330 / 488
Chapter
29 /
Provision s, Contingent Liabilities, and Contingent Assets (lAS 37)
321
An entity is bound under the terms of a f ranchise agreement fo r a local brand that it has marketed
fo r yea rs. Based on market survey and a cost-benefit study. the entity decided to stop marketing the
local brand and entered into a nell' agreement to market
01 1
international brand. Although the entity
does not derive any economic benefit from the franchise agreement fo r the local brand. there is
(Ill
obligation to pay a Ill/np-sIIIII amount to the fran chiser under the noncancellable fran chise agree–
ment fo r a period of two more years. Thus the entity would need to make a provision for the com–
mitment under the fran chise agreement (since it is an onerous
COil
tract).
Case Stu dy 3
Facts
XYZ
Inc. is gelling ready to move its factory from its existing location to a new industrial free zone spe–
cially created by the government for manufacturers. To avail itself of the preferential licensing offered
by the local governmental authorities as a reward for moving into the free trade zone and the savings in
costs that would ensue (since there are no duties or taxes in the free trade zone),
XYZ
Inc. has to move
into the new location before the end of the year. The lease on its present location is noncancelable and is
for another two years from year-end. The obligation under the lease is the annual rent of
$ 100,000.
Required
Advise
XYZ
Inc. what amount, if any, it needs to provide at year-end toward this lease obligation.
Solution
The lease agreement is an executory onerous contract because after moving to the new location.
XYZ
Inc. would derive no economic benefits from the existing factory building but would still need to pay
rent under the agreement since the lease is noncancelable. Thus the unavoidable costs exceed the bene–
fits expected under the lease contract.
Based on the annual lease obligation under the lease agreement, the total amount needed to be provided
at year-end is the present value of the total commitment under the lease
=
PY
of
[$ 100,000 x 2
(years)].
4.6 Restructuring
4.6.1 In the past, entities used to acc rue lump-sum pro visions fo r restructuring, because there
we re no Standa rds governing thi s import ant area . In some cases, thi s led to abu si ve practices of
man ipul at ion and creative accounting referred to as big bath provi sions. In order to control the
practice of dumping of all kinds of provision s under the banner of provision for restructuring,
lAS 37 prescribed rules to regul ate it. First and foremost, it defined the term, thereby rest ricting
restructuring to a structured program that is plann ed and controlled by the mana gement that materi –
ally changes
eithe r
the scope of a business of an entity
or
the manner in wh ich that business is con –
ducted.
4.6.2 To provide guidance on this contentious issue, lAS 37 provides these examples of events
that may quali fy as restructu ring:
• Sale or termination of a line of busin ess
• Cl osure of business locati ons in a region or relocati on of busin ess act iviti es fro m one loca–
tion to anoth er
• Ch anges in management structure, such as elimination of a layer of managem ent
• Fundamental reorgan ization of the entity such that it has a material and a signific ant impact
on its ope rations.
4.6 .3 Although many fundamen tal stru ctural changes to an entity' s operations would be signifi–
cant enough to warrant disclosure in footnotes to the finan cial statements, not all of these changes
qua lify as restru cturing that necessitates rec ogniti on (as opposed to disclosure) , becau se they do not
meet the criteria for recogni zing a pro vision. Recogniti on of the pro vision is required becau se a
cons tructive obligation may arise from the decision to restru cture. In other wo rds, a co nstructive
obliga tion may not arise in all cases . A co nstruc tive obliga tion arises when, and only when, an en–
tity
• Has a
detailed
fo rmal
p lan
for the restruc turing outli ning
at least
the bu sin ess or part of the
busin ess bein g restru ctured ; the princip al locati ons affec ted by the restructu ring ; the location ,
fun cti on, and approximate number of employees who will be compensa ted for terminating