IFRS PRACTICAL IMPLEMENTATION GUIDE AND WORKBOOK

Chap ter

29/

Provisions, Contingent Liabilities, and Contingent Assets (l A S 37)

319

the attention of the media. Environmentalists are protesting and the entity has engaged lawyers to advise

it about legal repercussions. In the past, other oil entities have had to settle with the environmentalists,

paying huge amounts in out-of-court settlements. The legal counsel of Excellent Inc. has advised it that

there is no law that would require it to pay anything for the oil spill; the parliament of Excessoil Islands

is currently considering such legislation, but that legislation would probably take another year to be fi–

nalized as of the date of the oil spill. However, in its television advertisements and promotional bro–

chures, Excellent Inc. often has clearly stated that it is very conscious of its responsibilities toward the

environment and will make good any losses that may result from its exploration. This policy has been

widely publicized, and the chief executive officer has acknowledged this policy in official meetings

when members of the public raised questions to him on this issue.

Required

Does the above give rise to an obligating event that requires Excellent Inc. to make a provision for the

cost of making good the oil spill?

Solution

(a) Present obligation as a result of a past obligating event. The obligating event is the oil spill. Be–

cause there is no legislation in place yet that would make cleanup mandatory for any entity op–

erating in Excessoil Islands, there is no legal obligation . However, the circumstances sur–

rounding the issue clearly indicate that there is a constructive obligation since the company,

with its advertised policy and public statements, has created an expectation in the minds of the

public at large that it will honor its environmental obligations.

(b) An outflow ofresources embodying economic benefits in settlement. Probable.

oil spill.

4.2 Measurement of Provisions

4.2.1 The amount to be recognized as a provision is the

best estimate

of the expenditure requ ired

to settle the presen t obligation at the ba lance shee t date. While a reliable es timate is usuall y possi–

ble, in rare circumstances, it may not be possible to obtain a relia ble es timate . In such cases, the

liability is to be d isclosed as a contingent liability (and not recognized as a provision).

4.2.2 "Bes t estima te" is a matter of judgmen t and is usuall y based on past expe rie nce with similar

transactions, evi de nce provided by tec hnical or legal experts, or additio nal ev ide nce provid ed by

events after the ba lance sheet date.

4.2.3 Risks and unce rtainties surrounding events and circ umstances sho uld be co nsi dered in ar–

riving at the best es tima te of a provision .

• If a group of items is bein g me asured , it is the "expected va lue."

• If a sing le obligation is being me asured , it the "mos t likely outcome ."

Case Study 2

Facts

A car dealership also owns a workshop that it uses for servicing cars under warranty. In preparing its fi–

nancial statements, the car dealership needs to ascertain the provision of warranty that it would be re–

quired to provide at year-end. The entity's past experience with warranty claims is

• 60% of cars sold in a year have zero defects.

• 25%

of cars sold in a year have normal defects.

• 15%

of cars sold in a year have significant defects.

The cost of rectifying a "normal defect" in a car is $10,000. The cost of rectifying a "significant defect"

in a car is $30,000.

Required

Compute the amount of "provision for warranty" needed at year-end.

Solution

The expected value of the provision for warranty needed at year-end is:

(60%

(25%

$10,000)

(15%

$30,000)

$7,000 .