Legal Claim, Restructuring Announcement and Onerous Warehouse Lease
Harbour Logistics Ltd has a 31 December year end. In November 20X4 a customer sued Harbour for £700,000 over delayed deliveries. Harbour’s lawyers advise that an outflow is probable and that the most likely outcome is £500,000, although a settlement anywhere between £300,000 and £700,000 is possible. In October the board announced a restructuring plan: detailed terms were published, affected employees were informed, and redundancy payments of £800,000 are expected in 20X5. The plan also includes £200,000 of staff retraining and £100,000 of relocation costs for retained staff. Harbour has a five-year warehouse lease with four years remaining; annual payments are £150,000, and the warehouse cannot be sublet for more than £50,000 a year. Harbour expects to recover £250,000 from its insurer in respect of the legal claim; the insurer has confirmed cover but has not yet agreed the amount.
1. Should Harbour recognise a provision for the legal claim? How should it measure the provision and treat the insurance recovery?
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A provision is recognised if there is a present obligation from a past event, a probable outflow of economic benefits, and a reliable estimate. The delayed deliveries create a present legal obligation. The lawyers consider an outflow probable, and a reliable estimate can be made. Recognise a provision.
Measure at the best estimate of the expenditure required to settle the obligation. The most likely outcome is £500,000, so use £500,000. The existence of a range of £300,000 to £700,000 does not automatically mean the midpoint is used; the midpoint is appropriate only where no amount within the range is more likely than any other. Here the most likely amount is identified.
The insurance recovery is a separate asset, not a reduction of the provision. Recognise it only when reimbursement is virtually certain. The insurer has confirmed cover, but the amount is not agreed. That is not virtually certain, so do not recognise an asset. Disclose a contingent asset if an inflow is probable, and do not offset it against the liability.
2. How much, if any, restructuring provision should be recognised at 31 December 20X4?
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A restructuring provision is recognised only when a detailed formal plan exists and a valid expectation has been created in those affected that the restructuring will be carried out. The board has published detailed terms and informed affected employees before the year end, so the obligation criterion is met.
However, IAS 37 limits the provision to direct expenditures necessarily entailed by the restructuring and not associated with the ongoing activities of the entity. The £800,000 redundancy payments are directly caused by the restructuring and qualify. The £200,000 retraining and £100,000 relocation costs for retained staff relate to future operations or to conducting business in the future; they are not incremental costs of the restructuring and cannot be provided for.
Recognise a restructuring provision of £800,000. The retraining and relocation costs are expensed as incurred in 20X5. If the restructuring also involves disposing of assets, any impairment is accounted for separately under the relevant asset standard, not as part of the restructuring provision.
3. Calculate the onerous contract provision for the warehouse lease and explain the principle used.
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An onerous contract is one in which the unavoidable costs of meeting the obligations exceed the economic benefits expected. The unavoidable cost is the lower of the cost of fulfilling the contract and any compensation or penalty arising from failing to fulfil it.
Here the cost of fulfilling the remaining four-year lease is 4 × £150,000 = £600,000. The expected sublease income is 4 × £50,000 = £200,000. The net cost of fulfilling the contract is therefore £400,000. No exit penalty is given, so the lower amount is the fulfilment cost of £400,000.
Recognise an onerous contract provision of £400,000. The provision reflects the net unavoidable outflow, not the gross lease payments, because the sublease income reduces the loss. If the warehouse were instead used for another purpose, the calculation would change. Under IFRS 16, first test any right-of-use asset for impairment; the onerous contract provision then covers the remaining unavoidable net cost.