History Question Analysis
　　Question 1 (Q3/December 2003)
　　IAS 37’ Provisions， Contingent Liabilities and Contingent Assets’ was issued in 1998. The Standard sets out the rinciples of accounting for these items and clarifies when provisions should and should not be made. Prior to its issue， the inappropriate use of provisions had been an area where companies had been accused of manipulating the financial statements and of creative accounting.
　　Required：
　　(a) Describe the nature of provisions and the accounting requirements for them contained in IAS 37.(6 marks)
　　(b) Explain why there is a need for an accounting standard in this area. Illustrate your answer with three practical examples of how the standard addresses controversial issues.(6 marks)
　　(a) IAS 37 ‘Provisions， Contingent Liabilities and Contingent Assets’ only deals with those provisions that are regarded as liabilities. The term provision is also generally used to describe those amounts set aside to write down the value of assets such as depreciation charges and provisions for diminution in value (e.g. provision to write down the value of damaged or slow moving inventory). The definition of a provision in the Standard is quite simple; provisions are liabilities of uncertain timing or amount. If there is reasonable certainty over these two aspects the liability is a creditor. There is clearly an overlap between provisions and contingencies. Because of the ‘uncertainty’ aspects of the definition， it can be argued that to some extent all provisions have an element of contingency. The IASB distinguishes between the tow by stating that a contingency is not recognized as a liability if it is either only possible and therefore yet to be confirmed as a liability， or where there is a liability but it cannot be measured with sufficient reliability. The IASB notes the latter should be rare.
　　The IASB intends that only those liabilities that meet the characteristics of a liability in its Framework for the Preparation and Presentation of Financial Statements should be reported in the balance sheet.
　　IAS 37 summarises the above by requiring provisions to satisfy all of the following three recognition criteria：
　　- there is a present obligation (legal or constructive) as a result of a past event;
　　- it is probable that a transfer of economic benefits will be required to settle the obligation;
　　A provision is triggered by an obligating event. This must have already occurred， future events cannot create current liabilities. The first of the criteria refers to legal or constructive obligations. A legal obligation is straightforward and uncontroversial， but constructive obligations are a relatively new concept. These arise where a company creates an expectation that it will meet certain obligations that is not legally bound to meet. These may arise due to a published statement or even by a pattern of past practice. In reality constrictive obligations are usually accepted because the alternative action is unattractive or may damage the reputation of the company. The most commonly quoted example of such is a commitment to pay for environmental damage caused by the company， even where there is no legal obligation to do so.
　　To summarise： a company must provide for a liability where the three defining criteria of a provision are met， but conversely a company cannot provide for a liability where they are not met. The latter part of the above may seem obvious， but it is an area where there has been some past abuse of provisioning as is referred to in (b).
　　(b) the main need for an accounting standard in this area is to clarify and regulate when provisions should and should not be made. Many controversial areas including the possible abuse of provision are based on contravening aspects of the above definitions. One of the most controversial examples of provisioning is in relation to future restructuring or recognization costs (often as part of an acquisition). This is sometimes extended to providing for future operating losses. The attraction of providing for this type of expense/loss is that once the provision has been made， the future costs are then charged to the provision such that they bypass the income statement (of the period when they occur). Such provisions can be glossed over by management as ‘exceptional items’， which analysts are expected to disregard when assessing the company’s future prospects. If this type of provision were to be incorporated as a liability as part of a subsidiary’s net assets at the date of costs and operating losses (unless they are for an onerous contract) do not constitute past events.
　　Another important change initiated by IAS 37 is the way in which environmental provisions must be treated. Practice in this area has differed considerably. Some companies did provide for such costs and those that did often accrued for them on an annual basis. If say a company expected environmental site restoration cost of $10 million in 10 years time， it might argue that this is not a liability until the restoration is needed or it may accrue $1 million per annum for 10 years (ignoring discounting). Somewhat controversially this practice is no longer possible. IAS 37 requires that if the environmental costs are a liability (legal or constructive)， then the whole of the costs must be provided for immediately. That has led to large liabilities appearing in some companies’ balance sheets.
　　A third example of bad practice is the use of‘big bath’ provisions and over provisioning. In its simplest form this occurs where a company makes a large provision， often for non-specific future expenses， or as part of an overall restructuring package. If the provision is deliberately overprovided， then its later release will improve future profits. Alternatively the company could charge to the provision a different cost than the one is was originally created for IAS 37 addresses this practice in two ways： by not allowing provisions to be created if they do not meet the definition of an obligation; and specifically preventing a provision made for one expense to be used for a different expense. Under IAS 37 the original provision would have to be reversed and a new one would be created with appropriate disclosures. Whilst this treatment does not affect overall profits， it does enhance transparency.
　　Note： other examples would be acceptable.
　　(c) Bodyline sells sports goods and clothing through a chain of retail outlets. It offers customers a full refund facility for any goods returned with in 28days of their purchase provided they are unused and in their original packaging. In addition， all goods carry a warranty against manufacturing defects for 12 months from their date of purchase. For most goods the manufacturer underwrites this warranty such that Bodyline is credited with the cost of the goods that are retumed as faulty. Goods purchased from one manufacturer， Header， are sold to Bodyline at a negotiated discount which is designed to compensate Bodyline for manufacturing defects. No refunds are given by Header， thus Bodyline has to bear the cost of any manufacturing faults of these goods.
　　Bodyline makes a uniform mark up on cost of 25% on all goods it sells， except for those supplied from Header on which it makes a mark up on cost of 40%. Sales of goods manufactured by Header consistently account for 20% of all Bodyline’s sales.
　　Sales in the last 28 days of the trading year to 30September 2003 were $1，750，000. Past trends reliably indicate that 10% of all goods are returned under the 28-day return facility. These are not faulty goods. Of these 70% are later resold at the normal selling price and the remaining 30% are sold as ‘sale’ items at half the normal retail price.
　　In addition to the above expected returns， an estimated $160，000 (at selling price) of the goods sold during the year will have manufacturing defects and have yet to be returned by customers. Goods returned as faulty have no resale value