Golden Anchor: Restructuring Provision, Litigation and Subsequent Events
Golden Anchor Manufacturing Ltd (GAM) has a 31 December year-end. On 15 December 20X5 its board formally approved a plan to close its Tsuen Wan factory and relocate production to Dongguan. Detailed plans were sent to affected employees on 20 December 20X5, but the public announcement was made on 5 January 20X6; the closure was completed on 31 March 20X6. Estimated costs at 31 December 20X5 are: redundancy pay HK$8,000,000; retraining of retained staff HK$1,200,000; relocation of machinery HK$3,000,000; and a loss on disposal of factory equipment of HK$2,000,000 (carrying amount HK$5,000,000, expected proceeds HK$3,000,000). GAM has a non-cancellable contract to buy steel for HK$4,000,000 at a price above market; the steel could be resold for HK$3,000,000. On 10 November 20X5 a customer sued GAM for HK$6,000,000 over defective goods. GAM's lawyers advise that a loss is probable, the best estimate is HK$2,500,000, and a reasonable range is HK$1,500,000 to HK$4,000,000. GAM's insurer has confirmed in writing that it will reimburse HK$1,000,000. On 10 February 20X6, before the financial statements were approved, a customer owing HK$3,000,000 at 31 December 20X5 was declared bankrupt; no allowance had been recognised. On 20 February 20X6 an uninsured warehouse was destroyed by fire.
1. Which restructuring costs should be provided for at 31 December 20X5? Explain the treatment of the onerous contract and the equipment.
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Recognition threshold (HKAS 37.72–83). A restructuring provision is recognised only when there is a present obligation arising from a past event, and only for costs that are necessarily entailed by the restructuring and not associated with the ongoing activities of the entity. A constructive obligation arises when a detailed formal plan exists and a valid expectation has been raised in those affected that the entity will carry out the restructuring.
Here the board approved a detailed plan on 15 December and letters were sent to affected employees on 20 December 20X5. That creates a valid expectation in the employees before the year-end, so the obligation exists at 31 December 20X5. The public announcement on 5 January 20X6 is not the triggering event for the employee obligation.
Costs:
- Redundancy pay HK$8,000,000: provide - directly attributable and necessarily entailed.
- Retraining HK$1,200,000: no provision - relates to future conduct of the business and is expressly excluded by HKAS 37.81.
- Relocation of machinery HK$3,000,000: provide - directly attributable to the restructuring and not an ongoing cost.
- Equipment loss HK$2,000,000: not a restructuring provision. The equipment must be tested for impairment under HKAS 36 at 31 December 20X5; carrying amount HK$5,000,000 versus recoverable amount HK$3,000,000 gives an impairment loss of HK$2,000,000 in profit or loss. A provision for a future disposal loss is not permitted.
- Onerous contract HK$1,000,000: provide - the contract is non-cancellable and unavoidable costs (HK$4,000,000) exceed expected benefits (HK$3,000,000). This is a separate onerous contract provision under HKAS 37.66.
Total restructuring-related provision: HK$8 million + HK$3 million = HK$11 million, plus the separate onerous contract provision of HK$1 million.
2. How should the customer lawsuit and the insurer's reimbursement be accounted for and presented?
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Provision. A present obligation exists at 31 December 20X5 because the defective goods were supplied and the claim was filed on 10 November 20X5. A loss is probable and a reliable estimate can be made, so a provision is recognised under HKAS 37.14.
Measurement. The amount recognised is the best estimate of the expenditure required to settle the obligation. That is HK$2,500,000, not the midpoint of the range or the maximum. The range of HK$1,500,000 to HK$4,000,000 informs the estimate but does not override it; if the range were evenly distributed around a point, the midpoint would be used, but here management has a specific best estimate.
Reimbursement. The insurer has confirmed in writing that it will reimburse HK$1,000,000. A reimbursement is recognised as a separate asset only when it is virtually certain that it will be received (HKAS 37.53). Written confirmation makes this likely to be virtually certain, so GAM recognises a separate reimbursement asset of HK$1,000,000. It is not offset against the provision. The net effect in profit or loss is an expense of HK$1,500,000, but the statement of financial position shows a provision of HK$2,500,000 and a receivable of HK$1,000,000 separately.
If the reimbursement were only probable rather than virtually certain, no asset would be recognised and the existence of the claim would be disclosed as a contingent asset.
3. Explain the accounting treatment of the customer bankruptcy and the warehouse fire.
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Customer bankruptcy - adjusting event. The bankruptcy was declared on 10 February 20X6, after the reporting date but before the financial statements were approved. However, it provides evidence of conditions that existed at 31 December 20X5: the customer's financial difficulty and the impairment of the receivable. Under HKAS 10.9, this is an adjusting event. GAM should recognise an allowance for the HK$3,000,000 receivable in the 20X5 financial statements, with the loss recognised in 20X5 profit or loss. If the receivable had been unimpaired at the year-end and the bankruptcy reflected a new condition arising after the year-end, it would be non-adjusting; the distinction is whether the condition existed at the reporting date.
Warehouse fire - non-adjusting event. The fire occurred on 20 February 20X6 and destroyed a warehouse that was intact at 31 December 20X5. It does not provide evidence of a condition existing at the reporting date, so no adjustment is made to the 20X5 financial statements. Under HKAS 10.21, GAM discloses the nature of the event and an estimate of its financial effect (the uninsured carrying amount of the warehouse and any business interruption), or a statement that such an estimate cannot be made. If the event were so material that it threatened the going concern basis, that would need separate consideration.