Ind AS 37, Provisions, Contingent Liabilities and Contingent Assets, Important Questions with Solutions for CA Final Financial Reporting May & Nov 2021 Exams
Question 1 –
U Ltd. is a large conglomerate with a number of subsidiaries. It is preparing consolidated financial statements as on 31st March 2018 as per the notified Ind AS. The financial statements are due to be authorised for issue on 15th May 2018. It is seeking your assistance for some transactions that have taken place in some of its subsidiaries during the year.
1) G Ltd. is a wholly owned subsidiary of U Ltd. engaged in management consultancy services. On 31st January 2018, the board of directors of U Ltd. decided to discontinue the business of G Ltd. from 30th April 2018. They made a public announcement of their decision on 15th February 2018.
2) G Ltd. does not have many assets or liabilities and it is estimated that the outstanding trade receivables and payables would be settled by 31st May 2018. U Ltd. would collect any amounts still owed by G Ltd’s customers after 31st May 2018. They have offered the employees of G Ltd. termination payments or alternative employment opportunities.
3) Following are some of the details relating to G Ltd.:
- On the date of public announcement, it is estimated by G Ltd. that it would have to pay 540 lakhs as termination payments to employees and the costs for relocation of employees who would remain with the Group would be Rs.60 lakhs. The actual termination payments totaling to Rs.520 lakhs were made in full on 15th May 2018. As per latest estimates made on 15th May 2018, the total relocation cost is Rs.63 lakhs.
- G Ltd. had taken a property on operating lease, which was expiring on 31st March 2022. The present value of the future lease rentals (using an appropriate discount rate) is Rs.430 lakhs. On 15th May 2018, G Ltd. made a payment to the lessor of Rs.410 lakhs in return for early termination of the lease.
4) The loss after tax of G Ltd. for the year ended 31st March 2018 was Rs. 400 lakhs. G Ltd. made further operating losses totalling Rs. 60 lakhs till 30th April 2018.
How should U Ltd. present the decision to discontinue the business of G Ltd. in its consolidated statement of comprehensive income as per Ind AS?
What are the provisions that the Company is required to make as per lnd AS 37?
Solution –
A discontinued operation is one that is discontinued in the period or classified as held for sale at the year end. The operations of G Ltd were discontinued on 30th April 2018 and therefore, would be treated as discontinued operation for the year ending 31st March 2019. It does not meet the criteria for held for sale since the company is terminating its business and does not hold these for sale.
Accordingly, the results of G Ltd will be included on a line-by-line basis in the consolidated statement of comprehensive income as part of the profit from continuing operations of U Ltd for the year ending 31st March 2018.
As per para Ind AS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’, restructuring includes sale or termination of a line of business. A constructive obligation to restructure arises when:
(a) an entity has a detailed formal plan for the restructuring
(b) has raised a valid expectation in those affected that it will carry out the restructuring by starting to implement that plan or announcing its main features to those affected by it.
The Board of directors of U Ltd have decided to terminate the operations of G Ltd. from 30th April 2018. They have made a formal announcement on 15th February 2018, thus creating a valid expectation that the termination will be implemented. This creates a constructive obligation on the company and requires provisions for restructuring.
A restructuring provision includes only the direct expenditures arising from the restructuring that are necessarily entailed by the restructuring and are not associated with the ongoing activities of the entity. The termination payments fulfil the above condition. As per Ind AS 10 ‘Events after Reporting Date’, events that provide additional evidence of conditions existing at the reporting date should be reflected in the financial statements. Therefore, the company should make a provision for Rs. 520 lakhs in this respect.
The relocation costs relate to the future conduct of the business and are not liabilities for restructuring at the end of the reporting period. Hence, these would be recognised on the same basis as if they arose independently of a restructuring.
The operating lease would be regarded as an onerous contract. A provision would be made at the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it. Hence, a provision shall be made for Rs. 410 lakhs.
Further operating losses relate to future events and do not form a part of the closure provision.
Therefore, the total provision required = Rs. 520 lakhs + Rs. 410 lakhs = Rs. 930 lakhs.
Question 2 –
X Telecom Ltd. has income tax litigation pending before appellate authorities. Legal advisor’s opinion is that X Telecom Ltd. will lose the case and estimated that liability of Rs. 1,00,00,000 may arise in two years. The liability is recognised on a discounted basis. The discount rate at which the liability has been discounted is 10% and it is assumed that discount rate does not change over the period of 2 years. How should X Telecom Ltd. calculate the amount of borrowing cost?
Solution –
The discount factor of 10% for 2 years is 0.827. X Telecom Ltd. will initially recognise provision for Rs. 82,70,000 (Rs. 1,00,00,000 x 0.827).
The discount factor of 10% at the end of year 1 is 0.909. At the end of year 1, provision amount would be Rs. 90,90,000 (Rs. 1,00,00,000 x 0.909).
As per the standard, the difference between the two present values i.e., Rs. 8,20,000 is recognised as a borrowing cost in year 1.
At the end of the Year 2, the liability would be Rs. 1,00,00,000.
The difference between the two present values i.e., Rs. 9,10,000 (Rs. 1,00,00,000 – Rs. 90,90,000) is recognised as borrowing cost in year 2.
Question 3 –
Sun Limited has entered into a binding agreement with Moon Limited to buy a custom-made machine for Rs.4,00,000. At the end of 2017-18, before delivery of the machine, Sun Limited had to change its method of production. The new method will not require the machine ordered which is to be scrapped after delivery. The expected scrap value is nil. Given that the asset is yet to be delivered, should any liability be recognized for the potential loss? If so, give reasons for the same, the amount of liability as well as the accounting entry.
Solution –
As per Ind AS 37, Executory contracts are contracts under which
- neither party has performed any of its obligations; or
- both parties have partially performed their obligations to an equal extent.
The contract entered by Sun Ltd. is an executory contract, since the delivery has not yet taken place. Ind AS 37 is applied to executory contracts only if they are onerous.
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.
As per the facts given in the question, Sun Ltd. will not require the machine ordered. However, since it is a binding agreement, the entity cannot exit / cancel the agreement. Further, Sun Ltd. has to scrap the machine after delivery at nil scrap value.
These circumstances do indicate that the agreement/contract is an onerous contract. Therefore, a provision should be made for the onerous element of Rs.4,00,000 ie the full cost of the machine.
|
|
Rs. | Rs. | |
| Onerous Contract Provision Expense A/c | Dr. | 4,00,000 | |
|
To Provision for Onerous Contract Liability A/c |
4,00,000 | ||
| (Being asset to be received due to binding agreement recognized) | |||
| Profit and Loss Account (Loss due to onerous contract) | Dr. | 4,00,000 | |
|
To Onerous Contract Provision Expense A/c |
4,00,000 | ||
| (Being loss due to onerous contract recognized and asset derecognsied) |
Question 4 –
X Solar Power Ltd., a power company, has a present obligation to dismantle its plant after 35 years of useful life. X Solar Power Ltd. cannot cancel this obligation or transfer to third party. X Solar Power Ltd. has estimated the total cost of dismantling at Rs. 50,00,000, the present value of which is Rs. 30,00,000. Based on the facts and circumstances, X Solar Power Ltd. considers the risk factor of 5% i.e., the risk that the actual outflows would be more from the expected present value. How should X Solar Power Ltd. account for the obligation?
Solution –
The obligation should be measured at the present value of outflows i.e., Rs. 30,00,000. Further a risk adjustment of 5% i.e., Rs. 1,50,000 (Rs. 30,00,000 x 5%) would be made.
So, the liability will be recognised at = Rs. 30,00,000 + Rs.1,50,000 = Rs. 31,50,000.
Question 5 –
(a) A manufacturer gives warranties at the time of sale to purchasers of its product. Under the terms of the contract for sale, the manufacturer undertakes to remedy, by repair or replacement, manufacturing defects that become apparent within three years from the date of sale. As this is the first year that the warranty has been available, there is no data from the firm to indicate whether there will be claim under the warranties. However, industry research suggests that it is likely that such claims will be forthcoming.
Should the manufacturer recognize a provision in accordance with the requirements of Ind AS 37. Why or why not?
(b) Assume that the firm has not been operating its warranty for five years, and reliable data exists to suggest the following:
- If minor defects occur in all products sold, repair costs of Rs.20,00,000 would result.
- If major defects are detected in all products, costs of Rs.50,00,000 would result.
- The manufacturer’s past experience and future expectations indicate that each year 80%of the goods sold will have no defects. 15% of the goods sold will have minor defects, and 5% of the goods sold will have major defects.
Calculate the expected value of the cost of repairs in accordance with the requirements of Ind AS 37, if any. Ignore both income tax and the effect of discounting.
Solution –
(a) For a provision to be recognized, Para 14 of Ind AS 37 requires that:
a) an 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 will required to settle the obligation, and
c) a reliable estimate can be made of the amount of the obligation.
Here, the manufacturer has a present legal obligation. The obligation event is the sale of the product with a warranty.
Ind AS 37 outlines that the future sacrifice of economic benefits is probable when it is more likely than less likely that the future sacrifice of economic benefits will required. The probability that settlement will be required will be determined by considering the class of obligation (warranties) as a whole. In accordance with para 24 of Ind AS 37, it is more likely than less likely that a future sacrifice of economic benefits will be required to settle the class of obligations as a whole.
If a reliable estimate can be made the provision can be measured reliably. Past data can provide reliable measures, even if the data is not firm specific but rather industry based. Ind AS 37 notes that only in extremely rare cases, a reliable measure of a provision cannot be obtained. Difficulty in estimating the amount of a provision under conditions of significant uncertainty does not justify non-recognition of the provision.
Here, the manufacturer should recognize a provision based on the best estimate of the consideration required to settle the present obligation as at the reporting date.
(b) The expected value of cost of repairs in accordance with Ind AS 37 is: (80% × nil) + (15% × Rs.20,00,000) + (5% × Rs.50,00,000) = 3,00,000 + 2,50,000 = 5,50,000.
Question 6 –
During the year, QA Ltd. delivered manufactured products to customer K. The products were faulty and on 1st October, 2016 customer K commenced legal action against the Company claiming damages in respect of losses due to the supply of faulty product. Upon investigating the matter, QA Ltd. discovered that the products were faulty due to defective raw material procured from supplier F. Therefore, on 1st December, 2016, the Company commenced legal action against F claiming damages in respect of the supply of defec tive raw materials.
QA Ltd. has estimated that it’s probability of success of both legal actions, the action of K against QA Ltd. and action of QA Ltd. against F, is very high.
On 1st October, 2016, QA Ltd. has estimated that the damages it would have to pay K would be Rs. 5 crores. This estimate was revised to Rs. 5.2 crores as on 31st March, 2017 and Rs. 5.25 crores as at 15th May, 2017. This case was eventually settled on 1st June, 2017, when the Company paid damages of Rs. 5.3 crores to K.
On 1st December, 2016, QA Ltd. had estimated that it would receive damages of Rs. 3.5 crores from F. This estimate was revised to Rs. 3.6 crores as at 31st March, 2017 and Rs. 3.7 crores as on 15th May, 2017. This case was eventually settled on 1st June, 2017 when F paid Rs. 3.75 crores to QA Ltd. QA Ltd. had, in its financial statements for the year ended 31st March, 2017, provided Rs. 3.6 crores as the financial statements were approved by the Board of Directors on 26th April, 2017.
i. Whether the Company is required to make provision for the claim from customer K as per applicable Ind AS? If yes, please give the rationale for the same.
ii. If the answer to (i) above is yes, what is the entry to be passed in the books of account as on 31st March, 2017? Give brief reasoning for your choice.
| (A) | Statement of Profit and Loss A/c | Dr | Rs. 5.2 crores | |
| To Current Liability A/c | Rs. 5.2 crores | |||
| (B) | Statement of Profit and Loss A/c | Dr. | Rs. 5.3 crores | |
| To Non-Current Liability A/c | Rs. 5.3 crores | |||
| (C) | Statement of Profit and Loss A/c | Dr. | Rs. 5.25 crores | |
| To Current Liability A/c | Rs. 5.25 crores |
iii. What will the accounting treatment of the action of QA Ltd. against supplier F as per applicable Ind AS?
Solution –
i. Yes, QA Ltd. is required to make provision for the claim from customer K as per Ind AS 37 since the claim is a present obligation as a result of delivery of faulty goods manufactured. Also, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligations. Further, a reliable estimate of Rs. 5.2 crore can be made of the amount of the obligation while preparing the financial statements as on 31st March, 2017.
ii.
| Statement of Profit and Loss A/c | Dr | Rs. 5.2 crore | |
| To Current Liability A/c | Rs. 5.2 crore |
iii. As per para 31 of Ind AS 37, QA Ltd. shall not recognise a contingent asset. Here the probability of success of legal action is very high but there is no concrete evidence which makes the inflow virtually certain. Hence, it will be considered as contingent asset only and shall not be recognized.
Question 7 –
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 how much provision in this regard is required?
Solution –
Ind AS 37 “Provisions, Contingent Liabilities and Contingent Assets” 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 co ntract 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 (Rs.2.5 million – Rs.2 million) and cost of exiting from the contract by paying penalty is rs.0.25 million. In accordance with the above reproduced paragraph, it is an onerous contract as cost of meeting the contract exceeds the economic benefits. Therefore, the provision should be recognised 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).