Powerpoint slide has been attached for example of decision tree. slide 22 and 26 pls refer
2108AFE Financial Accounting Workshop Questions Solution Topic 8 – Liabilities FOR HOMEWORK SUBMISSION: QUESTION 1 Moolie Ltd is a manufacturer of surfboards. Pursuant to the sales terms, it gives warranties at the time of sales to purchasers of the surfboards for manufacturing defects that become apparent within two years from the date of sale. Based on past experience, Moolie is predicted to have 5% of the sales returned on manufacturing defects. Required Using the decision tree (see lecture slides) helps management make judgements on classifying a liability. Using this decision tree, determine how the case should be recorded? 2 PowerPoint Presentation 2108AFE Financial Accounting Topic 8 - Liabilities Learning objectives Describe the purpose of AASB 137 Outline the concept of a provision and how it is distinguished from other liabilities Outline the concept of a contingent liability and how it is distinguished from other liabilities Explain when a provision should be recognised Explain how a provision should be measured Apply the definition, recognition, and measurement criteria for provisions and contingent liabilities to practical situations 2 A Scenario for you….(1) You are the Chief Financial Officer of a company listed on the ASX. Annual financial reports are in the final stages of preparation. Profit for the year is expected to be around $60 million You are informed by the company’s legal officer of a pending court case. A class action has been filed by former employees for compensation for sickness caused by working for the company 20 years earlier. They are suing for $30 million. Medical evidence has been provided that links the sickness with working with contaminated materials. As CFO, you must make a recommendation to the CEO about the treatment of this new information. 3 A Scenario for you….(2) Discuss with the person next to you: What would you do? How would you go about making your decision? 4 james hardie (JHX) an old case but a good case it is still ongoing (1) 2001 Media release: http://pandora.nla.gov.au/pan/45031/20041019-0000/R.pdf Asbestos liability shown on Balance Sheets. Non-current liability for asbestos payments: 2002 report: $A94.4 million 2003 report: $A0! 2007 report: $A1,614.2 million 2008 report: $A1,718.7 million 2008: ASIC commenced civil action against former directors (failure to discharge duties with due care and diligence) 2009: 10 Directors found guilty and given disqualifications of 5 – 15 years and fines of $30,000 - $350,000 2009 report: $A1,755.4 million 2010 report: $A1,651.5 million 2011 report: $US1,587.0 million ……..but wait, there’s more.. 5 5 james hardie (JHX) an old case but a good case it is still ongoing (2) 2012 report: $US1,662.6 million 2013 report: $US1,558.7 million 2014 report: $US1,571.7 million 2015 report: $US1,290.0 million 2016 report: $US1,176.3 million 2017 report: $US1,043.3 million Mesothelioma claims are still at peak levels of 400 per year and will remain there until 2016-2017 when they will start to decline Claims are rising, but payouts are falling – Why? Claims relate to exposure during the period from 1986 onwards Claimants are ageing – 60% are older than 70 years old Contingent liabilities will continue to appear on James Hardie’s Balance Sheet for many more years to come! 6 why are liabilities important? The way that a company measures and discloses its liabilities is important to its continuing survival Legal contracts and agreements can put conditions on the company’s debt e.g. specify maximum levels of debt, minimum levels of performance Influence on financial ratios and debt covenants 7 Conceptual framework Liabilities defined A liability is defined as (Framework 2014, para 49): “a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits” Three essential characteristics: A present obligation Duty or responsibility to act in a certain way More than just a commitment/intention Arising from a past event e.g. purchase of supplies/services Expected to result in an outflow of economic resources Little discretion in avoiding this outflow 8 LO2 8 conceptual framework liability recognition A liability should be recognised in the Statement of Financial Position when (Framework 2014, para 91): It is probable that an outflow of resources embodying economic benefits will result from settling the present obligation, and The amount at which the settlement will take place can be measured reliably An item MUST satisfy BOTH the definition and recognition criteria! 9 test yourself 10 Liability definition criteria: Pick the correct 3! Future disposition of economic benefits Future disposition of economic benefits to other entities Lots of money is owed Past transaction or event created the obligation The amount of money owed can be determined Past obligation Past or anticipated transaction or event created the obligation Money is owed Present obligation test yourself 11 Liability recognition criteria: Pick the correct 2! The amount of the liability can be measured reliably The amount of the liability can be known exactly The liability can be expressed in monetary terms It’s highly likely that future economic benefits will flow from the entity It’s certain that future economic benefits will flow from the entity The liability can be expressed as a percentage of assets It’s probable that future economic benefits will flow from the entity wesfarmers ltd liabilities on the balance sheet 12 Statement of Financial Position as at 30 June 2016 AASB 137 definition of a provision AASB 137 Provisions, Contingent Liabilities, and Contingent Assets (para 10) defines a liability as: “a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits” This definition is equivalent to the definition in the AASB Conceptual Framework Provision (a subset of liabilities) A liability of uncertain timing or amount (AASB 137, para 10) 13 LO2 13 Key characteristic Present obligation A present obligation may be: Legal: Arising from a contract Equitable: Arising from normal business practice or custom Constructive: Arising from established pattern of past practice Exists only where the entity has no realistic alternative but to make the sacrifice of economic benefits to settle the obligation 14 LO2 14 distinguishing provisions from other liabilities Key distinguishing factor The uncertainty relating to either the timing or the amount Accruals vs. Provisions Accruals: reported as part of trade and other payables Provisions: reported separately (e.g. provision for warranties) Employee benefits are not provisions under AASB 137 AASB 119 deals with employee benefits (internal) Only obligations to parties external to entity may be recognised as a provision (AASB 137, para 20) 15 LO2 Trade payables and accruals are liabilities (not provisions) because: (a) trade payables are liabilities to pay for goods or services that have been received or supplied and have been invoiced or formally agreed with the supplier; and (b) accruals are liabilities to pay for goods or services that have been received or supplied but have not been paid, invoiced or formally agreed with the supplier, including amounts due to employees (for example, amounts relating to accrued vacation pay). Although it is sometimes necessary to estimate the amount or timing of accruals, the uncertainty is generally much less than for provisions. 15 recognition of provisions A provision is recognised on the Statement of Financial Position if (AASB 137, para 14): Present obligation (legal or constructive) as a result of a past event Probable outflow of resources to settle obligation Amount of obligation can be reliably estimated If these conditions are not met, no provision shall be recognised (AASB 137, para 14) Consistent with the AASB Framework 2014 16 Warranty expense (E↑) (for example)DRXXX Warranty provision (L↑) CRXXX To record the provision for warranties LO4 16 measurement of provisions ‘Best estimate’ of the consideration required to settle the present obligation at the end of the reporting period (AASB 137, para 36): Requires professional judgements Is calculated using ‘expected value’ estimation Measured before tax Due to judgement involved, auditors focus on provisions more than other normal liabilities (e.g. trade creditors) 17 LO5 17 wesfarmers ltd notes to the accounts 30 june 2016 18 definition of contingent liabilities A Contingent Liability is defined as (AASB 137, para 10): A possible obligation whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly in control of the entity OR A present obligation that fails the recognition criteria because: It is not probable an outflow of resources will be required to settle the obligation or The amount cannot be measured reliably Not recognised, but they are disclosed in the notes to the financial statements Unless possibility of settlement is remote 19 LO3 19 reporting contingent liabilities Examples: Guarantees to cover another entity’s debts Potential obligations from legal actions Inappropriate to recognise them on the Statement of Financial Position Disclosures in notes consist of: Estimate of financial impact Indication of uncertainties relating to timing of any outflow Possibility of any reimbursement 20 LO3 20 wesfarmers ltd notes to the accounts 30 june 2016 Note 23 Parent Disclosures (p. 126) 21 22 decision tree Provision, contingent liability, or nothing? AASB 137 Part B – Guide on Implementing LO4 22 let’s review (1) Some provisions traditionally recorded by entities, e. g. provisions for maintenance, may not be considered liabilities under the AASB Framework because: Their amounts are not considered probable. There is no entity other than the reporting entity involved in the present obligation as a result of past transactions or other past events. They do not involve a future sacrifice of economic benefits. The identity of the external party to whom the present obligation is owed is unknown. 23 B let’s review (2) Dunk N’ Dive Limited is a manufacturer of swimming pools and provides its customers with warranties at the time of sale. The warranty applies for three years from the date of sale. Past experience shows that there will be some claims under the warranties. The appropriate treatment of this item under AASB 137 Provisions, Contingent Liabilities and Contingent Assets, is to: Transfer the expected amount of the warranty from retained earnings to a special reserve account in equity. Disclose by note, but do not recognise in the financial statements. Charge the costs directly to profit or loss in the period in which the economic outflows occur. Recognise the best estimate of costs as a provision. 24 D let’s revisit our scenario (1) 25 You are the Chief Financial Officer of a company listed on the ASX. Annual financial reports are in the final stages of preparation. Profit for the year is expected to be around $60 million You are informed by the company’s legal officer of a pending court case. A class action has been filed by former employees for compensation for sickness caused by working for the company 20 years earlier. They are suing for $30 million. Medical evidence has been provided that links the sickness with working with contaminated materials. As CFO, you must make a recommendation to the CEO about the treatment of this new information. 26 decision tree Provision, contingent liability, or nothing? AASB 137 Part B – Guide on Implementing LO4 26 let’s revisit our scenario (2) Choose the option