legal enforceability of the recovery or the ability of the supplier to pay), but is probable, the recovery of the costs is disclosed as a contingent asset.

Applying the recognition criteria to major repairs and maintenance in different situations Often, entities incur major repairs and maintenance to their own assets or leased assets under IFRS 16. Do they need to recognise a provision for such expenses? This is considered in the following examples. Owned assets It is highly unlikely that provision would ever be made for repairs and maintenance on owned assets, because it would not meet the recognition criteria in paragraph 14 of IAS 37. Entities have discretion over whether to incur the expenditure. It could avoid the expenditure, for example, by selling the asset. However, when an item of property, plant and equipment (‘PPE’) requires regular replacement or overhaul, the overhaul component should be depreciated over the remaining period to the next overhaul date. Example 1 – Overhaul of PPE An entity has a blast furnace, for which the lining needs to be replaced every five years. No provision can be made for replacement of the furnace lining before the entity incurs the expenditure; until that time, the entity has no present obligation, because it does not have to replace the lining. For example, it could avoid the obligation by shutting the blast furnace. No provision is made before the expenditure is incurred, but the blast furnace lining should be separately identified and depreciated over the period between replacements. When the expenditure is incurred to replace the lining, this will be capitalised as part of the cost of the furnace and depreciated over the period until it is next replaced. The cost and depreciation attributed to the original blast furnace lining should be removed once the cost of the new blast furnace lining has been capitalised. Maintenance expenditure in respect of owned assets cannot be provided in advance of being incurred, even if there is an external requirement for maintenance of those assets. This is illustrated in the following example. Example 2 – Covenants requiring maintenance An entity has purchased some assets outright and borrowed from a bank to do so. The bank covenants include conditions that the entity should maintain the assets in good condition. Should the entity provide for maintenance on the owned assets because of the maintenance covenant? Where an owned fixed asset is used as security for a loan, and the covenants require the asset to be maintained, there is no penalty as such in respect of non-maintenance. Of course, if the covenant is broken in any way, the bank could call its loan. The purpose of such a term is to ensure that the bank has sufficient security in case of default. A failure to maintain an asset used for secured lending might trigger a repayment of the lending, which has already been recognised as a liability. It does not trigger a claim for compensation for the maintenance work. Because the entity can avoid the maintenance by repaying the loan, the entity does not have a present obligation. No provision should be recognised in this situation. Leased assets Maintenance requirements can also arise for leased assets and might be required as part of the lease terms. Example 3 – Overhaul costs for leased assets An entity leases a ship for 25 years. It has to obtain a certificate of seaworthiness, which entails the entity carrying out significant maintenance and overhaul work in a dry dock every five years. Without such a certificate, the ship cannot operate. The ship cannot continue to operate without a certificate of seaworthiness, but this in itself does not obligate the entity to carry out the maintenance. It could, for example, decide to lay up the ship and not use it. The entity would consider the terms of the lease to determine whether there is anything that creates a contractual obligation. Where no obligation is created by the lease, there is no present obligation. No provision should be made until there is an obligation for an overhaul. When the overhaul is actually carried out, the costs will be capitalised as part of the right-of-use asset (under IFRS 16) and depreciated over the period until the next overhaul.

Applying the recognition criteria to lease dilapidation Many property leases include tenant repairing clauses for dilapidations. These clauses typically require the tenant to return the property to the landlord at the end of the tenancy in a specified condition. Should a provision be made for the costs of repairing dilapidations over the tenancy period, or should these costs be expensed when the repairing work is undertaken? The following example illustrates the issues. Example – Repairs required under property lease terms The entity is currently a tenant of a leased property and is due to vacate it in five years’ time. There is a clause in the tenancy agreement relating to work that must be undertaken before the property is vacated. There is also a clause that enables the landlord to recharge the tenant for costs related to repairing the building. Provision should be made for the estimated costs of the repairs over the period of the tenancy, because: ·        The tenant has a present contractual obligation, arising from the lease agreement. ·        The obligating event is the wear and tear to the property, which arises over the period of the tenancy. ·        The obligation arises from the wear and tear to the property, and is not related to future operating costs. ·        It is probable that the obligation will result in an outflow of economic benefits. ·        It is possible to make a reliable estimate of the obligation arising from the wear and tear. ·        It should be clear from the lease whether or not an obligation exists. ·        A provision should be recognised when any damage is identified.

Applying the recognition criteria to leasehold improvements Some leases allow the tenant to improve the property by adding, for example, additional partitioning, but include obligations on the lessee to return the property at the end of the lease in its original state. This might entail dismantling the improvements. Example – Returning property to its condition at lease inception An entity has entered into a lease for a warehouse. It wishes to use the warehouse for office accommodation. The lease permits the entity to build a mezzanine floor and partition the building for offices at a cost of C1.5 million. The lease is for a period of 15 years and specifies that the property must be returned to the lessor in its original condition. The entity estimates that the present value of the cost of removing the improvements is C500,000. The entity should capitalise leasehold improvements of C1.5 million and amortise them over the term of the lease under IAS 16. The entity has a present obligation under the lease to remove the improvements at the end of the lease term. The obligation arises when the entity completes the improvements, which is the past event. The present value of C500,000 should be recognised when the improvements are completed. The same amount should be recognised as part of the right-of-use asset under IFRS 16.

Applying the recognition criteria to abandonment and decommissioning costs Abandonment is the term used to describe: the plugging and abandonment of wells; the dismantlement of wellheads, production and transportation facilities; and restoration of producing areas in accordance with the licence requirements and the relevant legislation. These activities normally commence at the date when the facility ceases to produce, treat, transport or store saleable quantities of oil or gas. Similar costs are incurred in other industries, such as: decommissioning costs in the electricity and nuclear industries; abandonment costs in the mining and other extractive industries; clean-up and restoration costs of landfill sites; and environmental clean-up costs in other industries. Does the liability arise in the future when the asset is constructed or developed gradually over a period? The creation of the asset typically results in a present obligation to incur abandonment and decommissioning costs. IAS 37 includes an example of how the rules apply, and this example is explained below. Example 1 – Decommissioning oil rigs and repairing environmental damage An entity operates an oil field in the North Sea. Its operating licence requires it to remove the oil rig at the end of its production life and to restore the seabed. 90% of the costs of undertaking this work arise from the installation of the rig. A further 10% of the costs arise through the extraction of oil. The rig has been constructed at the balance sheet date, but no oil has been extracted. A provision should be made for 90% of the costs of abandoning the rig, because: ·        A present legal obligation exists because of the operating licence. ·        The obligating event is installing the rig, which has caused the damage. ·        The costs do not relate to the entity’s future operations; even if the rig is no longer operated after the balance sheet date, the costs would still have to be incurred. ·        The obligation will result in an outflow of economic benefits. ·        It is possible to make a reliable estimate of the costs. The costs are treated as part of the cost of the oil rig to be depreciated over the production life of the rig. There is no obligation to rectify the damage that will be caused by the extraction of the oil, until that oil is extracted. Provision for these costs will be recognised as the damage is caused (that is, as the oil is extracted). How should subsequent remeasurement of the provision be accounted for? Example 2 – How would a change in provisions affect the related assets from the decommissioning obligation? An entity has constructed a nuclear facility for C100 million. It expects that the plant will run for the next 30 years. It has estimated, using existing technology, that the cost of decommissioning the plant will be C200 million following the end of plant operation and C100 million in 50 years’ time in today’s currency. For simplicity of this example, it has been assumed that the obligation arises on day 1 and decommissioning cost will take place at the end of year 30 and year 50. It has also been assumed that the risk-free rate for cash flow in year 30 and year 50 is 4.5% and it does not change throughout out the years. Risk-free rate Cash flow of C200 million at year 30 Cash flow of C100 million at year 50 Total present value Present value at day 1 4.50% 53.40 11.07 64.47 Present value at end of year 10 82.93 17.19 100.12 Present value at end of year 30 200.00 41.46 241.46 Present value at end of year 50 – 100.00 100.00 The net present value of the decommissioning obligation is C64,470,000, using a discount rate of 4.5%. The facility should be recorded at its original cost of C100 million, together with the initial cost of the obligation of C64,470,000 – giving a total cost of C164,470,000. This amount should then be amortised over the 30-year operating life of the facility, giving an annual amortisation charge using the straight-line method of C5,480,000 (of which C2,150,000 per annum relates to the capitalised obligation). The increase in the obligation over the years arises solely from the unwinding of the discount. The effect is relatively small in the early years (for example, at the end of year 1, C2,900,000 is added to the obligation, but the discount effect is back-end loaded and, in the 30th year, the obligation increases by C10,400,000. The unwinding of the discount appears as a borrowing cost, whilst the benefits of the asset and the depreciation appear in operating profit. There is a mismatch between the useful life of the facility and the period before the decommissioning will take place. After payment of C200 million, the obligation will be C41,460,000 at the end of year 30, which is the end of the useful life of the facility. In years 31 to 50, the discount for the provision is unwound at the risk-free rate as a borrowing cost until the obligation crystallises at the end of year 50. This means that the entity will recognise C58,540,000 (that is, C100 million less C41,460.000) of borrowing cost in years 31 to 50. Several assumptions are required to estimate the decommissioning cost. These assumptions will be reassessed each period until the asset is decommissioned. Management will consider, for example, developments in decommissioning technology. Although there is no specific guidance in IAS 37, IFRIC 1 requires changes in the estimated cost of decommissioning or changes in the discount rate to be added to or deducted from the cost of the asset and to be depreciated prospectively over its remaining useful life. This method is consistent with the treatment of similar changes to estimates in IAS 16. Any amount deducted from the cost of the asset must not exceed the asset’s carrying amount. Any excess should be recognised immediately in the income statement. Management will need to consider whether any increase in the asset might be recoverable, in which case an impairment test will be performed. Assume the facts (including discount rate) are the same as in example 2. At the end of year 10, the obligation is C100,120,000. The carrying value of the asset is C109,650,000 (accumulated amortisation of C54,820,000 having been charged, of which C21,490,000 relates to the decommissioning element of the asset). Researchers have found a new way of decommissioning. It is believed that this new method, which is far safer and less labour intensive, will cost C175 million at end of year 30 and another C50 million at end of year 45. The net present value of the obligation should be reduced from C100,120,000 to C83,280,000 (representing the present value of C175 million in 30 years’ time and C50 million in 45 years’ time at a discount rate of 4.5%). The double entry is: Dr Balance sheet provision                         C16,840,000 Cr Fixed asset                                                                               C16,840,000   The revised book value of the asset will be C92,810,000, to be depreciated straight line over the remaining 20-year useful life of the asset. Whether the asset is held at cost or revalued once the asset has reached the end of its useful life, all changes to the estimated liability should be recognised in profit or loss in the period of the change.

Applying the recognition criteria to environmental liabilities Environmental damage can occur in a number of ways, including contamination of land, pollution of rivers and waterways, emission of harmful gases into the atmosphere, and excavating holes and drilling in the ground. Some aspects of environmental damage are controlled by legislation, whereas others are not. A present obligation can arise either from legislation (where damage that is controlled by legislation is caused) or from a constructive obligation (where an entity makes a statement that it will rectify damage or creates an obligation through an established practice of rectifying the damage). Some obligating events can occur over a period of time (for example, where damage is caused by the extraction of oil and gas). This is in addition to the obligating event that might arise when an oil rig is first built. IAS 37 covers these issues in a number of examples, which are explored below. Example 1 – Environmental legislation due to be enacted An oil company causes contamination, which it will clean up only when compelled to do so by law. No legislation currently exists that requires remediation but, at the entity’s year end, it is virtually certain that a draft law requiring clean-up will be enacted. The entity should recognise a provision, because: ·        There is a legal obligation, as it is virtually certain that the legislation will be enacted. ·        The obligating event is the contamination of the land. ·        The related costs do not form part of the entity’s future operations. ·        It is more likely than not that the obligation will result in an outflow of economic benefits. ·        It will be possible to make a reliable estimate of the obligation. If, at the balance sheet date, the draft legislation was not virtually certain to be enacted, no provision would be made, but the potential change in the law would be disclosed. Example 2 – Published environmental policy The facts are similar to example 1, except that there is no planned environmental legislation, but the entity has a published environmental policy under which it undertakes to clean up all contamination that it causes. The entity has a record of honouring its published policy. The entity should recognise a provision, because: ·        It has a present constructive obligation that arises from its commitment to the public at large by the publication of its environmental policies. ·        It has raised a valid expectation that it will incur clean-up costs from which it cannot realistically withdraw. ·        The obligating event is the contamination of the land. ·        The related costs do not form part of the entity’s future operations. ·        It is more likely than not that the obligation will result in an outflow of economic benefits. ·        It will be possible to make a reliable estimate of the obligation. Example 3 – Legislation in respect of future activity A new law has been passed that requires smoke filters (that will not be capitalised by the entity) to be fitted to factories by the middle of the entity’s next year. The entity has not yet fitted the smoke filters. The legislation has not yet come into operation, so there is no present legal obligation for the entity to fit the filters. The entity’s management has done nothing to suggest that a constructive obligation exists. Consequently, no provision should be made. Example 4 – Legislation in force The facts are the same as in example 3, except that the entity is now in the subsequent year and the law is effective, but the entity still has not fitted the filters. The entity should not make a provision for the cost of fitting the filters (assuming that the smoke filters will not be capitalised). Even though it might appear that there is a present obligation, as the law compelling the filters to be fitted is now operational, no obligation arises for the cost of fitting the filters, because no obligating event has taken place (that is, the filters have not yet been fitted). However, a provision might still be necessary for the cost of paying fines, because: ·        There is present obligation for the penalties that the entity will incur for not complying with the legislation. ·        The obligating event is the failure to comply with the law. ·        The fines do not relate to future operations. ·        It is more likely than not that the obligation will result in an outflow of economic benefits, based on an assessment of factors such as the stringency of the enforcement regime. ·        It is possible to make a reliable estimate of the fines, based on factors such as whether the rates have been published. Example 5 – Legislation in force in respect of past contamination Health and safety legislation have been introduced that requires asbestos to be removed from all buildings. Where its existence is known, asbestos removal is required, whether the property is in use or operations have ceased. The legislation is effective from 31 December 20X2. Entity A owns a 20-year-old factory and has confirmed that it contains asbestos. The estimated cost of removing the asbestos is C70,000, plus a further C30,000 in lost profits because the factory will not be able to operate at full capacity while the asbestos is being removed. At 31 December 20X2, work has not begun on asbestos removal; however, contracts have been signed with contractors for the work to be performed in the first few months of 20X3. The health and safety legislation has been enacted, and so there is a requirement to remove the asbestos. The obligating (past) event is the contamination caused by the presence of the asbestos. The legal requirement to remove it creates an obligation. So, entity A should recognise a provision for C70,000, being the direct cost of removing the asbestos. No provision should be made for the operating losses that will be incurred during the period of asbestos removal, because there is no obligation to incur these losses. The existence of signed contracts does not affect the conclusion of whether to provide for the costs. The contracts are executory contracts, so no liability to the contractor arises until the contractor performs work under the contract. The introduction of the new law does not create the obligating event on its own. It is the combination of the past contamination and the new law that creates the obligation to remove the asbestos. This can be contrasted with the smoke filters (in example 4 above), where there is no past contamination, and so the obligation created when the legislation comes into force is only for penalties and fines.

Applying the recognition criteria to emissions obligations Many jurisdictions have introduced cap and trade schemes to encourage a reduction in greenhouse gas emissions. The schemes generally involve the allocation of a limited number of allowances at the start of a compliance period and require entities to have sufficient allowances at the end of the compliance period to cover the volume of emissions made. Some schemes permit entities to purchase additional allowances (on top of their free allocation) or to sell any surplus allowances generated from reducing their emissions. The emission of greenhouse gases creates an obligation to deliver allowances. Entities recognise a liability (and related expense) in respect of this obligation to the extent of emissions made as at the balance sheet date. There are a number of accounting models that can be used for accounting for participation in these schemes. The liability’s measurement will depend on the accounting model used. One model is the IFRIC 3 model, which dealt with the accounting for a ‘cap and trade’ emissions rights scheme. It required entities to account for the emissions allowances that they received from governments as intangible assets, recorded initially at fair value. Where allowances are issued for less than fair value, the difference between the amount paid and the fair value is treated as a government grant and accounted for under IAS 20. The grant is initially recognised as deferred income in the balance sheet and subsequently taken to income on a systematic basis over the compliance period for which the allowances were issued, regardless of whether the allowances are held or sold. A liability is recognised for the obligation to deliver allowances equal to emissions that have been made. The liability is measured at the best estimate of the expenditure required to settle the present obligation at the balance sheet date (usually, the market price of the number of allowances required to cover emissions made up to the balance sheet date). IFRIC 3 was withdrawn by the IASB in June 2005, but it remains a valid interpretation of existing IFRS. However, other accounting models are acceptable. Three acceptable accounting models for emissions schemes are summarised in the table below (note: this summary does not deal with the accounting for emissions allowances by broker/traders). Acceptable accounting models for emissions accounting ‘Full market value’ approach (IFRIC 3) ‘Cost of settlement’ approach ‘Initial market value’ ‘Nominal amount’ Allowances (asset) When to recognise Recognise when able to exercise control. Recognise when able to exercise control. Recognise when able to exercise control. How much to recognise Measure initially at market value at the date of initial recognition. Measure initially at market value at the date of initial recognition. Measure initially and subsequently at cost which, for allowances awarded, is a nominal amount (usually nil). Measure subsequently based on either: (i) the amount initially recognised (cost model); or (ii) the revalued amount (revaluation model). Measure subsequently based on either: (i) the amount initially recognised (cost model); or (ii) the revalued amount (revaluation model).   Government grant When to recognise Recognise at the same time as allowances. Recognise at the same time as allowances. Recognise at the same time as allowances. How to recognise Measure initially based on the market value of the allowances at the date of initial recognition. Amortise over the compliance period on a systematic and rational basis. Measure initially based on the market value of the allowances at the date of initial recognition. Amortise over the compliance period on a systematic and rational basis. Measure initially and subsequently at a nominal amount (usually nil). Emissions obligations (liability) When to recognise Recognise when the liability is incurred. Recognise when the liability is incurred. Recognise when the liability is incurred. How to recognise Remeasure the liability based on the market value of allowances at each period end (or a value based on a forward rate), whether they are to be settled using the allowances on hand or purchased from the market. Remeasure the liability at each period end. The liability to be settled using allowances on hand is measured at the carrying amount of those allowances; any excess emission is measured at the market value of allowances at the period end (or a value based on a forward rate). Remeasure the liability at each period end. The liability to be settled using allowances on hand is measured at the carrying amount of those allowances, which is usually nil; any excess emission is measured at the market value of allowances at the period end (or a value based on a forward rate). The intangible assets recognised are not amortised, provided residual value is at least equal to carrying value. Emissions allowances recognised as an asset should be tested for impairment where there are indicators of impairment, in accordance with the requirements of IAS 36. Where an entity records some or all of its emissions obligations at market value, it should ordinarily calculate its provision using the market price of the relevant allowances that it will need to purchase. However, to the extent that the entity has entered into a forward contract to buy allowances at a fixed price on a future date, it is permissible to provide at the forward contracted rate (rather than the market rate), because this is the best estimate of the amount that the entity expects to pay to settle its obligation. Using the forward rate is not appropriate where the entity trades in these emission allowance. Once the entity commences trading, these instruments fall outside the ‘own use exemption’ in IAS 39. The forward contracts will be within IAS 39’s scope and are required to be measured at fair value. Any provision based on the market rate could alternatively be based on a forward rate, provided the entity meets the ‘own use exemption’ in IFRS 9 with respect to its emissions allowances forward contracts. The accounting policy chosen for emissions obligations (which should be consistently applied) will depend on the overall accounting model that is being used for emissions (including allowances). Entities should make clear in their accounting policy note which approach is applied. The ‘full market value’ approach (that is, the method set out in IFRIC 3) is illustrated in the following example. Example – Emissions accounting An entity participates in a ‘cap and trade’ scheme for emissions rights; on 1 January 20X6, it is allocated, free of charge, allowances to emit 10,000 tonnes of carbon dioxide during the calendar year 20X6, which is also its financial accounting period. The market price of an allowance (equivalent to one tonne of carbon dioxide) at 1 January 20X6 is C10, giving a fair value of C100,000. At 30 June 20X6, the entity has emitted 6,000 tonnes of carbon dioxide and expects its emissions for the full year to be 12,500 tonnes. The market price for allowances has risen to C11 (per tonne). At the year-end, the entity has emitted the expected 12,500 tonnes and the market price of allowances is C12 (per tonne). How should the entity account for the scheme under the method set out in IFRIC 3 (the ‘full market value’ approach), assuming that the entity uses the revaluation model in IAS 38 to measure the intangible asset at fair value after its initial recognition? The entity would record the initial receipt of allowances at the fair value of C100,000, setting up an intangible asset for this amount and recording a government grant as deferred income for the same amount. At 30 June 20X6, the entity would record a liability for the emissions to date of C66,000 (6,000 tonnes at C11 per tonne). The asset of C100,000 is revalued to C110,000 (10,000 tonnes at C11 per tonne). The deferred income is released in the proportion that emissions to date bear to total emissions expected for the year – that is, C100,000 × 6,000/12,500 = C48,000. The profit or loss to 30 June 20X6, therefore, reflects deferred income released of C48,000 less the accrued emissions liability expense of C66,000, giving a net charge to profit or loss of C18,000 for the period. The revaluation surplus of C10,000 on the intangible asset is reported in other comprehensive income. At 31 December 20X6 (and ignoring the 30 June 20X6 entries), the entity records a liability for emissions of C150,000 (12,500 tonnes at C12 per tonne). The asset is revalued to C120,000 (10,000 tonnes at C12 per tonne). All of the deferred income of C100,000 is released. The effect on profit or loss for the full year is to record a liability of C150,000 (based on the market price of allowances at the balance sheet date) in respect of the emissions obligation and to release deferred income of C100,000. The revaluation surplus of C20,000 is reported in other comprehensive income. There is a net charge to profit or loss of C50,000. Taken together with the revaluation surplus in other comprehensive income of C20,000, the net figure of C30,000 represents the cost to the entity of excess emissions of 2,500 tonnes (over the free allowances granted) multiplied by the market price at the year-end of C12 per tonne. If the cost model in IAS 38 had been used for the intangible asset, and the asset had been measured after its initial recognition at cost less amortisation and/or impairment (cost being fair value on initial recognition for this purpose), there would be no revaluation surplus of C20,000 at the year-end and the intangible asset would be stated at C100,000. Because part of the liability of C150,000 would be settled by using allowances stated at C100,000 (but worth C120,000), the entity would need to pay C30,000. The remaining balance of the liability of C20,000 would be released to the income statement when settlement occurs. So, the net charge in profit or loss would be C30,000. Again, this represents the cost of the excess emissions of 2,500 tonnes multiplied by C12 per tonne. Therefore, the overall net effect on total comprehensive income would be the same (C30,000 loss), whether the cost model or the revaluation model in IAS 38 is adopted. But there would be a timing difference because, under the cost model, the gain (C20,000) on release of the liability would only be recognised when the liability is settled, which would be after the year end. Entities using the ‘cost of settlement’ approach only measure the obligation at the current (that is, balance sheet date) market price of allowances to the extent that emissions made to date exceed the volume of allowances held. If emissions do not exceed allowances held, there is no obligation to purchase additional allowances and therefore no liability. In the example above, the allowances would be initially recognised at nil cost and the liability would be measured at 10,000 × nil (for allowances held by the entity) + 2,500 × C12 (for allowances to be purchased on the market), giving a total liability at the year-end of C30,000 (rather than C150,000 under the ‘full market value’ approach). There is an additional consideration for entities using the ‘cost of settlement’ approach, because the measurement of the obligation for which allowances are held will depend on whether the carrying amount of allowances is allocated to the obligation on a FIFO or on a weighted average basis. This is a particular issue where a balance sheet date is not the end of a compliance period – for example, at an interim balance sheet date (where the financial year is the same as the compliance period) or at a financial year end (where the financial year is not the same as the compliance period). Entities using the FIFO method measure the obligation at the carrying amount per unit of emissions, up to the number of allowances (if any) held at the balance sheet date and at the expected cost (that is, the market price at the balance sheet date) per unit for the shortfall (if any) at the balance sheet date. Entities using the weighted average method measure the obligation using the weighted average cost per unit of emissions expected to be incurred for the compliance period as a whole. To do this, the entity determines the expected total emissions for the compliance period and compares this with the number of allowance units granted by the government (and/or purchased) and still held by the entity for that compliance period, to determine the expected shortfall (if any) in allowances held for the compliance period. The weighted average cost per unit of emissions for the compliance period is the carrying amount of the allowances held (which might be nil for those granted for nil consideration) plus the cost of meeting the expected shortfall (using the market price at the balance sheet date), divided by the expected total number of units of emissions for the compliance period. In other words: Carrying amount of allowances held + Cost of meeting expected shortfall = Weighted average cost per unit of emissions for the compliance period Expected total units of emissions for the compliance period The weighted average method is consistent with the approach to measuring items at an interim date (listed in IAS 34), such as tax, bonuses and volume rebates. The principle under this approach is that, where an entity has an obligation, whose effective rateable measurement is determined by reference to a full period’s activities, measurement is made on the basis of the volume of activity giving rise to the obligation up to the interim date at the expected effective rate for the period (determined on the basis of expected activity for the full year). This principle can be rationalised on the basis that there is a presumption that the entity will continue operating and that the best estimate of the amount that the entity expects to pay should recognise this, as well as the fact that settlement can, in reality, only be for a specified period which straddles the interim period.

Applying the recognition criteria to self-insurance An entity might take out insurance to cover potential future losses. The cost is accounted for, based on the nature of the insurance premium. An entity might decide to self-insure rather than take out an insurance contract with a third party. An entity that self-insures some of its risks makes provision for claims in respect of events that occurred before the balance sheet date, even if those claims are reported after the year end. The entity should take into account any additional evidence that comes to light after the balance sheet date, to determine which obligating events have occurred by the balance sheet date. The entity also makes provision for an estimate of expected claims that have been incurred before the balance sheet date but are still not yet reported (known as ‘IBNR claims’). Example 1 – Self-insurance An entity that operates a chain of retail outlets decides not to insure itself with a third party for the risk of minor accidents to customers. Instead, it self-insures. Its past experience suggests that it will pay C200,000 on average per annum in respect of such accidents. An obligation to another party does not arise until an accident occurs. Therefore, if no accidents have occurred at the year-end, there is no present obligation and no provision should be made. Where an accident has happened, the retailer might not know of its occurrence, but should still be making a provision. The retailer should estimate (probably actuarially) the level of accidents that have occurred but which have not yet been reported (that is, IBNR claims by customers) and make a provision for its estimate of the obligation. During the period between the entity’s year end and the date on which its financial statements are finalised, a number of IBNR claims might have surfaced, so that a better estimate for these claims can be made. In summary: The entity has a legal obligation, which its past experience shows is likely to have arisen by the balance sheet date. The obligating event is the accident. The costs do not relate to future operations. The outflow of economic benefits is probable. A reliable estimate can be made based on the evidence of past claims experience. This approach is not the same as building up a reserve for insurance claims, and will mean that the expenses of different periods might vary, depending on the number of accidents that occur. This is different from the more constant expense that would arise if the entity’s policy had been to insure these risks with an insurance company. This variability in expense is a consequence of the entity’s exposure to risk.