ACCA DipIFR question papers and answers on IAS 37 from June 2014

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ACCA DipIFR question papers and answers on IAS 37 from June 2014

All questions on IAS 37 Provisions which have appeared in ACCA DipIFR from June 2014 have been indexed here. The answers are based on the standards prevalent at the exam point in time.

This is a topic which has come in almost every second exam and is a hot favourite with the examiners.

For the benefit of the readers, we have put the following sequentially to help them understand better

  • Question - Relevant portion of the exam pertaining to the standard has been recreated
  • Answer - Answers as shared by the ACCA Examination team which was required for the question
  • Examiners Feedback - Feedback on answers given by the students for that exam, this is a critical part of learning as students can learn from mistakes which other students did

Question

Delta is an entity which prepares financial statements to 30 September each year. Each year the financial statements are authorised for issue on 30 November. During the year ended 30 September 2014, the following transactions occurred:

On 15 May 2014, Delta was notified that a customer (Chi) was taking legal action against Delta in respect of financial losses incurred by Chi. Chi alleged that the financial losses were caused due to the supply by Delta of faulty products on 30 November 2013. Delta defended the case but considered, based on the progress of the case up to 30 September 2014, that there was a 75% probability they would have to pay damages of $20 million to the customer. The case was ultimately settled by Delta paying damages of $18 million to Chi on 15 November 2014.

Explain and show (where possible by quantifying amounts) how this event would be accounted for in the financial statements of Delta for the year ended 30 September 2014.

Answer

The potential payment of damages to Chi is an obligation arising out of a past event which can be reliably estimated. Therefore, following IAS 37 – Provisions, Contingent Liabilities and Contingent Assets – a provision is required.

The provision should be for the best estimate of the expenditure required to settle the obligation at 30 September 2014.

Under the principles of IAS 10 – Events After the Reporting Period – evidence of the settlement amount is an adjusting event.

Therefore at 30 September 2014 a provision of $18 million should be recognised as a current liability.

Examiners feedback

n part (c), whilst the vast majority of candidates realised a provision was required for the damages payable to Chi (the plaintiff), a number of candidates incorrectly stated that the payment of damages was a non-adjusting event. A significant number of candidates, whilst correctly stating that a liability existed, referred to this liability as a ‘contingent liability’, indicating a lack of understanding of the meaning of the term ‘contingent liability’.

Question

Delta is an entity which prepares financial statements to 31 March each year. Each year the financial statements are authorised for issue on 20 May. The following events are relevant to the year ended 31 March 2016:

On 1 August 2015, Delta supplied some products it had manufactured to customer C. The products were faulty and on 1 October 2015 C commenced legal action against Delta claiming damages in respect of losses due to the supply of the faulty products. Upon investigating the matter, Delta discovered that the products were faulty due to defective raw materials supplied to Delta by supplier S. Therefore on 1 December 2015, Delta commenced legal action against S claiming damages in respect of the supply of defective materials. Since that date Delta has consistently estimated that it is probable that both of the legal actions, the action of C against Delta and the action of Delta against S, will succeed.

On 1 October 2015, Delta estimated that the damages Delta would have to pay to C would be $5 million. This estimate was updated to $5·2 million as at 31 March 2016 and $5·25 million as at 15 May 2016. This case was eventually settled on 1 June 2016, when Delta was required to pay damages of $5·3 million to C.

On 1 December 2015, Delta estimated that they would receive damages of $3·5 million from S. This estimate was updated to $3·6 million as at 31 March 2016 and $3·7 million as at 15 May 2016. This case was eventually settled on 1 June 2016, when S was required to pay damages of $3·75 million to Delta.

 Answer

The potential liability to pay damages to C needs to be recognised as a provision because the event giving rise to the potential liability (the supply of faulty products) arose prior to 31 March 2016, there is a probable transfer of economic benefits and a reliable estimate can be made of the amount of the probable transfer.

The amount recognised should be the best estimate of the amount required to settle the obligation at the reporting date. In this case, this estimate is the one made on 15 May – just before the financial statements are authorised for issue. Therefore a provision of $5·25 million should be recognised as a current liability. There should also be a charge of $5·25 million to profit or loss.

The potential amount receivable from S is a contingent asset as it arose from an event prior to the year end but at the date the financial statements are authorised for issue, the ultimate outcome is uncertain.

Contingent assets are not recognised as assets in the statement of financial position. Their existence and estimated financial effect is disclosed where the future receipt of economic benefits is probable. This is the situation here.

Feedback

Candidates were required to consider the potential liability to pay damages on the claim from customer and the contingent assets to be recognised as assets (potential amount receivable) in the statement of financial position. This was a popular question and many candidates correctly classified a claim to S as contingent asset stating that estimated financial effect is disclosed where the future receipt of economic benefits is probable. But not all of them noted that it was to be included into the disclosure to the Financial Statements.

Many candidates correctly identified the adjusting event but some incorrectly stated the amount recognized as the best estimate of the amount required to settle the obligation. This should be the estimate made just before the financial statements are authorised for issue.
The knowledge of IFRS(IAS) 37
- Provisions, Contingent Liabilities and Contingent Assets, and IFRS (IAS) 10 - Events after the Balance Sheet Date – was a prerequisite in answering this part of the question. There were many candidates who mixed up contingent liabilities with provisions.

Most part of the candidates mentioned “provision” without any clarification that this is a liability as opposed to part of equity. Those who simply mentioned that “provision should be created” lost valuable marks for relevant explanation.

Question 

Delta prepares its financial statements to 30 September each year. The financial statements for the year ended 30 September 2017 are shortly to be authorised for issue. The following events are relevant to these financial statements:

On 1 April 2017, Delta completed the construction of a power generating facility. The total construction cost was $20 million. The facility was capable of being used from 1 April 2017 but Delta did not bring the facility into use until 1 July 2017. The estimated useful life of the facility at 1 April 2017 was 40 years.

Under legal regulations in the jurisdiction in which Delta operates, there are no requirements to restore the land on which power generating facilities stand to its original state at the end of the useful life of the facility. However, Delta has a reputation for conducting its business in an environmentally friendly way and has previously chosen to restore similar land even in the absence of such legal requirements. The directors of Delta estimated that the cost of restoring the land in 40 years’ time (based on prices prevailing at that time) would be $10 million. A relevant annual discount rate to use in any discounting calculations is 5%. When the annual discount rate is 5%, the present value of $1 receivable in 40 years’ time is approximately 14·2 cents.

 Answer 

The facility is depreciated from the date it is ready for use, rather than when it actually starts being used. In this case, then, the facility is depreciated from 1 April 2017.
Although Delta has no legal obligation to restore the piece of land, it does have a
constructive obligation, based on its past practice and policies.
The amount of the obligation will be
1,420, being the present value of the anticipated future restoration expenditure (10,000 x 0·142).

This will be recognised as a provision under non-current liabilities in the statement of financial position of Delta at 30 September 2017.

As time passes the discounted amount unwinds. The unwinding of the discount for the year ended 30 September 2017 will be 35·5 (1,420 x 5% x 6/12).

The unwinding of the discount will be shown as a finance cost in the statement of profit or loss and the closing provision will be 1,455·5 (1,420 + 35·5).

The initial amount of the provision is included in the carrying amount of the non-current asset, which becomes 21,420 (20,000 + 1,420).

The depreciation charge in profit or loss for the year ended 30 September 2017 is 267·75 (21,420 x 1/40 x 6/12).

The closing balance included in non-current assets will be 21,152·25 (21,420 – 267·75).

 Feedback

The issue of failure to back up computational work with supporting explanations was less evident in part (b) of question 2. That said, a number of candidates lost marks by failing to explain why Delta had a constructive obligation to decommission the power generating facility at the end of its useful life. Similarly, not all candidates explained why depreciation of the facility was required from 1st April 2017 rather than 1st July 2017. Other errors made in part (b) by a significant minority of candidates were:

  • 􏰀  Showing the corresponding debit entry to the credit for the provision as a cost in the statement of profit or loss rather than including it as part of the cost of the power generating facility in non-current assets.

  • 􏰀  Depreciating the facility from 1st July 2017 (when it was brought into use), rather than 1st April 2017 (when it was available for use – as required by IAS 16 – Property, Plant and Equipment.

 

Question

You are the financial controller of Omega, a listed entity which prepares consolidated financial statements in accordance with International Financial Reporting Standards (IFRS® Standards). The financial statements for the year ended 30 September 2018 are due to be published shortly. A trainee accountant who is assigned to your department is reviewing the financial statements as part of a training exercise. She has prepared a list of queries arising out of this review.

One of the notes to the financial statements refers to a legal claim made against Omega by Customer X. This relates to losses incurred by Customer X due to Omega supplying this customer with a faulty product. Further investigation revealed that the fault was due to one of Omega’s suppliers, Supplier Y, supplying Omega with a faulty component. This component was used to manufacture the product supplied to Customer X. Therefore Omega made a legal claim against Supplier Y in respect of that faulty component. The note states that both legal claims will probably succeed. I don’t understand why Omega’s financial statements include a liability in respect of the expected settlement of Customer X’s legal claim but do not include an asset in respect of the expected settlement of Omega’s legal claim against Supplier Y. This seems inconsistent. (4 marks)

Provide answers to the queries raised by the trainee. You should justify your answers with reference to relevant IFRS Standards.

 Answer

The accounting treatment of both items is governed by IAS 37 – Provisions, Contingent Liabilities and Contingent Assets.

The legal claim against Omega is a provision as it is a liability of uncertain timing or amount. IAS 37 requires provisions to be recognised where there is a probable outflow of economic benefits which can be reliably measured.

The legal claim by Omega against Supplier Y is a contingent asset as it is a possible asset arising from past events.

IAS 37 states that contingent assets should not be recognised in the financial statements but should be disclosed where there is a probable inflow of economic benefits.

This explains the distinction between the treatment of the two legal claims.

Feedback

Answers to query 3 were generally of a high standard. Candidates are to be congratulated for their knowledge of the relevant requirements of IAS 37 – Provisions, Contingent Liabilities and Contingent Assets.

Question

You are the financial controller of Epsilon, a listed entity. The financial statements of Epsilon for the year ended 31 March 20X7 are currently being prepared. Your managing director has sent you three questions regarding the financial statements. The questions appear in notes 1–3.

Note 3 – Redundancy programmes

You will be aware that the board of directors met on 10 March 20X7 to discuss over-capacity in parts of the group. The decision was reluctantly taken to implement a programme of redundancies. The programme was to be implemented in two phases:

    1.  Phase 1 involves 300 redundancies on 30 June 20X7. This phase of the programme was planned out in detail at the meeting on 10 March 20X7. The redundancy costs were calculated in some detail at the meeting and this first phase was made public to all affected parties on 25 March 20X7.
    2. –  Phase 2 involves 200 redundancies on 30 September 20X7. This phase of the programme was also planned out in detail at the meeting on 10 March. The redundancy costs were estimated at the meeting and this second phase was announced on 25 April 20X7.
The financial statements for the year ended 31 March 20X7 include a provision for the first phase of the redundancies but not the second phase. Both phases were agreed and the costs calculated at the same meeting. Surely both costs

should be accounted for consistently?

Provide answers to the questions raised by your managing director. Your answers should refer to relevant provisions of International Financial Reporting Standards (IFRS® Standards).

 Answer

Provisions are subject to the requirements of IAS 37 – Provisions, Contingent Assets and Contingent Liabilities. IAS 37 states that in order for a provision to be recognised, an obligation needs to exist at the reporting date which can be measured reliably.

The costs of both phases of the redundancy programme have been either estimated or calculated, so for both phases the potential obligation can be measured reliably.

The reason for the different treatments of the two phases is due to whether or not an obligation exists at the reporting date.

An obligation can be legal or constructive; in this case the redundancy programme was determined internally by the company so the obligation is not a legal one.

In the case of phase 1 of the programme, a constructive obligation does exist at the reporting date because the details have been announced to those affected by it, giving them a valid expectation that it will be carried through. Therefore IAS 37 requires a provision for the costs to be included in the financial statements. As no such obligation exists for phase 2 at the reporting date, since the announcement had not been made at that time, neither a provision or disclosure of a contingent liability is required.

Feedback

Answers to question 3 were often too brief and did not fully bring out the recognition principles set out in IAS 37® – Provisions, Contingent Liabilities and Contingent Assets. A number of candidates did not mention IAS 37 at all – concentrating solely on the timing of the redundancy announcements and attempting to apply IAS 10® – Events after the Reporting Period – to the scenario. IAS 10 is not completely irrelevant of course but the main focus of the answer should have been on IAS 37.

Question

Epsilon, a company with a year end of 30 September 20X7, is listed on a securities exchange. A director of Epsilon has a number of questions relating to the application of International Financial Reporting Standards (IFRS® Standards) in its financial statements for the year ended 30 September 20X7. The questions appear in notes 1–3.

Note 2 – Pending legal cases

At a recent board meeting, we discussed legal cases which customers A and B are bringing against Epsilon in respect of the supply of products which were allegedly faulty. We supplied the goods in the last three months of the financial year.

We have reliably estimated that if the actions succeed, we are likely to have to pay out $10 million in damages to customer A and $8 million in damages to customer B.

Epsilon’s legal advisers have reliably estimated that there is a 60% chance that customer A’s claim will be successful and a 25% chance that customer B’s claim will be successful.

I know we have insurance in place to cover us against claims like this. It is highly probable that any claims which were successful would be covered under our policy. Therefore I would have expected to see a provision for legal claims based on the likelihood of the claims succeeding. However, I would also have expected to see an equivalent asset in respect of amounts recoverable from the insurance company. The financial statements do contain a provision for $10 million but no equivalent asset. Disclosure of the information relating to both of the claims and the associated insurance is made in the notes to the financial statements. How can it be the correct accounting treatment to include a liability but not the corresponding asset, given the above facts?

Provide answers to the questions raised by the director in notes 1–3. You should justify your answers with reference to relevant International Financial Reporting Standards.

Answer

Provisions are covered by IAS 37 – Provisions, Contingent Liabilities and Contingent Assets. IAS 37 states that for a provision to be recognised, an obligating event must have incurred before the year end. In this case, both customer A and B were sold the product before the year end so an obligating event has occurred.

IAS 37 further states that a provision is only recognised when there is a probable outflow of economic benefits. IAS 37 interprets ‘probable’ to be 50% or more. This is only the case with the supply to customer A, so it is correct to only recognise a provision for customer A’s claim.

IAS 37 also states that any provision should be measured based on the best estimate of the likely outflow of economic benefits. In this case, this amount is $10 million. 

Any liability arising from the legal case brought by customer B would be regarded as a contingent liability because there is only a possible (rather than a probable) chance of an outflow of economic benefits. In this case, it is dealt with by disclosure, rather than provision. 

In addition to the recognition of a provision in the case of customer A’s claim, it is also necessary to disclose key facts relating to the case in the notes to the financial statements.

The possible recovery of funds from the insurance company would be regarded as a contingent asset. This would always be the case for possible assets unless it is virtually certain (rather than highly probable) that there will be an inflow of economic benefits. Where there is a probability of an inflow of funds relating to a
contingent asset, then this is dealt with by disclosure under IAS 37.

Feedback

Answers to the question that appeared in note 2 were generally of a good standard. The most common error that was made by candidates was computing a provision in respect of the two legal claims as 60% of customer A’s claim plus 25% of customer B’s claim. Such an approach is not acceptable when measuring discrete obligations.

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