ACCOUNTING STANDARD 29 PROVISIONS CONTINGENT LIABILITIES AND CONTINGENT

ACCOUNTING STANDARD 29 PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS AS 29 B P BRao, FCA P Rao, FCA

Applicability of AS-29 o Issued in 2003. o Applicable WEF 01/04/04 o Mandatory in entirety for Level I enterprises o Applicable for SMCs with certain relaxations regarding disclosure. o Specified Paragraphs of AS 4 on contingencies stand withdrawn except to the extent they deal with impairment of Financial assets and are not covered by AS 28. n Ø AS 29 ON AS-30 FI-Recognition BECOMING MANDATORY, FOLLOWING WILL BE WITHDRAWN In AS-4 all balance paras pertaining to Contingencies (balance after AS 29 was introduced was only reg. Impairment of assets not dealt with by any other standard like “Impairment of Receivable”). B P Rao, FCA 2

OBJECTIVE: o To ensure appropriate recognition criteria and measurement bases for n n provisions contingent liabilities o Disclosure o Accounting for contingent assets o Provision for restructuring costs AS 29 requirements to understand their nature, timing & amount. B P Rao, FCA enable users to 3

SCOPE Applicable to all Provisions, Contingent Liabilities and Contingent Assets other than: x Financial instruments carried at fair value x Insurance contracts with policy holders x Those covered by other AS like x Executory þ [Onerous contracts n n 7 (Construction Contracts) 22 (Taxes on Income), etc. 19 (Leases). In case an Operating Lease has become Onerous, AS 29 would apply. -15 (Employee Benefits) contracts [Contracts under which neither party has performed any of its obligations or both parties have partially performed their obligations to an equal extent] n n AS 29 AS AS (Cost >Benefit from contract) are covered by AS-29] Contract where the unavoidable costs of meeting the obligations under the contract exceed the expected economic benefits. Provision to be recognised [as per ASI-30] B P Rao, FCA 4

ONEROUS CONTRACTS Case Study 1: o o Contract to purchase 1 million units of gas @ 0. 23/unit [Contract price is Rs. 230, 000]. Current market price for a similar contract is 0. 16/unit [Market price is Rs. 160, 000]. Contract to sell to a third party @ 0. 18 per unit [Sale price is Rs. 180, 000]. In the event of cancellation of contract, penalty to be paid is Rs. 55, 000. What should be the treatment under AS -29 ? Ans. Liability of Rs. 50, 000 is to be provided for, Being Lower of: o Cost of fulfilling the contract i. e. Rs. 50000 OR o Penalty cost of Rs. 55, 000. AS 29 B P Rao, FCA [Rs. 230000 – Rs. 180000] 5

DEFINITIONS A PROVISION Øis a liability Øwhich can be measured only by using a substantial degree of estimation. (Quantum not certain - differs with ACCRUAL to this extent) A LIABILITY Øis a present obligation of the enterprise arising from past events, Øthe settlement of which is expected to result in an outflow of economic resources. PRESENT OBLIGATION - an obligation is a present obligation if, based on the evidence available, its existence at the B/S date is considered probable, i. e. , more likely than not. AS 29 B P Rao, FCA 6

SETTLEMENT OF PRESENT OBLIGATION o o o o AS 29 Either Payment of cash transfer of other assets Provision for services Replacement with another obligation conversion to equity waiver or forfeiture B P Rao, FCA 7

PROVISION: AS 29 defines Provision as a liability which can be measured only by using a substantial degree of estimation. RECOGNITION CRITERIA PROVISION = AS 29 Present obligation from past event + Outflow Is probable B P Rao, FCA + Ability to measure + No alternative settlement 8

PRESENT OBLIGATION AND PAST EVENTS: Condition 1 Existence of a present obligation arising from a past obligating event is essential for classification as a provision. Examples where provision is not required: § No provision for cost to be incurred to operate in future. § No provision for constructive obligations § No provision for possible obligation which may arise at a later date due to change in legislation § Provisions should not be made to spread out expenses just to produce reasonably level charge every year AS 29 B P Rao, FCA 9

PRESENT OBLIGATION AND PAST EVENTS - COMPARISON WITH IFRS IAS 37 covers constructive obligations also. Under AS-29, an obligating event is one which creates an obligation that results in the enterprise having no other alternative but to settle the obligation Whereas, as per IAS 37, an obligating event is one which creates a legal or constructive obligation that results in the enterprise having no other alternative but to settle the obligation o o AS 29 Legal obligation is one which derives either from: n Terms of a contract n Legislation; or n Other operation of law Constructive obligation derives from an entity’s actions where: n By established pattern of past practice, published policies or sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and n As a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities. B P Rao, FCA 10

PRESENT OBLIGATION AND PAST EVENTS o Condition 2 – Probable Outflow : It is extent of an obligation to transfer economic benefits, i. e. , obligation is more likely than not to occur, which means that the chance that a transfer of economic benefits will occur is over 50% PPR Analysis Probable > 50% Chance of occurrence Provision Possible <50% Chance of occurrence Contingent Liability Remote o AS 29 Almost 0% Disclose CL or forget Condition 3 – Reliable Estimate: Recognition of provision requires a greater degree of estimation. In extremely rare cases where no reliable estimate can be made, it implies that a liability exists which cannot be recognised. This liability would be a contingent liability. B P Rao, FCA 11

MEASUREMENT OF PROVISION ü Amount to be “Best Estimate” required to settle present obligation at BS date. ü Estimate based on ü management’s judgment, ü supplemented by experience on similar transactions & ü Reports by independent experts. ü Provision not to be discounted [IFRS requires discounting] ü It is Pre tax. Tax consequences of provision & its changes, are dealt in AS 22. ü Risks & uncertainties to be considered using PRUDENCE as in Framework. ü Likely gains from expected disposal of assets are not to be considered AS 29 B P Rao, FCA 12

MEASUREMENT OF PROVISION ü Future events that may affect the amount required to settle an obligation should be considered in arriving at the amount of provision where there is sufficient objective evidence that such future events will occur. ü CHANGES IN TECHNOLOGY Development of completely new technology to be taken into account only where there is sufficient evidence that it will be available & effective for the required task. ü CHANGE IN LEGISLATION New legislation to be reflected in the measurement of a provision for an existing obligation when there is sufficient objective evidence that the legislation is virtually certain to be enacted. AS 29 B P Rao, FCA 13

MEASUREMENT OF PROVISION o REIMBURSEMENT OF EXPENSES n n o n AS 29 If recognized , it will be a separate asset. Reimbursement should not exceed the amount of provision In P&L a/c, Reimbursement can be netted off against expense provision. Changes in Provisions n o Do not recognise reimbursement of expenditure required to settle a provision unless there is a virtual certainty that it will be received. Provisions should be reviewed at each balance sheet and adjusted to reflect current best estimates. If provision is no longer required the provision should be reversed. FUTURE OPERATING LOSSES n Do not recognise provision for future operating losses B P Rao, FCA 14

USE OF PROVISIONS U A provision should be used only for expenditures for which the provision was originally recognised. U Only expenditures that relate to the original provision are adjusted against it. U Adjusting expenditures against a provision that was originally recognised for another purpose would conceal the impact of two different events. AS 29 B P Rao, FCA 15

RESTRUCTURING o RESTRUCTURING is a programme that is planned & controlled by management, and materially changes either: a the scope of a business undertaken by an enterprise; or b o AS 29 the manner in which that business is conducted. RESTRUCTURING n No obligation arises for the sale of an operation until there is a binding sale agreement n Recognise a provision for re-structuring cost only if the recognition criteria as stipulated in the beginning is met B P Rao, FCA 16

CONTINGENT LIABILITY: a)A possible obligation that arises from past event and existence of which will be confirmed only by occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise or b) A present obligation that arises from past events but is not recognized because: i) It is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation: or ii) A reliable estimate of the amount of the obligation cannot be made. AS 29 B P Rao, FCA 17

CONTINGENT LIABILITY: Contingent = Liability AS 29 Possible obligation from past event + B P Rao, FCA Dependent upon a contingent event + Future event not within control 18

CONTINGENT LIABILITIES (CL) R R An enterprise should not recognise a CL. R Where an enterprise is jointly & severally liable for an obligation, A CL is disclosed, unless the possibility of an outflow of resources embodying economic benefits is remote. R The part of obligation that is expected to be met by other parties is treated as a CL. R The remainder, being the entity's share is to be recognised as a provision, except in the extremely rare circumstances where no reliable estimate can be made. R Conduct a continuous review of CL. Characteristics of an item that was originally reckoned as a CL may change over time. In turn, this may lead to recognition of a provision, in line with recognition criteria. AS 29 B P Rao, FCA 19

CONTINGENT ASSET: A possible asset arises from past events and existence of which is dependent upon a contingent event. Contingent = Asset AS 29 Possible asset from past event + B P Rao, FCA Dependent upon a contingent event + Future event not within control 20

CONTINGENT ASSETS (CA) h An enterprise should not recognise a CA. CA are not h CAs usually arise from unplanned or other unexpected events that give rise to the possibility of an inflow of economic benefits. h When the realisation of income is virtually certain, then the related asset is not a CA & its recognition is appropriate. h CAs are assessed continually & if it has become virtually certain that an inflow of economic benefits will arise, the asset & the related income are recognised in F/Ss of the period in which the change occurs. AS 29 disclosed in the financial statements. It may be disclosed in the report of the approving authority. B P Rao, FCA 21

DECISION TREE Start Present obligation as a result of an obligating event ? No Yes Probable outflow ? Yes Remote ? No Yes Reliable estimate ? No Possible Obligation ? No (rare) Disclose contingent liability Do nothing Provide AS 29 B P Rao, FCA 22

DISCLOSURE REQUIREMENTS For each class of provision, following should be disclosed PARA-66 o Carrying amount –opening and closing o Additions [including to existing provisions o Amounts used during the period o Reversals, if any PARA-67 o Brief description of nature of obligation & expected timing of probable outflow of resources o Uncertainties about outflows & Major assumptions reg. future events o Expected Reimbursements [State the amount of any assets recognized] Excise Trade / other litigation Environment Warranty Total Opening Balance Additions Utilisation Reversals Closing Balance AS 29 B P Rao, FCA 23

DISCLOSURE REQUIREMENTS Unless the possibility of any outflow is remote, For each class of contingent liability, following should be disclosed n Brief description of the nature a n where practicable o o o Estimate of its financial affect Indications of uncertainties involved Possibility of reimbursements Any information not practicable –such fact Exemption from Disclosures in extremely rare cases. However general nature of dispute, fact that and reason for non disclosure to be given. n AS 29 B P Rao, FCA 24

DISCLOSURE REQUIREMENTS o o o AS 29 In extremely rare cases, disclosure of some or all of the information required by paragraphs 66 -70 can be expected to prejudice seriously the position of the enterprise in a dispute with other parties on the subject matter of the provision or contingent liability. In such cases, an enterprise need not disclose the information, but should disclose the general nature of the dispute, together with the fact that, and reason why, the information has not been disclosed. B P Rao, FCA 25

RECOGNITION OF PROVISION o o AS 29 Provision for warranties? Provision to be scientifically determined based on trend analysis & other technical estimates. Will require assistance of actuary. Contaminated land –Legislation Virtually Certain to be Enacted? Contamination is an obligation event, virtual certainty of enactment is probable and hence an obligating event exists as at the balance sheet date. Provision should therefore be made. Credit card bonus points scheme? Obligation arises as soon as customer becomes entitled to reward points although utilization may be by the customer at a future date. Provision should therefore be made. Staff retraining costs as a result of change in legislation? On account of change in legislation an enterprise will need to retrain large proportion of staff. As at balance sheet date, no training has been imparted. No provision is required, since obligating event viz. , training has not occurred as at the balance sheet date. B P Rao, FCA 26

RECOGNITION OF PROVISION o o Case Study: A furnace has a lining that needs to be replaced every 5 years for technical reasons. As at March 31, 2009 has been used for 3 years. What should be the treatment under AS -29 ? Cost of replacing the lining is not recognized because n n AS 29 No obligation to replace the lining exists independently of the Company’s future actions. Intention to incur the expenditure depends on the Company deciding to continue operating the furnace or to replace the lining. B P Rao, FCA 27

COMPARISON OF AS 29 WITH IAS 37 o o o AS 29 IAS 37 permits discounting of provisions. AS 29 does not permit any discounting IAS 37 requires provisions for onerous contracts to be recognized AS 29 does not mandate it. IAS 37 requires provisioning on constructive obligation on restructuring. AS 29 prohibits the same. IAS 37 requires disclosure of Contingent Assets in FS. AS 29 allows such disclosure only in approving authority’s Report. IAS 37 provides basis & statistical methods for arriving at “best estimate” of expenditure for which provision is recognised. AS 29 doesn’t contain any such guidance & relies on management judgment. IAS 37 defines only “obligation” but not “present obligation” & “possible obligation”. AS 29 defines present obligation and possible obligation as well. B P Rao, FCA 28

EXAMPLES WARRANTIES: 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 make good, by repair or replacement, manufacturing defects that become apparent within three years from the date of sale. The obligating event is the sale of the product with a warranty o Conclusion - A provision is recognized for the best estimate of the costs of making good under the warranty products sold before the balance sheet date AS 29 B P Rao, FCA 29

EXAMPLES o o AS 29 REFUND POLICY: A retail store has a policy of refunding purchases by dissatisfied customers, even though it is under no legal obligation to do so. Its policy of making refunds is generally known. The obligating event is the sale of the product. An outflow of resources embodying economic benefits in settlement- Probable, a proportion of goods are returned for refund. Conclusion - A provision is recognized for the best estimate of the costs of refunds. B P Rao, FCA 30

EXAMPLES o o o AS 29 Legal Requirement to Fit Smoke Filters Under new legislation, an enterprise is required to fit smoke filters to its factories by 30 September, 2005. The enterprise has not fitted the smoke filters. (a) At the balance sheet date of 31 March, 2005 There is no obligation because there is no obligating event either for the costs of fitting smoke filters or fines under the legislation. Conclusion - No provision is recognized for the cost of fitting the smoke B P Rao, FCA 31

EXAMPLES o AS 29 (b) At the balance sheet date of 31 March, 2006 There is still no obligation for the costs of fitting smoke filters because no obligating event has occurred. However, an obligation might arise to Provisions, Contingent Liabilities and Contingent Assets 661 pay fines or penalties under the legislation because the obligating event has occurred Assessment of probability of incurring fines and penalties by non-compliant operation depends on the details of the legislation and the stringency of the enforcement regime. Conclusion - No provision is recognized for the costs of fitting smoke filters. However, a provision is recognized for the best estimate of any fines and penalties B P Rao, FCA 32

AS-29 ILLUSTRATIVELY Extract of the B. H. E. L Annual Report 2007 -08 o Claims by/against the Company (i) Claims for liquidated damages against the Company are recognized in accounts based on management’s assessment of the probable outcome with reference to the available information supplemented by experience of similar transactions. (ii) Claims for export incentives/duty drawbacks/duty refunds and insurance claims etc. are taken into accounts on accrual. AS 29 B P Rao, FCA 33

BHEL ANNUAL REPORT 2007 -08 (iii) Amounts due in respect of price escalation claims and/or variations in contract work are recognized as revenue only when there are conditions in the contracts for variations and/or evidence of the acceptability of the same from customers. However, escalation is restricted to intrinsic value. AS 29 B P Rao, FCA 34

BHEL ANNUAL REPORT 2007 -08 o Provision for Warranties (i) For construction contracts entered into on or after 01. 04. 2003: Provision for contractual obligation is maintained at 2. 5% of the contract value on completion of trial operation. (ii) For all other contracts: Provision for contractual obligations in respect of contracts under warranty at the year end is maintained at 2. 5% of the value of contract. In the case of contracts for supply of more than a single product 2. 5% of the value of each completed product is provided. (iii) Warranty claims/ expenses on rectification work are accounted for against natural heads as and when incurred and changed to provisions in the year end. AS 29 B P Rao, FCA 35

BHEL ANNUAL REPORT 2007 -08 o Contingent Liabilities: 1. (a) Claims against the company not acknowledged as debt: Income Tax pending appeals (net of provisions) Rs. 28. 41 crores (previous year Rs. 48. 72 crores) against which Rs. 0. 01 crore (previous year Rs. 0. 01 crore) has been paid under protest and including under the head deposits- others. AS 29 B P Rao, FCA 36

BHEL ANNUAL REPORT 2007 -08 (b) Sales Tax demands Rss. 295. 18 crores (previous year Rs. 328. 60 crores) against which Rs. 78. 03 crores (previous year Rs. 88. 90 crores) has been paid under protest/court orders and included under the head advances recoverable. (c) Excise Duty demands Rs. 140. 23 crores (previous year Rs. 149. 18 crores), against which Rs. 12. 49 crores (previous year Rs. 6. 52 crores) has been paid under protest/court orders and included under the head advances recoverable. AS 29 B P Rao, FCA 37

BHEL ANNUAL REPORT 2007 -08 (d) Custom Duty demands Rs. Nil (previous year Rs. 0. 76 crore) (e) Court / Arbitration cases Rs. 76. 17 crores (previous year Rs. 82. 47 crores) (f) Liquidated Damages Rs. 809. 53 crores (previous year Rs. 257. 22 crores) (g) Counter claim by contractors Rs. 40. 99 crores (previous year Rs. 40 crores). AS 29 B P Rao, FCA 38

BHEL ANNUAL REPORT 2007 -08 (h) Others Rs. 56. 31 crores (previous year Rs. 47. 65 crores). (g) Counter claim by contractors Rs. 40. 99 crores (previous year Rs. 40 crores). (h) Others Rs. 56. 31 crores (previous year Rs. 47. 65 crores). (i) In view of the various court cases / litigations and claims disputed by the company financial impact as to outflow of resources is not ascertainable at this stage. 2. Bills discounted under IDBI scheme outstanding at the close of the year amount to Rs. 0. 40 crore (previous year Rs. 1. 78 crores). AS 29 B P Rao, FCA 39

INFOSYS ANNUAL REPORT 2008 -09 An extract from the Infosys Annual Report for the year 2008 -09 o (a) For Post- sales Client Support and Warranties: The company provides its clients with a fixed period warranty for corrections of errors and telephone support on all its fixed-price and fixed-timeframe contracts. Costs associated with such support services are accrued at the time when related revenues are recorded and included in cost of sales. Company estimates such costs based on historical experience and the estimates are reviewed annually for any material changes in assumptions. AS 29 B P Rao, FCA 40

INFOSYS ANNUAL REPORT 2008 -09 o For onerous contracts Provisions for onerous contracts are recognized when the expected benefits to be derived by the Company from a contract are lower than the unavoidable costs of meeting the future obligations under the contract. The provisions is measured at lower of the expected cost of terminating the contract and the expected net cost of fulfilling the contract. AS 29 B P Rao, FCA 41

COMPENDIUM OF OPINIONS o AS 29 Treatment of contingency relating to additional power tariff demands by a State Government. A company has set up a unit to manufacture Ferro alloys. Its economics was based on the policies and assurances of the State Government to provide certain incentives. One of the incentives was to provide power at a tariff which was about Te. 0. 50 per unit for a period of 5 years. B P Rao, FCA 42

COMPENDIUM OF OPINIONS o AS 29 The State Government later unilaterally withdrew the notification on power tariff and sought to levy tariff at the revised rates. The revision of the notification of the government was challenged in the High Court, which stayed the application of the order pending full hearing. B P Rao, FCA 43

COMPENDIUM OF OPINIONS o AS 29 According to the querist, if the company accounts for the tariff at the revised rates, it would be a sick industrial company under section 3(1)(0) of the Sick Industrial Companies (Special Provision) Act, 1985, and if it does not account for the tariff at the revised rates, it would result into payment of income tax because the electricity expenses due to concessional tariff is lower as compared to the revised tariff. B P Rao, FCA 44

THANK YOU AS 29 B P Rao, FCA