Question

Gromit plc operates a fleet of commercial aircraft.
On 21 February 20X1 the government passed a new law requiring the mandatory upgrade of the electronic security systems on board all commercial aircraft. The deadline to complete the upgrade works was 31 September 20X1 and failure to meet the deadline would be punishable with a penalty of £1 million.
Gromit plc drafted an upgrade plan and estimated total upgrade costs to be £2 million, however by 31 December 20X1 (Gromit plc’s financial year end) the company had not yet committed to the plan, and none of the upgrade work had started.
The government started legal proceedings against Gromit plc in November 20X1 for non- compliance with the law. In December 20X1, Gromit plc’s lawyers provided an opinion suggesting that it was more likely than not that Gromit plc would be found liable to pay the £1 million statutory penalty, and that the final judgment on the court case would probably be provided in late 20X2.
Gromit plc’s accountants recognised a provision of £3 million (£2 million related to the cost of the upgrade works and £1 million related to the penalty) in Gromit plc’s statement of financial position at 31 December 20X1.

1. Explain how the events described above should be accounted in Gromit plc’s financial statements for the year ending 31 December 20X1 according to IAS 37 Provisions, Contingent Liabilities and Contingent Assets, describing the relevant IFRS rules and specifying whether you agree with the amounts recognised by Gromit plc’s accountants.

2. Explain the meaning of ‘cookie jar’ accounting and briefly discuss whether the events described above could provide Gromit plc with an opportunity to engage in this form of earnings manipulation.

Answer 1

As per IAS 37

Provision: a liability of uncertain timing or amount.

Contingent liability:

• a possible obligation depending on whether some uncertain future event occurs, or
• a present obligation but payment is not probable or the amount cannot be measured reliable

Recognition of a provision

An entity must recognise a provision if, and only if: [IAS 37.14]

• a present obligation (legal or constructive) has arisen as a result of a past event (the obligating event),
• payment is probable ('more likely than not'), and
• the amount can be estimated reliably.

Contingent liabilities

Since there is common ground as regards liabilities that are uncertain, IAS 37 also deals with contingencies. It requires that entities should not recognise contingent liabilities – but should disclose them, unless the possibility of an outflow of economic resources is remote. [IAS 37.86]

As per the above explanations it is clear that upgradation cost of 2 million is a provision since it is an obligtion at the balance sheet date whose payment is probable and amount can be reliably measurable.

But I disagree to the act of making provision for the penalty.Since the penalty is based on a future event of judgement,it shall be disclosed as foot note to the financial statement.

Cookie Jar Accounting

Cookie jar accounting is the act of recording the earnings from previous period savings so that the earnings of the company meets target and looks higher than other companies in the industry.This is highly discouraged by people as it mislead the investors.

Yes,actually the upgradation expenses were the expenses that the company need to incur in the current financial year.If the company does no record the expenses as provision,then the earnings looks higher.This will be more than those companies in the same industry that spemd for same expesne.This is quite misaleading to the investors.