Accounting

CHAPTER 4 PROVISION Contingent liability

TECHNICAL KNOWLEDGE

To understand the nature of a provision.

To know the conditions for the recognition of a provision. To know the measurement of a provision.

To identify measurement considerations for a provision. To know the requirements for the recognition of contingent liability and contingent asset.

PROVISION

A provision is an existing liability of uncertain timing om uncertain amount.

The essence of a provision is that there is uncertainty about the timing or amount of the future expenditure.

It is this uncertainty that distinguishes provision from other liabilities.

The liability definitely exists at the end of reporting period but the amount is indefinite or the date when the obligation is due is also indefinite, and in some cases, the payee cannot be identified or determined.

Actually, a provision may be the equivalent of an estimated liability or a loss contingency that is accrued because it is both probable and measurable.

Recognition of provision PAS 37, paragraph 14, provides that a provision shall be recognized as a liability in the financial statements under the following conditions:

a. The entity has a present obligation, legal or constructive, as a result of a past event.

b. It is probable that an outflow of resources embodying economic benefits would be required to settle the obligation.

C. The amount of the obligation can be measured reliably.

Present obligation The present obligation may be legal or constructive. It is fairly clear what a legal obligation is. A legal obligation is an obligation arising from a contract, legislation or other operation of law. A constructive obligation is an obligation that is derived from an entity's actions where: a. The entity has indicated to other parties that it will accept certain responsibilities by reason of an established pattern of past practice, published policy, or a sufficiently specific current statement. b. And as a result, the entity has created a valid expectation on the part of other parties that it will discharge those responsibilities. Otherwise defined, a constructive obligation exists when the entity from an established pattern of practice or stated policy has created a valid expectation that it will accept certain responsibilities.

Past event The past event that leads to a present obligation is called an obligating event.

An accounting provision cannot be created in anticipation of a future event. The event must have already occurred which gives rise to the legal or constructive obligation.

An obligating event is an event that creates a legal or constructive obligation because the entity has no realistic alternative but to settle the obligation created by the event.

This is the case where:

a. The settlement of the obligation can be enforced by law. b. The event creates valid expectations on the part of other parties that the entity will discharge the obligation, as in the case of a constructive obligation.

Probable outflow of economic benefits For a provision to qualify for recognition, there must be not only a present obligation but also a probable outflow of resources embodying economic benefits to settle the obligation.

An outflow of resources is regarded as probable if the event is more likely than not to occur, meaning, the probability that the event will occur is greater than the probability that it will not occur.

As a rule of thumb, probable means more than 50% likely or substantially more.

Possible means 50% or less likely to occur.

Remote means 10% or less likely to occur or very slight occurrence.

Reliable estimate Paragraph 25 of PAS 37 provides that the use of estimates is an essential part of the preparation of financial statements and does not undermine their reliability.

This is especially true in the case of provision because by nature, a provision is more uncertain that most items in the statement of financial position.

The standard suggests that by using a range of possible outcomes, an entity usually would be able to make an estimate of the obligation that is sufficiently reliable.

Where no reliable estimate can be made, no liability is recognized.

Measurement of provision The amount recognized as a provision should be the best estimate of the expenditure required to settle the present obligation at the end of reporting period. The best estimate is the amount that an entity would rationally pay to settle the obligation at the end of reporting period or to transfer it to a third party at that time.

Where a single obligation is being measured, the individual most likely outcome adjusted for the effect of other possible outcomes may be the best estimate. Where there is a continuous range of possible outcomes and each point in that range is as likely as any other, the midpoint of the range is used. Where the provision being measured involves a large population of items, the obligation is estimated by "weighting" all possible outcomes by their associated possibilities. The name for this statistical method of estimation is "expected value".

Illustration - "expected value" method An entity sells goods with a warranty under which customers are covered for the cost of repairs of any manufacturing defects that become apparent within 6 months after purchase. If minor defects are detected in all products gold, repair costs would be about P1,000,000 If major defects are detected in all products sold, repair costs of P5,000,000 would result. The entity's past experience and future expectations indicate that 75% of the goods sold will have no defects, 20% will have minor defects and 5% will have major defects. The expected value or cost of repairs is measured as follows: 75% sales

None

20% sales

(20% x 1,000,000)

200,000

5% sales

(5% x 5,000,000)

250,000

Total expected value or cost of repairs

450,000

Another illustration An entity is a defendant in a patent patent infringement suit. The lawyers believe that there is a 60% chance that the court will not dismiss the case and entity will incur an outflow of future economic benefits. If the court rules against the entity and in favor of the claimant, the lawyers believe that there is a 30% chance the entity will be required to pay damages of P4,000,000 and a 70% chance that the damages will be P2,000,000. A 10% risk adjustment factor to the probabilities of the expected cash flows is considered appropriate to reflect the uncertainties in the cash flow estimate.

Measurement of provision Weighted probabilities: 30% x 4,000,000 x 60%

720,000

70% x 2,000,000 x 60%

840,000

Expected cash outflow

1,560,000

Risk adjustment factor (10% x 1,560,000)

156,000

Estimated amount of provision

1,716,000

The amount of the provision shall be discounted if the effect of the time value of money is material.

Other measurement considerations The following items are taken into consideration in recognizing and measuring a provision: 1. Risks and uncertainties 2. Present value of obligation 3. Future events 4. Expected disposal of assets 5. Reimbursements 6. Changes in provision 7. Use of provision 8. Future operating losses 9. Onerous contract

Risks and uncertainties The risks and uncertainties that inevitably surround events and circumstances shall be taken into account in reaching the best estimate of a provision. Risk describes variability of outcome. A risk adjustment may increase the amount at which a liability is measured. As prudence dictates, caution is needed in making judgment under conditions of uncertainty so that income and assets are not overstated, or expenses and liabilities are not understated However, uncertainty does not justify the creation of excessive provision or a deliberate overstatement of liabilities.

Present value of obligation Where the effect of the time value of money is material, the amount of provision shall be the present value of the expenditure expected to settle the obligation. The discount rate should be a pretax rate that reflects the current market assessment of the time value of money and the risk specific to the liability. The discount rate should not reflect the risk for which cash flow estimates have already been adjusted.

Future events Future events that affect the amount required to settle an obligation shall be reflected in the amount of a provision where there is a sufficient evidence that they will occur. Such future events include new legislation and changes in technology

Expected disposal of assets Gains from expected disposal of assets shall not be taken into account in measuring a provision. Instead, an entity shall recognize gain on disposal at the time of the disposition of the assets. In other words, any cash inflows from disposal are treated separately from the measurement of the provision.

Reimbursements Where some or all of the expenditure required to settle a provision is expected to be reimbursed by another party, the reimbursement shall be recognized when it is virtually certain that reimbursement would be received if the entity settles the obligation. The reimbursement shall be treated as a separate asset and not netted against the estimated liability for the provision. The amount of reimbursement shall not exceed the amount of the provision. However, in the income statement, the expense relating to the provision may be presented net of the reimbursement.

Changes in provision Provisions shall be reviewed at every end of the reporting period and adjusted to reflect the current best estimate. The provision shall be reversed if it is no longer probable that an outflow of economic benefits would be required to settle the obligation. Where discounting is used, the carrying amount of the provision increases each period to reflect the passage of time.

Use of provision A provision shall be used only for expenditures for which the provision was originally recognized. For example, a provision for plant dismantlement cannot be used to absorb environmental pollution claims or warranty payments. If an expenditure is charged against a provision that was originally recognized for another purpose, that would camouflage the impact of two different events, thus distorting financial performance and possibly constituting financial reporting fraud.

Future operating losses Provision shall not be recognized for future operating losses. In other words, a provision for operating losses is not recognized because a past event creating a present obligation has not occurred. However, an expectation of future operating losses is an indication that certain assets may be impaired. An impairment test for these assets may be necessary. Onerous contract If an entity has an onerous contract, the present obligation under the contract shall be recognized and measured as a provision. An onerous contract is a contract in which the unavoidable costs of meeting the obligation under the contract exceed the economic benefits expected to be received under it. PAS 37. paragraph 68, mandates that the unavoidable costs under a contract represent the "least net cost of exiting from the contract". The lower amount between the cost of fulfilling the contract and the compensation or penalty arising from failure to fulfill the contract is the least cost of exiting from the contract.

Examples of provision a. Warranties - The best estimate of the warranty cost is recognized as a provision because there is clear constructive obligation arising from an obligating event which is the sale of the product with warranty. b. Environmental contamination - If an entity has an environmental policy such that other parties would expect the entity to clean up any contamination, or if the entity has broken current environmental legislation then a provision for environmental damage shall be made. The obligating event is the contamination of the propertywhich gives rise to constructive or legal obligation. A provision is recognized for the best estimate of the cost of cleaning up the contamination. c. Decommissioning or abandonment costs - When an oil entity initially purchases an oil field, it is put under a legal obligation to decommission the site at the end of its life. The costs of abandonment or decommissioning shall be recognized as a provision and may be capitalized as cost of the oil field. d. Court case - After a wedding in the current year, ten people died possibly as a result of food poisoning from products sold by the entity. Legal proceedings are started seeking damages from the entity. When the entity prepares the financial statements for the current year, the lawyers advise that owing to the developments in the case, it is probable that the entity would be found liable. A provision is recognized for the best estimate of the damages because there is a present obligation. e. Guarantee - In the current year, an entity gives a guarantee of certain borrowings of another entity. During the year, the financial condition of the borrower deteriorates and at year-end, the borrower files a petition for bankruptcy. A provision is recognized for the best estimate of the guarantee obligation because there is legal obligation rising from the obligating event which is the guarantee.

Restructuring PAS 37, paragraph 10, defines restructuring as a "program that is planned and controlled by management and materially changes either the scope of a business of an entity or the manner in which that business is conducted". Events that may qualify as restructuring include: a. Sale or termination of a line of business b. Closure of business location in a region or relocation of business activities from one location to another or relocation of headquarters from one country to another. c. Change in management structure, such as elimination of a layer of management or making all functional units autonomous. d. Fundamental reorganization of an entity that has a material and significant impact on its operations.

Provision for restructuring Recognition of the provision for restructuring is required because a constructive obligation may arise from the decision to restructure. A constructive obligation for restructuring arises when two conditions are present: 1.

The entity has a detailed formal plan for the restructuring which includes the following: a. The business being restructured. b. The principal location affected. c. The location, function and approximate number of employees who will be compensated for terminating their employment. d. Date when the plan will be implemented. e. The expenditures that will be undertaken.

2.

The entity has raised valid expectation in the minds of those affected that the entity will carry out the restructuring by starting to implement the plan and announcing the main features to those affected by it.

Illustration The board of directors of an entity at their meeting held at the current year-end decided to close down all its international branches and shift its international operations and consolidate them with its domestic operations. A detailed formal plan for winding up the international operations was also formalized and agreed by the board of directors in that meeting. Letters were sent out to customers, suppliers, workers thereafter. Meetings were called to discuss the features of the formal plan to wind up international operations and representatives of all interested parties were present in those meetings

Amount of restructuring provision A restructuring provision shall include only direct expenditures arising from the restructuring. These expenditures are necessarily incurred for the restructuring and not associated with the ongoing activities of the entity For example, salaries and benefits of employees to be incurred after operations cease and that are associated with the closure of the operations shall be included in the amount of the restructuring provision PAS 37, paragraph 81, specifically excludes the following expenditures from the restructuring provision: a. Cost of retraining or relocating continuing staff. b. Marketing or advertising program to promote the new company image. C. Investment in new system and distribution network. Such expenditures are categorically disallowed as restructuring provisions because these are considered to be expenses relating to the future conduct of the business of the entity, and thus are not liabilities relating to the restructuring program.

Contingent liability PAS 37, paragraph 10, defines a contingent liability in two ways: A contingent liability is a possible obligation that arises from past event and whose existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of the entity. A contingent liability is a present obligation that arises from past event but is not recognized because it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation or the amount of the obligation cannot be measured reliably.

Contingent liability and provision The second definition states that a contingent liability is a present obligation. However, the present obligation is either probable or measurable but not both to be considered a contingent liability. If the present obligation is probable and the amount can be measured reliably, the obligation is not a contingent liability but shall be recognized as a provision.

Treatment of contingent liability A contingent liability shall not be recognized in the financial statements but shall be disclosed only. The required disclosures are: a.Brief description of the nature of the contingent liability b. An estimate of its financial effects. c. An indication of the uncertainties that exist. d. Possibility of any reimbursement. If a contingent liability is remote, no disclosure is necessary.

Contingent asset PAS 37. paragraph 10, provides the following definition: A contingent asset is a possible asset that arises from past event and whose existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of the entity. A contingent asset shall not be recognized because this may result to recognition of income that may never be realized. However, when the realization of income is virtually certain, the related asset is no longer contingent asset and its recognition is appropriate. A contingent asset is only disclosed when it is probable. The disclosure includes a brief description of the contingent asset and an estimate of its financial effects. If a contingent asset is only possible or remote, no disclosure is required.

Decommissioning liability A decommissioning liability is an obligation to dismantle, remove and restore an item of property, plant and equipment as required by law or contract. A decommissioning liability is also called asset retirement obligation.

Illustration An entity extracts natural gas and oil in the Philippine Deep. On January 1, 2020, the entity constructed a drilling platform for P25,000,000 and is required by Philippine law to remove and dismantle the platform at the end of its useful life of 10 years. The straight line method is used in depreciating the drilling! platform The entity has estimated that such decommissioning will cost P5,000,000 Based on a 12% discount rate, the present value of 1 for 10 years is 0.322 Thus, the present value of the decommissioning liability is P5,000,000 times 0.322 or P1,610,000 The decommissioning liability is initially recognized at present value and included in the cost of the related asset.

Journal entries for 2020 and 2021 2020 Jan. 1

Drilling platform Cash Decommissioning liability

26.610,000 25,000.000 1,610.000

Dec. 31 Depreciation Accumulated depreciation (26,610,000/10 years)

2,661,000

31 Interest expense Decommissioning liability (12% 1,610,000)

193 200

2,661,000

193.200

2021 Dec. 31 Depreciation Accumulated depreciation

2,661,000

31 Interest expense Decommissioning liability

216,384

2,661.000

216 382

Decommissioning liability - January 1, 2020 Interest expense for 2020

1.610,000 193.210

Carrying amount - December 31, 2020

1.803,200

Interest expense for 2021 (12% x 1,803,200)

216,384

Settlement of decommissioning liability On December 31, 2029, after 10 years, the entity contracted with another entity to dismantle and remove the drilling platform for P5,500,000. The journal entry to record the settlement of the decommissioning liability is: Decommissioning liability Loss on settlement of decommissioning liability Cash

5,000,000 500,000 5,500,000

On January 1, 2020, the decommissioning liability is P1,610,000. This amount plus 12% interest compounded annually will build up to P5,000,000 after 10 years on December 31, 2029. Thus, the decommissioning liability is debited at P5,000,000. The journal entry to derecognize the carrying amount of the drilling platform on December 31, 2029 is: Accumulated depreciation Drilling platform

26,610,000 26,610,000

Change in decommissioning liability Under IFRIC 1, changes in the measurement of an existing decommissioning liability shall be accounted for as follows: 1. A decrease in the liability is deducted from the cost of the asset. If the decrease in liability exceeds the carrying amount the excess is recognized in profit or loss. 2. An increase in liability is added to the cost at the asset. However, the entity shall consider whether this is an indication that the carrying amount of the asset may not be fully recoverable. If there is such an indication, the asset should be tested for impairment..

Illustration On January 1, 2020, the plant of Sea oil Company is 10 years old. The cost of the plant is P12,000,000 with accumulated depreciation of P4,000,000 The plant has a useful life of 30 years and was depreciated using the straight line with no residual value. Because of the unwinding discount of 6% over 10 years, the decommissioning liability has grown from P1,000,000 to P1,790,000 On January 1, 2020, the discount rate has not changed. However, the entity has estimated that as a result of technological advances, the net present value of the decommissioning liability has decreased by P800,000.

Journal entries for 2020 Jan. 1

Decommissioning liability Plant asset

800,000

Dec 31 Depreciation Accumulated depreciation

360,000

800,000

360.000

Cost of plant Reduction of decommissioning liability

12,000,000 (800,000)

Net cost Accumulated depreciation

11,200,000 (4,000,000)

Carrying amount

7,200,000

Depreciation for 2020 (7,200,000/20 years)

360,000

31 Interest expense Decommissioning liability

59,400 59,400

Decommissioning liability - January 1, 2020 Reduction

1,790,000 (800,000)

Adjusted carrying amount - January 1, 2020

990,000

Interest expense for 2020 (6% x 990,000)

59.400

QUESTIONS

1. Explain the meaning of a provision. 2. What are the three conditions necessary for the recognition a provision as a liability? 3. What is a legal obligation? 4. What is a constructive obligation? 5. What is an obligating event? 6. Explain the terms probable, possible and remote in relation to a provision. 7. What is the measurement of a provision? 8. Explain a restructuring provision. 9. Define a contingent liability 10. Distinguish a contingent liability from a provision. 11. Explain the treatment of a contingent liability. 12. Define a contingent asset. 13. Explain the treatment of a contingent asset. 14. What is a decommissioning liability? 15. Explain the treatment of a decommissioning liability.

PROBLEMS

Problem 4-1 (IAA) Toy Company provided the following facts regarding pending litigation on December 31, 2020: The entity is defending against a first lawsuit and believes there is a 51% chance it will lose in court. The entity estimates that damages will be P1,000,000. The entity is defending against a second lawsuit for which management believes it is virtually certain to lose in court. If it loses the lawsuit, management estimates damages will fall somewhere in the range of P3,000,000 to P5,000,000 with each amount in that range equally likely to occur The entity is defending against a third lawsuit but the relevant loss will only occur far into the future. The present values of the endpoints of the range are P1,500,000 and P2,500,000. The management believes the effects of time value of money on these amounts are material but also believes the timing of these amounts is uncertain. The entity is defending against a fourth lawsuit and believes there is only a 25% chance it will lose in court. If the entity loses, management believes damages will fall somewhere in the range of P3,000,000 to P4,000,000 with each amount in that range equally likely to occur.

Required: Indicate how the entity would disclose or account for the lawsuits under IFRS in the financial statements for the year ended December 31, 2020.

Problem 4-2 (IAA) Bourne Company provided the following selected transactions related to contingencies. The fiscal year ends on December 31, 2020 and financial statements are issued on March 31, 2021.  Bourne is involved in a lawsuit resulting from a dispute with a customer over a 2020 transaction. On December 31, 2020, attorneys advised that it was probable that Bourne would lose P3,000,000 in an unfavorable outcome. On February 15, 2021, judgment was rendered against Bourne in the amount fP4,000,000 plus interest. P500,000. Bourne does not plan to appeal the judgment.  Since August 2020, Bourne has been involved in labor dispute. Negotiations between the entity and the union have not produced a settlement. Since January 2020, strikes have been ongoing at these facilities. It is virtually certain that material costs will be incurred but the amount of resultant costs cannot be adequately predicted  Bourne is the defendant in a lawsuit filed in January 2021 in which the plaintiff seeks P5,000,000 as an adjustment to the purchase price related to the sale of Bourne's hardwood division in 2020. The lawsuit alleges that Bourne misrepresented the division's assets and liabilities. Legal counsel advised that it is reasonably possible that Bourne could lose P2,000,000 but that it is extremely unlikely it could lose the P5,000,000 asked for.  On March 1, 2021, the provincial government is in the process of investigating the possibility of environmental violation by Bourne but has not proposed a penalty assessment. Management feels an assessment is reasonably possible and if an assessment is made, a settlement of up to P4,000,000 is probable.

Required: Prepare journal entries that should be recorded as a result of the contingencies

Problem 4-3 (AICPA Adapted) Sunrise Company provided the following information on December 31, 2020

 A personal injury liability suit for P500,000 was brought against Sunrise Company in March 2020. The management and legal counsel of Sunrise Company concluded that it is not probable that Sunrise Company will be responsible for damages and that P150,000 is the best estimate of the damages.  In July 2020, Sunrise Company became involved in a tax dispute with the BIR pertaining to 2019 income tax.. In December 2020, a judgment for P400,000 was assessed against Sunrise Company, by the tax court. Sunrise Company is appealing the amount of the judgment. The tax advisor and legal counsel of Sunrise Company believed it is probable that the assessment can be reduced on appeal by 50%.  Sunrise Company signed as guarantor for P200,000 loan by PNB to Sunset Company, a principal supplier of Sunrise. By reason of financial difficulties, it is probable that Sunrise Company shall pay the P200,000 loan with only a 60% recovery anticipated from Sunset Company.

Required: Prepare journal entries to recognize any provision on December 31, 2020.

Problem 4-4 (IAA) Eastern Company provided the following information 011 December 31, 2020.  In May 2020, Eastern Company became involved in litigation. In December 2020, the court assessed a judgment for P1,600,000 against Eastern Company. The entity is appealing the amount of the judgment. The attorneys believed it is probable that the assessment can be reduced on appeal by 50%. The appeal is expected to take at least a year.  In July 2020, Pasig City brought action against Eastern Company for polluting the Pasig River with its waste products. It is probable that Pasig City will be successful but the amount of damages the entity might have to pay should not exceed P1,500,000.  Eastern Company has signed as guarantor for a P1,000,000 loan by First Bank to Northern Company, a principal supplier to Eastern Company. At this time, there is a only a remote likelihood that Eastern Company will have to make payment on behalf of Northern Company.  Eastern Company has long owned a manufacturing site that has now been discovered to be contaminated with toxic waste. The entity has acknowledged its responsibility for the contamination. An initial clean up feasibility study has shown that it will cost at least P500,000 to clean up the toxic waste.  Eastern Company has been sued for patent infringement and lost the case. A preliminary judgment of P300,000 was issued and is under appeal. The entity's attorneys agree that it is probable that the entity will lose this appeal.

Required: Prepare journal entries to recognize any provision at the end of current year.

Problem 4-5 (IFRS) A Singapore-based shipping entity lost an entire shipload of cargo valued at P5.000.000 on a voyage to Australia. It is however covered by an insurance policy. According to the report of the investigator, the amount is collectible, subject to the deductible clause in the insurance policy Before year-end, the shipping entity received a letter from the insurance entity that a check was in the mail for 90% of the claim The international freight forwarding entity that entrusted the shipping entity with the delivery of the cargo overseas has filed a lawsuit for P5,000,000 claiming the value of the cargo that was lost on high seas, and also consequential damages of P2,000,000 resulting from the delay. According to the legal counsel for the shipping entity, it is probable that the shipping entity would have to pay the P5,000,000 However, it is a remote possibility that it would have to pay the additional P2,000,000 claimed by the international freight forwarding entity, since this loss was specifically excluded in the freight forwarding contract.

Required: Determine the amount of provision at year-end. Explain fully your answer.

Problem 4-6 (IFRS) Troy Company decided on November 1, 2020 to restructure the entity's operations.  Mindanao Branch would be closed down November 30, 2020 to concentrate on Manila operations.  200 employees working in Mindanao Branch would be retrenched on November 30, 2020, and would be paid their accumulated entitlements plus three months wages.  The remaining 50 employees working in Mindanao Branch would be transferred to Manila, which would continue operating.  Five executives would be retrenched on December 31, 2020, and would be paid their accumulated entitlements plus three months' wages.  The 200 retrenched employees have left and their accumulated entitlements have been paid. However, an amount of P1,500,000, representing a portion of the three months' wages for the retrenched employees, has still not been paid.  Costs of P400,000 were expected to be incurred in transferring the 50 employees to their new work in Manila. The transfer is planned for January 15, 2021.  Four of the five executives who have been retrenched have had their accumulated entitlements paid, including the three months' wages. However, one remains in order to complete administrative tasks relating to the closure of Mindanao Branch and the transfer of staff to Manila. This executive is expected to stay until January 31, 2021. His salary for January will be P50,000 and his retrenchment package will be P200,000, all of which will be paid on the day he leaves. He estimates that he would spend 60% of his time administering the closure of Mindanao Branch, 30% on administering the transfer of staff to Manila, and the remaining 10% on general administration.

Required: Prepare journal entry to record the provision for restructuring.

Problem 4-7 (IAA) Anneliese Company is involved in a restructuring related to its toy division. The controller and chief finance officer are considering the following costs to accrue as part of the restructuring. The entity has a long-term lease on one of the facilities related to the division. It is estimated that it will have to pay a penalty of P4,000,000 to break the lease. The entity estimates that the present value related to payment on the lease contract is P6,500,000. The entity's allocation of overhead costs to other divisions will increase by P15,000,000 due to the restructuring of the facilities. Also, some employees will be shifted to other divisions within the entity and cost of retraining the employees is estimated at P20,000,000. The entity has hired an outplacement firm to help in dealing with the number of terminations related to the restructuring. It is estimated that the cost to the entity will be P6,000,000. Employee termination costs are estimated to be P30,000,000 and the entity believes that moving usable assets from the toy division to other division within the entity will cost P3,200,000.

Required: Compute the total amount that should be included in restructuring provision.

Problem 4-8 (IAA) Western Company provided the following selected transactions related to contingencies. The fiscal year ends December 31, 2020. Financial statements are issued on April 1, 2021.  No customer accounts have been shown to be uncollectible as yet but Western estimated that 3% of credit sales will eventually prove uncollectible. Credit sales amounted P30,000,000 for 2020.  Western offers a one-year warranty against manufacturer's defects for all its products. Industry experience indicates that warranty costs will approximate 2% of credit sales. Actual warranty expenditures totaled P350,000 in 2020 and were recorded as warranty expense when incurred.  In December 2020, Western became aware of a engineering flaw in a product that poses a potential risk of injury. As a result, a product recall appears inevitable. This move would likely cost the entity P1,500,000  In November 2020, the City of Manila filed suit against Western asking civil penalties and injunctive relief for violations of clean water laws. Western reached a settlement with the city government authorites to pay P4,200,000 in penalties on February 15, 2021.  Western is the plaintiff in a P4,000,000 lawsuit filed against a customer for costs and lost profit from contracts rejected in 2020. The lawsuit is in final appeal and attorneys advised that it is virtually certain that Western will be awarded P3,000,000

Required: Prepare the appropriate journal entries that should be recorded as a result of each of these contingencies. If no journal entry is indicated, state the reason why.

Problem 4-9 (TAA) Baron Company is involved with several situations about contingencies. The fiscal year ends December 31, 2020 and the financial statements are issued on March 1, 2021. 

On March 1, 2021, the city government is in the process of investigating possible chemical leaks at Baron's facilities but has not proposed a deficiency assessment. Management feels an assessment is reasonably possible and if an assessment is made an unfavorable settlement of up to P4,000,000 is reasonably possible.

 Baron is the plaintiff in a P3,000,000 lawsuit filed against Faye Company for damages due to lost profit from rejected contracts and for unpaid receivables. The case is in final appeal and legal counsel advised that it is probable that Baron will prevail and be awarded P2,500,000.  In July 2020, the provincial government filed suit against Baron seeking civil penalties and injunctive relief for violation of environmental law regulating hazardous waste. On February 15, 2021, Baron reached a settlement with state authorities. Based upon discussions with legal counsel, Baron feels it is probable that P2,000,000 will be required to cover the cost of violation. Baron believed that the ultimate settlement of this claim will not have a material adverse effect on the entity.  Baron is involved in a lawsuit resulting from a dispute with a customer. On January 5, 2021, judgment was rendered against Baron in the amount of P1,500,000 plus interest of P300,000. Baron plans to appeal the judgment and is unable to predict its outcome though it is not expected to have a material adverse effect on the entity.

Required: Prepare any necessary journal entries to recognize the situations involving contingencies.

Problem 4-10 (IAA) On January 1, 2020, Petron Company purchased on oil tanker depot at a cost of P6,000,000. The entity is expected to operate the depot for 5 years after which it is legally required to dismantle the depot and remove the underground storage tanks. The oil tanker depot is depreciated using straight line with no residual value. It is reliably estimated that the cost of decommissioning the depot will amount to P1,500,000. The appropriate discount rate is 10%. The present value of 1 at 10% for 5 periods is 0.62 On December 31, 2024, after 5 years of operating the depot, the entity paid a demolition entity to dismantle the depot at a price of P1,700,000.

Required: 1.Prepare journal entries in 2020 in relation to the depot and the decommissioning liability. 2. Prepare journal entries to record the derecognition of the depot and the settlement of the decommissioning liability on December 31, 2024.

Problem 4-11 (IAA) On January 1, 2020, Stanford Company purchased a mini site that will have to be restored to certain specifications when the mining production ceases. The cost of the mining site is P8,000,000 and the restoration cost is expected to be P2,000,000 It is estimated that the mine will continue in operation from 10 years. The appropriate discount rate is 8%. The present value of 1 at 8% for 10 periods is 0.4632. On December 31, 2029, the entity contracted with another entity for the restoration of the mining site in accordance with specifications at a cost of P1,800,000

Required: 1. Prepare journal entries in 2020 to record the purchase of the mining site and the recognition of the decommissioning liability. 2. Prepare journal entry to record the settlement of the decommissioning liability on December 31, 2029.

Problem 4-12 (TAA) On January 1, 2020, Camille Company purchased a gas detoxification facility for P9.000.000 The cost of cleaning up the routine contamination caused by the initial location of gas on the property is estimated to be P1,500,000 This cost will be incurred in 10 years when all of the existing stockpile of gas is detoxified and the facility is decommissioned. Additional contamination may occur in succeeding years that the facility is in operation. On January 1, 2022, additional contamination clean up cost is estimated at P200.000. The appropriate discount rate is 6%. The present value of 1 at 6% is 0.63 for 8 periods and 0.56 for 10 periods. On December 31, 2029, the entity paid a contractor an amount of P2,000,000 for the decommissioning of the detoxification facility.

Required: 1. Prepare journal entries in 2020 in relation to the detoxification facility and the decommissioning liability 2. Prepare journal entries in 2022 in relation to the detoxification facility and decommissioning liability. 3. Prepare journal entries on December 31, 2029 to record the derecognition of the detoxification facility and the settlement of the decommissioning liability.

Problem 4-13 (IFRS) Toyo Company owns a car dealership that it uses to servicing cars under warranty. In preparing the financial statements, the entity needs to ascertain the provision for warranty that it would be required to provide at the end of the year. The entity's experience with warranty claims is: 60% of all cars sold in a year have zero defect, 25% of all cars sold in a year have normal defect, and 15% of all cars sold in a year have significant defect. The cost of rectifying a normal defect in a car is P10,000. The cost of rectifying a significant defect in a car is P30,000. The entity sold 500 cars during the year. What is the expected value of the warranty provision for the current year? a. 3,500,000 b. 1.750,000 c. 1,400,000 d. 4,000,000

Problem 4-14 (IFRS) Chato Company sells electrical goods covered by a one-year warranty for any defects. Of the sales of P70,000,000 for the year, the entity estimated that 8% will have major defect, 5% will have minor defect and 92% will have no defect. The cost of repairs would be P5,000,000 if all the products sold had major defect and P3,000,000 if all had minor defect. What amount should be recognized as a warranty provision? a. 8,000,000 b. 5,600,000 c. 300,000 d. 190,000

Problem 4-15 (IFRS) During 2020, Odyssey Company is the defendant in a patent infringement lawsuit. The entity's lawyers believe there is a 30% chance that the court will dismiss the case and the entity will incur no outflow of economic benefits. However, if the court rules in favor of the claimant, the lawyers believe that there is a 20% chance that the entity will be required to pay damages of P200,000 and an 80% chance that the entity will be required to pay damages of P100,000, Other outcomes are unlikely. The court is expected to rule in late December 2021. There is no indication that the claimant will settle out of court. A 7% risk adjustment factor to the probability weighted expected cash flows is considered appropriate to reflect the uncertainties in the cash flow estimates. An appropriate discount rate is 5% per year. The present value of 1 at 5% for one period is 0.95. 1. What is the amount of undiscounted cash flows for the provision? a. 200,000 b. 100,000 c. 150.000 d. 89.880

2. What is the measurement of the provision for lawsuit on December 31, 2020? a 95,000 b. 79,800 c. $3,200 d. 85,886

Problem 4-16 (IFRS) During 2020, Libya Company is the defendant in a breach of patent lawsuit The lawyers believe there is an 80% chance that the court will not dismiss the case and the entity will incur outflow of benefits. If the court rules in favor of the claimant, the lawyers believe that there is a 60% chance that the entity will be required to damages of P2,000,000 and a 40% chance that the entity will be required to pay damages of P1,000,000. Other amounts of damages are unlikely. There is no indication that the claimant will settle out of court. The court is expected to rule in late December 2021. An 8% risk adjustment factor to the cash flows is considered appropriate to reflect the uncertainties in the cash flow estimates, The appropriate discount rate is 12%. The PV of 1 at 12% for one period is .89. 1. What is the amount of undiscounted cash flows for the provision? a. 1,382,400 b. 1,280,000 c. 1,036,800 d. 1,620,000

2. What is the measurement of the provision on December 31, 2020? a. 1,139,200 b. 1,335,000 c. 1,230,336 d. 922,752

Problem 4-17 (IFRS) Electro Company gives warranties at the time of sale to purchasers of its product. The entity undertakes to make good, by repair or replacement, manufacturing defects that become apparent within one year from the date of sale. Sales of P5,000,000 were made evenly throughout 2020. The expenditures for warranty repairs and replacements for the products sold in 2020 are expected to be made 50% in 2020 and 50% in 2021. The 2021 outflows of economic benefits related to the warranty will take place on December 31, 2021. The entity estimated that 75% of products sold require no warranty repairs, 15% of products sold require minor repairs costing P100,000 and 10% of products sold require major repairs costing P400,000. An appropriate risk adjustment factor to reflect the uncertainties in the cash flow estimates is an increment of 6% to the probability weighted expected cash flows. The appropriate discount factor for cash flows expected to occur on December 31, 2021 is 0.94. 1. What is the warranty expense for 2020? a. 500,000 b. 498,200 C. 514,100 d. 530,000

2. What is the warranty liability on December 31, 2020? a. 265,000 b. 249,100 c. 250,000 d. 235,000

Problem 4-18 (IFRS) During 2020, Thor Company was sued by a competitor for P5,000,000 for infringement of a trademark. Based on the advice of the entity's legal counsel, the entity accrued the sum of P3,000,000 as a provision in the financial statements for the year ended December 31, 2020. Subsequent to the end of the reporting period, on February 15, 2021, the Supreme Court decided in favor of the party alleging infringement of the trademark and ordered the defendant to pay the aggrieved party a sum of P3,500,000 The financial statements were prepared by the entity's management on January 31, 2021, and approved by the board of directors on February 20, 2021. What amount of provision should have been accrued on December 31, 2020? a. 5,000,000 b. 3,000,000 c. 3,500,000 d. 0

Problem 4-19 (AICPA Adapted) On November 5, 2020, a Dunn Company truck was in an accident with an auto driven by Bell. The entity received notice on January 12, 2021 of a lawsuit for P700,000 damages for personal injuries suffered by Bell. The entity's counsel believed it is probable that Bell will be awarded an estimated amount in the range between P200,000 and P500,000. The possible outcomes are equally likely. The accounting year ends on December 31 and the 2020 financial statements were issued on March 31, 2021. What amount of provision should be accrued on December 31, 2020? a.0 b. 200,000 c. 500,000 d. 350,000

Problem 4-20 (AICPA Adapted) During 2020, Manfred Company guaranteed a supplier's P500,000 loan from a bank. On October 1, 2020, the entity was notified that the supplier had defaulted on the loan and filed for bankruptcy protection. Counsel believed the entity will probably have to pay P250,000 under its guarantee. As a result of the supplier's bankruptcy, the entity entered into a contract in December 2020 to retool its machines so that the entity could accept parts from other suppliers. Retooling costs are estimated to be P300,000. What amount should be reported as accrued liability on December 31, 2020? a. 250,000 b. 450,000 c. 550,000 d. 750,000

Problem 4-21 (AICPA Adapted) During 2020, Beal Company became involved in a tax dispute with the BIR On December 31, 2020, the entity's tax advisor believed that an unfavorable outcome was probable and the best estimate of additional tax was P500,000 but could be as much as P650,000. After the 2020 financial statements were issued, the entity received and accepted a BIR settlement offer of P550,000. What amount of accrued liability should be reported on December 31, 2020? a. 650,000 b. 550,000 c. 500,000 d. 0

Problem 4-22 (AICPA Adapted) On February 5, 2021, an employee filed a P2,000,000 lawsuit against Steel Company for damages suffered when a plant of the entity exploded on December 29, 2020. The entity's legal counsel believed the entity will probably lose the lawsuit and estimated the loss to be P500,000. The employee has offered to settle the lawsuit out of court for P900,000 but the entity will not agree to the settlement. On December 31, 2020, what amount should be reported as accrued liability? a. 2,000,000 b. 1,000,000 c. 900,000 d. 500,000

Problem 4-23 (AICPA Adapted) On November 25, 2020, an explosion occurred at a Rex Company plant causing extensive property damage to area buildings. By March 10, 2021, claims had been asserted against Rex Company. The management and counsel concluded that it is probable Rex Company will be responsible for damages, and that P3,500,000 would be a reasonable estimate of the liability. The entity's P10,000,000 comprehensive public liability policy has a P500,000 deductible clause. The financial statements for 2020 were issued on March 25, 2021 1. What amount of loss from lawsuit should be reported in the income statement for 2020? a. 3.500.000 b. 3,000,000 c. 500,000 d. 0 2. What amount of liability from lawsuit should be reported on December 31, 2020? a. 3,500,000 b. 1.750,000 c. 1,500,000 d. 750,000

Problem 4-24 (IAA) Winter Company is being sued for illness caused to local residents as a result of negligence on the entity's part in permitting the local residents to be exposed to highly toxic chemicals from its plant. The entity's lawyer stated that it is probable that the entity will lose the suit and be found liable for a judgment costing the entity anywhere from P1,200,000 to P6,000,000 However, the lawyer estimated that the most probable cost is P3.600.000 What amount should be accrued and disclosed? a.

A loss contingency of P1.200.000 and disclose an additional contingency of up to P4,800,000. b. A loss contingency of P3.600.000 and disclose an additional contingency of up to P2,400,000 c. A loss contingency of P3,600,000 but not disclose any additional contingency. d. No loss contingency but disclose a contingency of P1,200,000 to P6,000,000.

Problem 4-25 (AICPA Adapted) On December 31, 2020, Mith Company was a defendant in a pending lawsuit. In the opinion of the entity's attorney, it is probable that Mith Company will have to pay P500,000 and it is reasonably possible that Mith Company will have to pay P600,000 as a result of this lawsuit. What should be reported in the 2020 financial statements? a. An accrued liability of P500,000 only. b. An accrued liability of P500,000 and disclosure of a contingent liability of P100,000 c. An accrued liability of P600,000 only. d. No information about this lawsuit.

Problem 4-26 (AICPA Adapted) During the current year, Haze Company won a litigation award for P1,500,000 which was tripled to P4,500,000 to include punitive damages. The defendant, who is financially stable, has appealed only the P3,000,000 punitive damages. The entity was awarded P5,000,000 in an unrelated suit it filed, which is being appealed by the defendant. Counsel is unable to estimate the outcome of these appeals. What amount of pretax gain should be reported? a. 1,500,000 b. 4,500,000 c. 5,000,000 d. 9,500,000

Problem 4-27 (AICPA Adapted) In May 2020, Caso Company filed suit against Wayne Company seeking P1,900,000 damages for patent infringement. A court verdict in November 2020 awarded Caso Company P1,500,000 in damages, but Wayne Company's appeal is not expected to be decided before 2021. The legal counsel believed it is probable that Caso Company will be successful against Wayne Company for an estimated amount in the range between P800,000 and P1,100,000, with P1,000,000 considered the most likely amount. What amount should Caso Company record as income from the lawsuit for the year ended December 31, 2020?! a. 1,500,000 b. 1,100,000 c. 1,000,000 d. 0

Problem 4-28 (IAA) On November 1, 2020, Vienna Company was awarded a judgment of P1,500,000 in connection with a lawsuit. The decision is being appealed by the defendant and it is expected that the appeal process will be completed by the end of 2021. The attorney believed that it is highly probable that an award will be upheld on appeal but that the judgment may be reduced by an estimated 40%. What amount should be reported as a receivable on December 31, 2020? a. 1,500,000 b. 600,000 c. 900,000 d. 0

Problem 4-29 (AICPA Adapted) During 2020, Smith Company filed suit against West Company seeking damages for patent infringement. On December 31, 2020, the legal counsel believed that it was probable that Smith Company would be successful against West Company for an estimated amount of P1,500,000 On March 31, 2021, Smith Company was awarded P1,000,000 and received full payment thereof The financial statements were issued March 1, 2021. In Smith Company's 2020 financial statements, how should this award be reported? a. As a receivable and revenue of P1,000,000 b. As a receivable and deferred revenue of P1,000,000 c. As a disclosure of a contingent asset of P1,000,000 d. As a disclosure of a contingent asset of P1,500,000.

Problem 4-30 (AICPA Adapted) Tone Company is the defendant in a lawsuit filed by Witt in 2019 disputing the validity of copyright held by Tone. On December 31, 2019, Tone determined that Witt would probably be successful for an estimated amount of P400,000. Appropriately, & P400,000 loss was accrued by a charge to income for the year ended December 31, 2019. On December 31, 2020. Tone and Witt agreed to a settlement providing for cash payment of P250,000 by Tone to Witt and transfer of Tone's copyright to Witt, The carrying amount of the copyright on Tone's accounting records was P60.000 on December 31, 2020, What would be the effect of the settlement on Tone's income before tax in 2020? a. 150,000 increase b. 60,000 decrease c. 90,000 increase d. 90.000 decrease

Problem 4-31 Multiple choice (IFRS) 1. Which is the correct definition of a provision? a. A possible obligation arising from past events b. A liability of uncertain timing or uncertain amount c. A liability which cannot be easily measured d. An obligation to transfer funds to an entity 2. A provision shall be recognized when a. An entity has a present obligation as a result of a past event. b. It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation c. The amount of the obligation can be measured reliably. d. All of these are required for the recognition of a provision. 3. A legal obligation is an obligation that is derived from all of the following, except A. Legislation b. A contract c. Other operation of law d. An established pattern of practice 4. A constructive obligation is an obligation I. That is derived from an entity's action that the entity will accept certain responsibilities because of past practice or published policy. II. The entity has created a valid expectation in other parties that it will discharge those responsibilities. a. I only b. II only c. Both I and II d. Either I or II

5. It is an event that creates a legal or constructive obligation because the entity has no other realistic alternative but to settle the obligation. a. obligation event b. Past event c. Subsequent event d. Current event 6.

An outflow of resources embodying economic benefits is regarded as "probable" when a. The probability that the event will occur is greater than the probability that the event will not occur. b. The probability that the event will not occur is greater than the probability that the event will occur. c. The probability that the event will occur is the same as the probability that the event will not occur. d. The probability that the event will occur is 90% likely.

7.

Where there is a continuous range of possible outcomes and each point in that range is as likely as any other, the range to be used is the a. Minimum b. Maximum c. Midpoint d. Summation of the minimum and maximum

8.

When the provision involves a large population of items, the estimate of the amount a. Reflects the weighting of all possible outcomes by their associated probabilities. b. Is determined as the individual most likely outcome. c. May be the individual most likely outcome adjusted for the effect of other possible outcomes. d. Midpoint of the possible outcomes.

9. When the provision arises from a single obligation, the estimate of the amount a. Reflects the weighting of all possible outcomes by their associated probabilities. b. Is determined as the individual most likely outcome c. Is the individual most likely outcome adjusted for the effect of other possible outcomes. d. Midpoint of the possible outcomes.

10. Which statement is incorrect when the expenditure required to settle a provision is expected to be reimbursed by another party? a. The reimbursement shall be recognized only when it is virtually certain that the reimbursement will be received if the entity settles the obligation. b. The amount of the reimbursement shall not exceed the amount of the provision. c. The reimbursement shall be "netted" against the estimated liability for the provision. d. In the income statement, the expense relating to the provision may be presented net of the reimbursement!

Problem 4-32 Multiple choice (IFRS) 1.

A provision shall be recognized for a b. c. d.

Future operating losses Obligations under insurance contracts Reductions in fair value of financial instruments Obligations for plant decommissioning costs

2. Provisions shall be recognized for all, except a. Cleaning-up costs of contaminated land when an oil entity has a published policy that it will undertake to clean up all contamination that it causes. b. Restructuring costs after a binding sale agreement. c. Rectification costs relating to products sold. d. Future refurbishment costs due to introduction of a new computer system.

3.

An entity is closing one of its operating divisions, and the conditions for making restructuring provision have been met. The closure will happen in the first quarter of the next financial year. At the current year-end, the entity has announced the formal plan publicly and is calculating the restructuring provision Which of the following costs should be included in the restructuring provision? a. Retraining staff continuing to be employed b. Relocation costs relating to staff moving to other divisions c. Contractually required costs of retiring staff being made redundant from the division being closed d. Future operating losses of the division being closed up to the date of closure

4.

An entity has been served a legal notice at year-end by the Department of Environment and Natural Resources to fit smoke detectors in its factory on or before middle of the next year. The cost of fitting smoke detector be measured reliably. How should the entity treat this in the financial statements at year-end? a. Recognize a provision for the current year equal to the estimated amount. b. Recognize a provision for the current year equal to one-half only of the estimated amount. c. No provision is recognized at year-end because there is no present obligation for the future expenditure since the entity can avoid the future expenditure by changing the method of operations, but disclosure is required. d. lgnore the event.

5. An entity operates chemical plants. The published policies include a commitment to making good any damage caused to the environment by its operations. The entity has always honored this commitment. Which of the following scenarios relating to the entity would give rise to a provision? a. On past experience it is likely that a chemical spill which would result in having to pay fines and penalties will occur in the next year. b. Recent research suggests there is a possibility that the entity's actions may damage surrounding wildlife. c. The government has outlined plans for a new law requiring all environmental damage to be rectified. d. A chemical spill from one of the entity's plants has caused harm to the surrounding area and wildlife

Problem 4-33 Multiple choice (AICPA Adapted) 1. An entity did not record an accrual for a present obligation but disclose the nature of the obligation and the range of the loss. How likely is the loss? a. Remote b. Reasonably possible c. Probable d. Certain 2. The likelihood that the future event will or will not occur can be expressed by a range of outcome. Which range means that the future event occurring is very slight? a. Probable b. Reasonably possible c. Certain d. Remote 3.

An expropriation of asset which is imminent and for which the amount of loss can be reasonably estimated should be a. Accrued b. Disclosed c. Accrued and disclosed d. Ignored

4. A present obligation that is probable and for which the amount can be reliably estimated should a.Not be accrued but disclosed in the notes to the financial statements. b. Be accrued by debiting an appropriated retained earnings account and crediting a liability account. c. Be accrued by debiting an expense account and crediting an appropriated retained earnings account. d. Be accrued by debiting an expense account and crediting a liability account. 5. General or unspecified contingencies should a. Be accrued in the financial statements and disclosed b. Not be accrued and need not be disclosed. c. Not be accrued but should be disclosed. d. Be accrued but need not be disclosed.

6. A contingent liability a. Definitely exists as a liability but the amount and due date are indeterminable. b. Is accrued even though not reasonably estimated c. Is the result of a loss contingency. d. Is not recognized in the financial statements 7.

A contingent liability is a. An estimated liability. b. An event which is not recognized because it is not probable that an outflow will be required or the amount cannot be reliably estimated. c. A potential large liability. d. A potential small liability

8. Reporting is required for a. Loss contingencies that are probable and can be reliably measured. b. Gain contingencies that are probable and can be reliably measured. c. Loss contingencies that are possible and can be reliably measured. d. All gain and loss contingencies. 9. Contingent assets are usually recognized when a. Realized b. Occurrence is reasonably possible and the amount can be reasonably estimated c. Occurrence is probable and the amount can be reasonably estimated d. The amount can be reasonably estimated 10. Which is the proper way to report a contingent asset receipt of which is virtually certain? a. As an asset b. As unearned revenue c. As a disclosure only d. No disclosure and no accrual