14.8 Dunino Limited is a company manufacturing, selling and laying carpet tiles,
ID: 2508063 • Letter: 1
Question
14.8 Dunino Limited is a company manufacturing, selling and laying carpet tiles, currently preparing financial statements at 31 December 2015 Under the terms of sale, Dunino gives a warranty, whereby it agrees to make good manufacturing or laying defects that become apparent within three years after the date of laying. Independent inspectors would determine if making good was best done by repair or replacement. On the basis of past experience the company expects that 3 per cent of sales will be the subject of a claim for making good, of which two- thirds will result in repair or replacement. State whether you believe the above matter would give rise to a provision under FRS 12 and IAS 37, giving your reasons a provision is recognized, what work the auditor perform to ensure that i best estimate of costs to be incurre d?Explanation / Answer
IAS 37 defines and specifies the accounting for and disclosure of provisions, contingent liabilities, and contingent assets.
Provisions
A provision is a liability of uncertain timing or amount. The liability may be a legal obligation or a constructive obligation. A constructive obligation arises from the entity’s actions, through which it has indicated to others that it will accept certain responsibilities, and as a result has created an expectation that it will discharge those responsibilities. Examples of provisions may include: warranty obligations; legal or constructive obligations to clean up contaminated land or restore facilities; and obligations caused by a retailer’s policy to make refunds to customers.
An entity recognises a provision if it is probable that an outflow of cash or other economic resources will be required to settle the provision. If an outflow is not probable, the item is treated as a contingent liability.
A provision is measured at the amount that the entity would rationally pay to settle the obligation at the end of the reporting period or to transfer it to a third party at that time. Risks and uncertainties are taken into account in measuring a provision. A provision is discounted to its present value.
IAS 37 elaborates on the application of the recognition and measurement requirements for three specific cases:
Contingent liabilities
Contingent liabilities are possible obligations whose existence will be confirmed by uncertain future events that are not wholly within the control of the entity. An example is litigation against the entity when it is uncertain whether the entity has committed an act of wrongdoing and when it is not probable that settlement will be needed.
Contingent liabilities also include obligations that are not recognised because their amount cannot be measured reliably or because settlement is not probable. Contingent liabilities do not include provisions for which it is certain that the entity has a present obligation that is more likely than not to lead to an outflow of cash or other economic resources, even though the amount or timing is uncertain.
A contingent liability is not recognised in the statement of financial position. However, unless the possibility of an outflow of economic resources is remote, a contingent liability is disclosed in the notes.
Contingent assets
Contingent assets are possible assets whose existence will be confirmed by the occurrence or non-occurrence of uncertain future events that are not wholly within the control of the entity. Contingent assets are not recognised, but they are disclosed when it is more likely than not that an inflow of benefits will occur. However, when the inflow of benefits is virtually certain an asset is recognised in the statement of financial position, because that asset is no longer considered to be contingent.
FRS 12's objective is to ensure that a provision (a liability that is of uncertain timing or amount) is recognised only when it actually exists at the balance sheet date. A provision should be recognised therefore only when:
The amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date.
Contingent liabilities and contingent assets are not recognised as liabilities or assets. However, a contingent liability should be disclosed if the possibility of an outflow of economic benefit to settle the obligation is more than remote. A contingent asset should be disclosed if an inflow of economic benefit is probable.
The standard was developed as a joint project with IASC.
Provisions often have a substantial effect on an entity's financial position and performance. Earlier published guidance, however, had tended to concentrate on particular forms of provision rather than the general principles underlying all provisions. Furthermore the practice had grown up of aggregating present liabilities with expected liabilities of future years, including sometimes items related to ongoing operations, in one large provision, often reported as an exceptional item. The effect of such 'big bath' provisions was not only to report excessive liabilities at the outset but also to boost profitability during the subsequent years, when the liabilities were in fact being incurred.
Auditors usually ask management to write a statement acknowledging they disclosed all known contingent liabilities
Search for Undisclosed Contingencies
In a perfect world, management would disclose all contingent liabilities to their auditors. This doesn't always happen and auditors should perform extended search procedures after an initial inquiry. Auditors can review any company Internal Revenue Service reports for unsettled income tax liabilities. It's also helpful to search the board of director meeting minutes for discussion of potential or current lawsuits. Auditors should pay special attention to the content of any legal expense accounts in the accounting system. The supporting documentation for legal expense transactions may reveal contingent liabilities.
Evaluate Materiality
To determine the correct accounting treatment, auditors must evaluate the materiality of the contingent liabilities. Before examining the specifics of the contingent liabilities, auditors will determine a dollar amount they consider significant based on the company's financial situation. If the contingent liability is under the immateriality limit, no special disclosure or treatment is necessary. For example, consider a company with $8 million in revenue is facing a lawsuit with potential damages of around $800. Even if it's probable the company will have to pay, the auditor may not consider the amount to be material.
Evaluate Event Likelihood
If a contingent liability is a material amount or the amount can't be estimated, auditors should estimate the likelihood that the event will occur. The likelihood can be remote, reasonably possible or probable. U.S. generally accepted accounting principles do not offer specific percentage definitions of these three levels, so auditors must use their professional judgment. The company must disclose material contingent liabilities that are possible or probable by adding a footnote to the financial statement.
Look at Probable Events
Auditors should pay special attention to any contingent liabilities in the "probable" category, because they may require special accounting treatment. If the contingent liability is probable, but the amount cannot be estimated, the liability should be disclosed in the footnotes, and no more action is necessary. However, liabilities that are probable and can be estimated, need a specific accounting journal entry. The auditor should ensure the company debited legal expense and credited accrued liabilities for any probable and measurable contingent liabilities.
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