Dalton Ltd: restructuring and onerous contract provisions at the year end
Dalton Ltd's board approved a detailed plan on 15 November 20X6 to close its Leeds factory and move production to Hull. The plan identified the site, the 120 employees to be made redundant, statutory redundancy of $1,800,000, completion by 30 June 20X7, retraining of retained staff at $300,000 and relocation costs of $250,000. The plan was announced to employees and customers on 20 December 20X6 and a formal agreement with employee representatives was signed on 15 January 20X7. Dalton expects the Leeds site to make operating losses of $500,000 up to closure. Separately, Dalton has a non-cancellable contract to buy 40,000 units of component X at $50 each over the next two years; the market price is now $35 and the penalty for cancelling would be $900,000. Dalton has never paid more than statutory redundancy. Its 20X6 financial statements were authorised for issue on 20 March 20X7.
1. Which of the listed costs give rise to a provision at 31 December 20X6? Apply the recognition criteria and explain the significance of the dates.
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Recognition test (IAS 37): a present obligation arising from a past event, probable outflow of resources, and a reliable estimate. For a restructuring, a constructive obligation arises only when there is a detailed formal plan and a valid expectation in those affected that the entity will carry out the restructuring.
- Redundancy $1,800,000 – provision. The detailed plan was board-approved on 15 November, and the announcement to employees on 20 December 20X6 created a valid expectation before the year end. The past event is the creation of that expectation, not the future termination. The union agreement signed on 15 January 20X7 is an adjusting event under IAS 10: it provides evidence of the condition existing at 31 December 20X6 and of the amount, and it confirms rather than creates the obligation.
- Retraining $300,000 and relocation $250,000 – no provision. These are costs of the future conduct of the business, not direct expenditures necessarily entailed by the restructuring.
- Future operating losses of $500,000 – no provision. Identifiable future operating losses up to the date of restructuring are not provided for; they are recognised as they are incurred.
- Onerous supply contract – separate provision. This obligation exists independently of the restructuring, so timing of the closure announcement is irrelevant to it.
2. Measure the provisions to be recognised at 31 December 20X6, showing the onerous contract calculation and the measurement principles applied.
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Restructuring provision: $1,800,000. Measured at the best estimate of the expenditure required to settle the obligation. It is payable by 30 June 20X7 – within 12 months – so discounting is not required (and there is no voluntary enhancement to add, since Dalton has no history of paying above statutory terms and has not announced one).
Onerous contract provision. A contract is onerous when the unavoidable costs of meeting the obligations exceed the economic benefits expected. The unavoidable cost is the lower of the cost of fulfilling and the compensation/penalty for non-fulfilment:
- Cost of fulfilling: 40,000 units x ($50 - $35) = $600,000
- Penalty for cancellation: $900,000
- Provision = the lower = $600,000.
The $15 shortfall per unit is the measure of the loss, not the full $50 purchase price, because the units will be used in production and generate revenue; only the net excess cost is provided for. The provision is presented gross of any inventory already held and unwound as the units are taken and used.
Total provision at 31 December 20X6 = $2,400,000, split between restructuring and onerous contract, and disclosed with the nature of the obligation, the expected timing and any uncertainties.
3. In February 20X7, before the 20X6 financial statements are authorised, Dalton agrees with the union to pay an additional $300,000 of hardship payments to the redundant employees. How should this be treated, and what would change if the payment instead arose from a new concession negotiated in 20X7 covering employees retained at Hull?
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Hardship payments to the redundant Leeds employees – adjusting event. The obligation to make enhanced redundancy payments arises from the same past event (the announcement creating a valid expectation of redundancy). The February agreement resolves the amount of that pre-existing obligation and is therefore the best evidence of the amount that would have been paid at 31 December 20X6. Under IAS 10, the resolution after the reporting date of an uncertainty that existed at that date is an adjusting event. The provision is increased to $2,100,000 (1,800,000 + 300,000) in the 20X6 financial statements.
If instead it were a new concession for Hull staff: the obligation would arise from a negotiation and an announcement taking place in 20X7, i.e. from a condition that did not exist at 31 December 20X6. It would be a non-adjusting event – disclose its nature and estimated financial effect if material, and recognise it in 20X7.
The distinguishing question is always: does the post-year-end information tell us more about the obligation as it stood at the reporting date, or does it reflect a genuinely new obligation created afterwards?