Provisions, contingent assets and a restructuring announced after the year end
Delimara Engineering Ltd manufactures steel components. Its draft profit before tax for the year ended 31 December 2024 is €1,150,000, and the directors are keen to show growth to a prospective investor. Three matters are unresolved.
Warranty: the company gives a two-year warranty on all sales. Sales for 2024 were €9,000,000. The provision brought forward at 1 January 2024 was €95,000, and claims settled during the year cost €118,000. Past experience indicates a warranty cost of 2.3% of sales.
Legal claim: Beltrami SpA is suing for €450,000 over components supplied in 2023. On 10 February 2025 the company's lawyers advised that Beltrami will probably succeed and that the loss is estimated at €300,000. Delimara has filed a counter-claim against its own steel supplier for €120,000; counsel consider this probable but not certain.
Restructuring: on 15 December 2024 the board approved a detailed plan to close the Mgarr plant, but the plan was announced to employees and suppliers only on 10 January 2025, before the financial statements were authorised for issue on 31 March 2025. Redundancy and closure costs are estimated at €1,200,000, and retraining of retained staff at a cost of €300,000 is planned.
1. Compute the warranty provision at 31 December 2024 and the charge to profit or loss, explaining the measurement logic.
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Computation
| € | |
|---|---|
| Provision b/f 1 January 2024 | 95,000 |
| Charge for 2024: 2.3% × €9,000,000 | 207,000 |
| Claims settled in 2024 | (118,000) |
| Provision c/f 31 December 2024 | 184,000 |
The charge to profit or loss for the year is €207,000; the €118,000 paid is a settlement against the existing obligation and does not hit profit again.
Measurement logic
IAS 37 requires a provision where there is a present obligation from a past event (the sale of warranted goods), a probable outflow, and a reliable estimate. All three are met, and a reliable estimate is available from historical claims experience. The provision is the best estimate of the expenditure required to settle the present obligation at the reporting date, which is why it is measured at 2.3% of sales rather than at a maximum or a 'safe' round figure. It is not discounted because settlement is expected within about two years and the effect is immaterial.
A common error is to charge only the year's claims paid (€118,000) and ignore the obligation still outstanding on goods sold but not yet returned. That would understate both the liability and the expense. Conversely, the retail 2.3% rate should be re-examined if product mix or supplier quality has changed, and any material deterioration in experience should be reflected in the estimate and disclosed.
2. Advise on the accounting treatment of the Beltrami claim and the counter-claim, including whether they may be netted.
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The claim - recognise €300,000
All three IAS 37 conditions are met. The past event is the supply of the defective components in 2023. The obligation is present at 31 December 2024, not contingent. The lawyers' advice that Beltrami will 'probably' succeed establishes that an outflow is more likely than not. The best estimate is the €300,000 the lawyers expect to pay, not the €450,000 claimed: the estimate of the expenditure required to settle is the amount the entity would rationally pay, and the pleaded sum is the claimant's aspiration.
The February 2025 legal advice does not make this a non-adjusting event. The claim arises from components supplied in 2023, so the condition existed at the reporting date; the advice is new evidence about that existing condition and is therefore an adjusting event under IAS 10.
The counter-claim - no asset, disclose
A reimbursement is recognised separately and only when it is virtually certain to be received. Counsel consider success 'probable but not certain', which fails the virtual certainty threshold, so no asset is recorded. Instead a contingent asset is disclosed, with a statement that it is not virtually certain.
Netting - not permitted
The provision of €300,000 is presented gross, with the reimbursement recognised as a separate asset only if the threshold is met. Netting would allow management to judge its own case favourably and quietly reduce the liability. If the counter-claim later becomes virtually certain, €120,000 may be recognised as a separate asset, with the expense and the reimbursement shown distinctly in profit or loss. The claim should be disclosed as a provision with its nature and uncertainties, since the directors expect it to materially affect the reported profit.
3. Advise on the restructuring and on whether the directors' wish to show growth should influence the treatment.
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No provision at 31 December 2024
A restructuring provision requires a present obligation. Under IAS 37, a constructive obligation for restructuring arises only when two conditions are both met: a detailed formal plan exists, and the entity has raised a valid expectation in those affected that it will carry out the restructuring, normally by announcing it. The board approved the plan on 15 December 2024, but the announcement to employees and suppliers came on 10 January 2025. Until that announcement, employees could not have a valid expectation, so no obligation existed at the reporting date.
IAS 10 - non-adjusting event requiring disclosure
The decision and announcement concern circumstances that arose after the reporting date and do not provide evidence of conditions existing at that date. They are non-adjusting events. Because the closure is material - €1,200,000 is more than the draft profit - IAS 10 requires disclosure of the nature of the event and an estimate of its financial effect, so that users are not misled by statements that make no mention of a plant closure.
The €300,000 retraining would not be provided for in any case: it is expenditure on future operations, not a present obligation to a third party arising from a past event.
The directors' motivation
Recognising the €1,200,000 would cut profit to a small figure or a loss, and not recognising it leaves profit intact - which is precisely the pressure that IAS 37 and IAS 10 exist to control. The correct answer is not 'choose the treatment that flatters growth' but 'apply the criteria on the facts, and disclose fully'. Deliberately omitting the required note to present a growth story to an investor would be misleading, and would also expose the directors to criticism for a material omission. Full disclosure protects them: the profit of €1,150,000 is genuinely earned in 2024, and the €1,200,000 belongs to 2025.