Chapter 6: Liabilities Based Accounting Standards - Test 3: answer key

Question 1 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · hard

Scenario. Sterling Appliances Ltd. manufactures kitchen appliances and provides a two-year warranty on all products sold. Based on past experience, warranty claims are estimated at 3% of sales in the first year after sale and 5% in the second year. Sales for the year ended 31 March 2026 were ₹80,00,000. The warranty provision balance on 1 April 2025 was ₹1,80,000. Actual warranty expenses incurred and paid during 2025-26 were ₹2,10,000. The company also operates a factory that causes environmental damage. Under current legislation, the company is required to restore the site at the end of the factory's useful life, estimated to be 10 years from now. The estimated restoration cost in today's prices is ₹50,00,000, and the appropriate pre-tax discount rate is 8% per annum. The present value of the restoration cost is to be recognised as a provision and capitalised as part of the factory's cost. In addition, a customer has filed a lawsuit claiming damages of ₹15,00,000 for injuries caused by a defective product. The company's legal counsel advises that it is probable (60% likelihood) that the company will lose the case and that the most reliable estimate of the damages payable is ₹10,00,000. The company has an insurance policy that will reimburse 80% of any damages paid, and the insurer has confirmed in writing that the coverage applies and that reimbursement is virtually certain. The company also has a counter-claim against a supplier for ₹5,00,000, which the legal team believes is probable but not virtually certain to be received. The company prepares its financial statements under AS 29.

For the year ended 31 March 2026, what is the warranty expense to be recognised in profit or loss and the closing warranty provision?

1. Expense ₹6,40,000; Provision ₹6,40,000
2. Expense ₹8,50,000; Provision ₹8,20,000
3. Expense ₹6,10,000; Provision ₹6,40,000
4. Expense ₹6,70,000; Provision ₹6,40,000 (correct answer)

Answer: D — Expense ₹6,70,000; Provision ₹6,40,000

Explanation. Opening provision ₹1,80,000. Actual warranty costs ₹2,10,000 exceed opening provision by ₹30,000, which is expensed. Current year sales require provision at 8% (3% + 5%) = ₹6,40,000. Total expense = ₹6,40,000 + ₹30,000 = ₹6,70,000. Closing provision = ₹6,40,000. AS 29 requires measurement at most reliable estimate of expenditure required to settle present obligation.

Where it goes wrong. Adding opening provision to expense or ignoring the shortfall between actual costs and opening provision.

Authority. AS 29 (Revised), paras 14 and 25

Question 2 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · medium

What amount should be recognised as the environmental restoration provision at 31 March 2026?

1. ₹50,00,000
2. ₹23,16,000 (correct answer)
3. ₹25,00,000
4. ₹21,50,000

Answer: B — ₹23,16,000

Explanation. AS 29 allows discounting for decommissioning, restoration and similar liabilities recognised as cost of PPE. Present value of ₹50,00,000 due in 10 years at 8% = ₹50,00,000 × 0.4632 = ₹23,16,000 (approx). The provision is capitalised as part of factory cost.

Where it goes wrong. Not discounting the future cost or using an incorrect discount factor.

Authority. AS 29 (Revised), para 27

Question 3 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · hard

How should the lawsuit and the insurance reimbursement be recognised?

1. Provision ₹10,00,000; Reimbursement asset ₹8,00,000 (correct answer)
2. Provision ₹2,00,000; No separate asset
3. Provision ₹8,00,000; Reimbursement asset ₹8,00,000
4. Provision ₹10,00,000; No reimbursement asset

Answer: A — Provision ₹10,00,000; Reimbursement asset ₹8,00,000

Explanation. Under AS 29, a provision of ₹10,00,000 is recognised for the lawsuit as a present obligation exists from a past event with a probable outflow. Under paragraph 46 of AS 29, where some or all of the expenditure required to settle a provision is expected to be reimbursed by another party (e.g., via insurance), the reimbursement is recognised as a separate asset when it is virtually certain, but cannot exceed the amount of the provision. The reimbursement cannot be netted against the provision in the balance sheet.

Where it goes wrong. Netting the reimbursement against the provision or failing to recognise the reimbursement asset.

Authority. AS 29 (Revised), paras 14, 30 and 31

Question 4 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · medium

How should the counter-claim against the supplier for ₹5,00,000 be treated?

1. Recognise as an asset in the balance sheet
2. Disclose as a contingent asset in the notes to accounts
3. Disclose in the report of the approving authority (correct answer)
4. Ignore completely as it is not virtually certain

Answer: C — Disclose in the report of the approving authority

Explanation. A contingent asset is a possible asset arising from past events whose existence will be confirmed by uncertain future events. AS 29 prohibits recognition. When inflow is probable, it is disclosed in the report of the approving authority (Board of Directors), not in the financial statements.

Where it goes wrong. Recognising the contingent asset or disclosing it in the notes to accounts instead of the Board's report.

Authority. AS 29 (Revised), paras 20 and 40

Question 5 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · medium

Scenario. Zenith Chemicals Ltd. is restructuring its operations to improve profitability. On 1 January 2026, the board of directors approved a detailed formal plan to close down one of its manufacturing divisions. The plan identifies the division, the locations affected, the estimated number of employees to be compensated (200 employees, with average compensation of ₹2,00,000 each), and the expected timing of the restructuring, which is to be completed within 12 months. The plan was announced to the affected employees and their representatives on 15 January 2026, creating a valid expectation that the restructuring will be carried out. As at 31 March 2026, the restructuring had not been completed, but the company had no realistic alternative but to proceed. The company also has a contract to purchase 10,000 units of raw material at ₹50 per unit. Due to a fall in market prices, the current market price is ₹40 per unit. If the company cancels the contract, it must pay a penalty of ₹60,000. The company expects to use the raw materials in its production process. Additionally, the company is pursuing a legal claim against a former contractor for breach of contract, claiming ₹8,00,000. The company's lawyers believe it is virtually certain that the company will receive ₹6,00,000. The company also has a reimbursement right from an insurance company for a provision recognised in the previous year for environmental cleanup costs. The reimbursement amount is ₹4,00,000, and it is virtually certain to be received. The company follows AS 29 for provisions, contingent liabilities and contingent assets.

Under AS 29, what amount should be recognised as a restructuring provision at 31 March 2026 if the enterprise has only approved a formal plan without creating a binding legal obligation?

1. ₹4,00,00,000
2. ₹2,00,00,000
3. ₹Nil (correct answer)
4. ₹4,20,00,000

Answer: C — ₹Nil

Explanation. Under AS 29, a provision is recognised only when an enterprise has a present obligation as a result of a past event. A management or board decision alone does not give rise to a present obligation at the balance sheet date unless a binding agreement has been executed. Hence, provision required at 31 March 2026 is ₹Nil.

Where it goes wrong. Not recognising the provision because restructuring is incomplete, or including future operating losses.

Authority. AS 29 (Revised), paras 35 and 36

Question 6 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · hard

What provision should be recognised for the onerous raw material contract?

1. ₹1,00,000
2. ₹40,000
3. ₹Nil
4. ₹60,000 (correct answer)

Answer: D — ₹60,000

Explanation. An onerous contract is one in which unavoidable costs exceed economic benefits. The provision is measured at the least net cost of exiting, i.e., lower of cost of fulfilling (₹1,00,000 loss) and penalty (₹60,000). Since ₹60,000 is lower, provision is ₹60,000.

Where it goes wrong. Providing for the full loss on fulfilling the contract instead of the lower penalty amount.

Authority. AS 29 (Revised), paras 10 and 14

Question 7 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · medium

How should the legal claim against the former contractor be treated?

1. Recognise an asset of ₹6,00,000 and related income (correct answer)
2. Disclose as a contingent asset of ₹8,00,000
3. Recognise an asset of ₹8,00,000
4. No recognition or disclosure

Answer: A — Recognise an asset of ₹6,00,000 and related income

Explanation. When realisation of income is virtually certain, the related asset is not a contingent asset and recognition is appropriate. Since the lawyers believe it is virtually certain to receive ₹6,00,000, the asset and income are recognised.

Where it goes wrong. Treating it as a contingent asset because the claim amount is ₹8,00,000, or recognising the full claim.

Authority. AS 29 (Revised), paras 20 and 40

Question 8 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · medium

How should the reimbursement right from the insurance company for environmental cleanup be treated?

1. Net against the environmental provision
2. Disclose as a contingent asset
3. Recognise as income directly in reserves
4. Recognise as a separate asset of ₹4,00,000 (correct answer)

Answer: D — Recognise as a separate asset of ₹4,00,000

Explanation. AS 29 requires reimbursement to be recognised as a separate asset when it is virtually certain to be received. It cannot be netted against the provision. The provision continues to be shown at its full amount.

Where it goes wrong. Netting the reimbursement against the provision or treating it as a contingent asset.

Authority. AS 29 (Revised), paras 30 and 31

Question 9 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · medium

Scenario. A company has a present obligation with a probable outflow of resources, but no reliable estimate of the amount can be made. What is the correct accounting treatment?

A company has a present obligation with a probable outflow of resources, but no reliable estimate of the amount can be made. What is the correct accounting treatment?

1. Recognise a provision at a nominal amount
2. Disclose as a contingent liability (correct answer)
3. Recognise a provision at the maximum possible amount
4. Ignore the obligation completely

Answer: B — Disclose as a contingent liability

Explanation. AS 29 requires a reliable estimate to recognise a provision. If no reliable estimate can be made, the liability is disclosed as a contingent liability, unless the possibility of outflow is remote. Recognition is not permitted without reliable estimation.

Where it goes wrong. Recognising a provision despite the inability to make a reliable estimate.

Authority. AS 29 (Revised), paras 18 and 19

Question 10 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · hard

Scenario. A company is defending a lawsuit. Legal counsel believes it is possible (30% chance) that the company will lose and pay ₹10,00,000. What is the treatment?

A company is defending a lawsuit. Legal counsel believes it is possible (30% chance) that the company will lose and pay ₹10,00,000. What is the treatment?

1. Recognise a provision of ₹10,00,000
2. Disclose as a contingent liability (correct answer)
3. Recognise a provision of ₹3,00,000
4. No disclosure as the possibility is remote

Answer: B — Disclose as a contingent liability

Explanation. A 30% chance is not probable (probable means more likely than not, i.e., >50%). It is a possible obligation, not a present obligation requiring provision. Since the possibility is not remote, it is disclosed as a contingent liability.

Where it goes wrong. Recognising a provision because 30% is significant, or ignoring disclosure because it is not probable.

Authority. AS 29 (Revised), paras 19 and 21

Question 11 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · hard

Scenario. A company has a provision for restructuring. It expects to sell a segment and make a gain of ₹2,00,000 on disposal of assets. Should the gain be considered in measuring the restructuring provision?

A company has a provision for restructuring. It expects to sell a segment and make a gain of ₹2,00,000 on disposal of assets. Should the gain be considered in measuring the restructuring provision?

1. Yes, reduce the provision by ₹2,00,000
2. No, gains on expected disposal are not considered (correct answer)
3. Yes, but only if the sale is probable
4. Yes, disclose the net provision

Answer: B — No, gains on expected disposal are not considered

Explanation. AS 29 explicitly states that gains on expected disposal of assets are not taken into account in measuring a provision, even if the disposal is closely linked to the event giving rise to the provision. The gain is recognised separately when the asset is disposed.

Where it goes wrong. Netting the expected gain against the restructuring provision.

Authority. AS 29 (Revised), para 29

Question 12 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · hard

Scenario. A company has a provision for environmental cleanup of ₹10,00,000. It expects new technology will reduce the cleanup cost by 30% in the future. Should the provision be reduced?

A company has a provision for environmental cleanup of ₹10,00,000. It expects new technology will reduce the cleanup cost by 30% in the future. Should the provision be reduced?

1. Yes, reduce by 30% as technology is expected
2. No, unless there is sufficient objective evidence of the reduction (correct answer)
3. Yes, reduce by 15% as a conservative estimate
4. Yes, but only if the technology is already available

Answer: B — No, unless there is sufficient objective evidence of the reduction

Explanation. Future events that may affect the amount required to settle an obligation should be reflected only where there is sufficient objective evidence that they will occur. An expectation of new technology without such evidence cannot be used to reduce the provision.

Where it goes wrong. Anticipating future cost reductions without sufficient objective evidence.

Authority. AS 29 (Revised), para 28

Question 13 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · hard

Scenario. A company has sold 100 units of a product with a one-year warranty. At year-end, the remaining warranty period is six months. The expected warranty cost for the remaining period is ₹500 per unit. What provision should be recognised?

A company has sold 100 units of a product with a one-year warranty. At year-end, the remaining warranty period is six months. The expected warranty cost for the remaining period is ₹500 per unit. What provision should be recognised?

1. ₹50,000 (correct answer)
2. ₹25,000
3. ₹1,00,000
4. ₹Nil

Answer: A — ₹50,000

Explanation. The provision is the most reliable estimate of the expenditure required to settle the present obligation at the balance sheet date. For 100 units at ₹500 each, the provision is ₹50,000. The remaining warranty period is already factored into the ₹500 estimate.

Where it goes wrong. Taking half the amount because half the warranty period remains, or ignoring the provision entirely.

Authority. AS 29 (Revised), paras 14 and 25

Question 14 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · medium

Scenario. A company has a present obligation with probable outflow. The most reliable estimate is a range of ₹1,00,000 to ₹2,00,000, with all points in the range equally likely. What amount should be provided?

A company has a present obligation with probable outflow. The most reliable estimate is a range of ₹1,00,000 to ₹2,00,000, with all points in the range equally likely. What amount should be provided?

1. ₹1,00,000
2. ₹2,00,000
3. ₹1,50,000 (correct answer)
4. ₹1,25,000

Answer: C — ₹1,50,000

Explanation. Where the most reliable estimate is a continuous range of possible outcomes and each point is equally likely, the midpoint of the range is used. Midpoint of ₹1,00,000 and ₹2,00,000 is ₹1,50,000.

Where it goes wrong. Choosing the lower or upper end of the range instead of the midpoint.

Authority. AS 29 (Revised), para 25

Question 15 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · hard

Scenario. A company has a provision for decommissioning costs of ₹20,00,000 due in 5 years. Should the provision be discounted?

A company has a provision for decommissioning costs of ₹20,00,000 due in 5 years. Should the provision be discounted?

1. Yes, because it is a decommissioning liability (correct answer)
2. No, AS 29 prohibits discounting of all provisions
3. Only if the amount is material
4. Only if required by law

Answer: A — Yes, because it is a decommissioning liability

Explanation. AS 29 generally prohibits discounting of provisions. However, it specifically permits discounting for decommissioning, restoration and similar liabilities that are recognised as cost of property, plant and equipment. Therefore, the decommissioning provision should be discounted.

Where it goes wrong. Assuming all provisions are undiscounted, or discounting non-qualifying provisions.

Authority. AS 29 (Revised), para 27

Question 16 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · hard

Scenario. A company has a reimbursement right from an insurer for a provision. The reimbursement is virtually certain. How should it be presented in the balance sheet?

A company has a reimbursement right from an insurer for a provision. The reimbursement is virtually certain. How should it be presented in the balance sheet?

1. Net against the provision
2. Disclose only in the notes
3. Recognise as income directly in reserves
4. Recognise as a separate asset (correct answer)

Answer: D — Recognise as a separate asset

Explanation. AS 29 requires that a reimbursement be recognised as a separate asset when it is virtually certain to be received. It cannot be netted against the provision. The provision remains on the liabilities side at its full amount.

Where it goes wrong. Netting the reimbursement against the provision or failing to recognise it as an asset.

Authority. AS 29 (Revised), paras 30 and 31

Question 17 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · medium

Scenario. A company has a contingent liability for which the possibility of outflow is remote. What is the disclosure requirement?

A company has a contingent liability for which the possibility of outflow is remote. What is the disclosure requirement?

1. Disclose in the notes to accounts
2. Disclose in the Board's report
3. No disclosure is required (correct answer)
4. Recognise a provision

Answer: C — No disclosure is required

Explanation. A contingent liability is disclosed unless the possibility of an outflow of resources is remote. If remote, no disclosure is required and no provision is recognised.

Where it goes wrong. Disclosing remote contingencies or providing for them.

Authority. AS 29 (Revised), paras 19 and 21

Question 18 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · hard

Scenario. A company is involved in a lawsuit where it is probable that it will lose and pay damages, but the amount cannot be estimated reliably. What is the treatment?

A company is involved in a lawsuit where it is probable that it will lose and pay damages, but the amount cannot be estimated reliably. What is the treatment?

1. Recognise a provision at a nominal amount
2. Disclose as a contingent liability (correct answer)
3. Recognise a provision at the maximum possible amount
4. Ignore the lawsuit

Answer: B — Disclose as a contingent liability

Explanation. Even if the outflow is probable, a provision cannot be recognised unless a reliable estimate can be made. AS 29 requires disclosure as a contingent liability in such cases, unless the possibility of outflow is remote.

Where it goes wrong. Recognising a provision despite the inability to estimate reliably.

Authority. AS 29 (Revised), para 18

Question 19 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · hard

Scenario. A company has a contract to supply goods at a fixed price. Due to cost increases, the contract is now onerous. The expected loss on fulfilling is ₹80,000. The penalty for cancellation is ₹50,000. What provision should be recognised?

A company has a contract to supply goods at a fixed price. Due to cost increases, the contract is now onerous. The expected loss on fulfilling is ₹80,000. The penalty for cancellation is ₹50,000. What provision should be recognised?

1. ₹80,000
2. ₹30,000
3. ₹Nil
4. ₹50,000 (correct answer)

Answer: D — ₹50,000

Explanation. For an onerous contract, the provision is measured at the least net cost of exiting the contract, i.e., the lower of the cost of fulfilling and the penalty. Lower of ₹80,000 and ₹50,000 is ₹50,000.

Where it goes wrong. Providing the full loss on fulfilling the contract instead of the lower penalty amount.

Authority. AS 29 (Revised), para 14 and definition of executory contract

Question 20 · 2 marks · Chapter 6: Liabilities Based Accounting Standards · hard

Scenario. A company has a detailed formal restructuring plan approved by the board, but it has not yet been announced to employees. Can the company recognise a restructuring provision?

Under AS 29, can a provision for restructuring be recognised solely on the basis of a board-approved restructuring plan before any binding contract or legal obligation exists?

1. Yes, because board approval is an internal obligating event.
2. Yes, if the plan is detailed and has quantified cost estimates.
3. Yes, if the restructuring is planned to be completed within twelve months.
4. No, because a board decision alone does not produce a present legal or statutory obligation. (correct answer)

Answer: D — No, because a board decision alone does not produce a present legal or statutory obligation.

Explanation. Under AS 29 Provisions, Contingent Liabilities and Contingent Assets, an obligation must be a present obligation arising from a past event. Internal management decisions or board resolutions do not create a present obligation to third parties until a binding contract is executed or an obligating event occurs.

Where it goes wrong. Recognising a provision based solely on board approval without announcement.

Authority. AS 29 (Revised), para 35