Change in Provisions and Use of Provisions – Ind AS 37
Change in Provisions
- Provisions shall be reviewed at the end of each reporting period and adjusted to reflect the current best estimate
- If it is no longer probable that an outflow of resources embodying economic benefits will be required to settle the obligation, the provision shall be reversed
- Where discounting is used, the carrying amount of a provision increases in each period to reflect the passage of time. This increase is recognized as borrowing cost
Use of Provisions
- A provision shall be used only for expenditures for which the provision was originally recognized
- Only expenditures that relate to the original provision are set against it. Setting expenditures against a provision that was originally recognized for another purpose would conceal the impact of two different events
- When you incur expenditures associated with the settlement of your obligation, you should “utilize a provision “
- In most cases, you simply recognize this utilization directly with incurring the invoices from suppliers or any related payments (e.g. Debit Provision / Credit Cash)
Future operating Losses
- Provisions shall not be recognized for future operating losses as Future operating losses do not meet the definition of a liability (in paragraph 10) and the general recognition criteria set out for provisions (in paragraph 14) of Ind AS 37
- An expectation of future operating losses is an indication that certain assets of the operation may be impaired. An entity tests these assets for impairment under Ind AS 36, Impairment of Assets
Another look at the said concept may be as follows:
- You should not make a provision for future operating loss. Why?
- Because there is no past event. The future operating losses can be avoided by some future actions, for example – by selling a business
What is an Onerous Contract?
- An onerous contract is a contract in which
- the unavoidable costs of meeting the obligations under the contract exceed
- the economic benefits expected to be received under it.
- As soon as an entity is aware that a contract is onerous, the full loss should be provided for as a liability in the statement of profit and loss
- The unavoidable costs reflect the least net cost of exiting the contract, which is the lower of the costs to fulfill the contract and any compensation/penalties arising from failing to fulfill the contract
- Before a separate provision for an onerous contract is established, an entity recognizes any impairment loss that has occurred on assets dedicated to that contract (see Ind AS 36)
Entity XYZ entered into a contract to supply 1000 television sets for Rs 2 million. An increase in the cost of inputs has resulted into an increase in the cost of sales to Rs. 2.5 million. The penalty for non- performance of the contract is expected to be Rs. 0.25 million. Is the contract onerous and provision in this regard required?
Ind AS 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”. Paragraph 68 of Ind AS 37 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 fulfill it”. In the instant case, cost of fulfilling the contract is Rs. 0.5 million and cost of exiting from the contract by paying penalty is Rs. 0.25 million.
In accordance with the above paragraph, it is an onerous contract as cost of meeting the contract exceeds the economic benefits. Therefore, the provision should be recognized at the best estimate of the unavoidable cost, which is lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfill it, i.e., at Rs. 0.25 million (lower of Rs. 0.25 million and Rs. 0.5 million).
An entity has entered into a contract to purchase specific quantity of coal at the rate of Rs. 50 per unit over a period of three years. The contract is not cancellable without payment of compensation. The current market price of coal is Rs. 45 per unit. The coal is purchased for consumption during the manufacturing process the output of which is sold in the market at a profit. Is the contract an onerous contract? Yes / No?
No, the contract is not an onerous contract because the entity will derive economic benefits from the contract including the benefits of using the coal in the manufacturing process and the final product will be sold in the market at a profit.
Assume the same conditions as in previous question above except that the final product is sold in the market at loss and the loss is primarily on account of high cost of coal. In this case, is the contract an onerous contract? Yes / No?
Yes. In this case, since the entity is making losses in the contract and the contract is not cancellable without payment of compensation, the contact is onerous. Therefore, as per paragraph 66, the present obligation under the contract should be recognized and measured as provision.
- Restructuring is a plan of management to change the scope of business or a manner of conducting a business
- One should recognize a provision for restructuring only when the general criteria for recognizing provisions are met
- In the case of restructuring, an obligation to restructure arises only if
- There is a detailed formal plan for restructuring with relevant information in it (about business, location, employees, time schedule and expenditures)
- A valid expectation related to restructuring has been raised in the affected parties
- The following are examples of events that may fall under the definition of restructuring:
- sale or termination of a line of business
- the closure of business locations in a country or region or the relocation of business activities from one country or region to another
- changes in management structure, for example, eliminating a layer of management; and
- fundamental reorganizations that have a material effect on the nature and focus of the entity’s operations
- No obligation arises for the sale of an operation until the entity is committed to the sale, i.e. there is a binding sale agreement
- Restructuring provision shall 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
- A restructuring provision does not include such costs as
- retraining or relocating continuing staff
- marketing; or
- investment in new systems and distribution networks
- These expenditures relate to the future conduct of the business and are not liabilities for restructuring at the end of the reporting period
- Such expenditures are recognized on the same basis as if they arose independently of a restructuring
Suppose a company decides to close down one of its production facilities as a result of COVID-19. If the company announces its plan, specifying the facility to be closed, the estimated timing of the closure and the approximate number of employees it plans to make redundant, then it recognizes a restructuring provision. The approval of the restructuring plan by the company’s board is not by itself sufficient to recognize a restructuring provision. [Ind AS 37.75]
Termination benefits for employees made redundant as part of the restructuring are recognized in accordance with the specific requirements of Ind AS 19 Employee Benefits
An entity has developed a detailed formal plan for restructuring a business, and it has announced the key features for the restructuring to all affected by it in a manner that meets the criteria of Ind As 37. 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 Rs. 50 Lacs. The settlement fee represents a direct cost resulting from the restructuring; therefore Rs. 50 lacs represent the minimum expected obligation (As the entity doesn’t seem to be able to sub lease the property).
A provision should be recognized for Rs. 50 lacs 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 as it has publicly announced the plan to restructure.
Measurement of Restructuring:
- Under Ind AS 37, restructuring provisions include only direct costs arising from the restructuring – e.g. employee termination benefits and consulting fees that relate directly to the restructuring, onerous contract provisions, contract termination costs and expected costs from when operations cease until final disposal. [Ind AS 37.80]
- Costs associated with ongoing activities are not included in restructuring provisions. For example, the costs of retaining or relocating employees, administration or marketing costs and investment in new systems are not recognized as part of a restructuring provision. [Ind AS 37.81]