This article will provide you with more details about when the restructuring reserve should be accounted for, what items it should involve, including the specification of the respective legal regulation.
The restructuring process may include in particular the relocation of business activities to another region, the closing down of operation as well as reduction or discontinuation of business activities.
Restructuring reserves in Czech legislation
The legal regulation of restructuring reserves is based on the general provisions of accounting for reserves as defined in Act No. 563/1991 Coll., on Accounting, as amended (hereinafter the “Act”). Section 25 (3) of the Act stipulates that entities shall consider, as of the balance sheet date, all foreseeable risks and potential losses relating to assets and liabilities which are known to them as of the date of preparing the financial statements regardless of whether the entity recorded operating profit or loss. In addition to provisions and depreciation of assets, reserves are also defined in this Section. Pursuant to Section 26 (3) of the Act, reserves are intended to cover liabilities and expenditure the nature of which is clearly defined and which are either likely to be incurred or certain to be incurred as of the balance sheet date but uncertain as to their amount or as to the date on which they will arise.
Basic principles of creating and using reserves are stipulated in Accounting Standard No. 004 Reserves with a reference to Regulation No. 500/2002 Coll. (hereinafter the “Regulation”) implementing certain provisions of the Accounting Act.
Reserves are addressed in greater detail by International Financial Reporting Standards, specifically IAS 37 Provisions, Contingent Liabilities and Contingent Assets, from which certain rules that are applicable in the Czech accounting environment and included in this article may be deducted.
Content definition of the restructuring reserve
Item B.4 ‘Other Reserves’ primarily includes a restructuring reserve that may only be created and used in respect of expenditure necessary for realising the restructuring programme which, however, do not relate to the entity’s ongoing activities, the nature of which is clearly defined and which are likely to be incurred but uncertain as to their amount or as to the date on which they will arise.
The definition of the restructuring reserve is de facto contained in a single provision – Section 16 (4) of the Regulation with effect from 1 January 2016 when a more-detailed definition of restructuring reserves was removed from Czech Accounting Standard No. 004 Reserves. The provision which is no longer part of the current Regulation but is still used in accounting practice also included a list of expenditure ruled out from the accounting reserve; this specifically relates to the retraining or relocation costs of employees who will remain to be employed at the entity or marketing costs.
The restructuring reserve must include solely expenses which have been, or will be, incurred in the restructuring process and as such would not be incurred without the restructuring being performed.
As an example, expenses to be included in the restructuring reserve include the costs of advisory services, legal and tax advisory necessary for the restructuring process to be realised in line with legal regulations, costs of crisis management ensuring that the restructuring process is governed in accordance with the set schedule, costs of disassembly of the existing production equipment, fines and penalties for premature termination of contracts with sub-suppliers and customers, severance pay to dismissed employees etc.
On the other hand, the restructuring reserve must not include the costs of project work and advisory services concerning the entity’s future operation model or relocation, investments in distribution networks and systems to ensure the future subject of the entity’s activities, bonuses and remuneration to employees who will remain to be employed at the entity, and employee requalification costs as these costs relate to the entity’s “ongoing activities” and must be recognised in the accounting records in the period in which they were incurred.
Restructuring may also involve additional steps that, by their nature, arise from the restructuring process, being rather uncustomary, such as additional provisions against fixed assets and inventory due to a decline in a certain segment and the resulting “forced” sale, disposal of assets and inventory or physical liquidation (scrapping) etc.
Furthermore, we would like to draw attention to the term reorganisation as a regime within insolvency proceedings. Reorganisation may, but does not have to, have similar implications as restructuring.
Timing of the recognition of the restructuring reserve
The restructuring reserve is created by an entity based on the restructuring programme approved by a relevant body pursuant to a specific legal regulation, or by shareholders in a business corporation. The restructuring programme shall constitute a formal plan of changes in the entity, defining areas and employee positions to be affected by the restructuring and the budget, i.e. calculation of anticipated expenses to be incurred in relation to the restructuring process. The affected parties must be notified of the restructuring programme and all steps on the part of the entity must be aimed at the fulfilment of the plan to generate real expectations about realisation.
Creation and use of the restructuring reserve
Restructuring reserves are created and used in line with Sections 27 and 57 of the Regulation and Art. 4.2. of Accounting Standard No. 004 Reserves.
The creation of reserves is recognised in the relevant account within account group 45 – Reserves by a corresponding entry in the relevant expense account within account group 55 – Depreciation, reserves, comprehensive deferred expenses and operating provisions. The use of reserves or their reversal due to redundancy is recognised in the relevant account within account group 45 – Reserves by a corresponding entry in the relevant expense account within account group 55 – Depreciation, reserves, comprehensive deferred expenses and operating provisions.
The creation and use of reserves is disclosed by the entity in its notes to the financial statements. Similarly to other reserves, the restructuring reserve is subject to reconciliation in which the amount and appropriateness of the reserve is assessed, or the budget for the restructuring programme costs is updated for the reserve to be the best estimate of expenditure which are likely to be incurred, or, in the event of payables, an amount necessary for settlement. For the sake of clear arrangement, the reserve is recommended to be maintained in a stand-alone analytical account.
Tax aspects of accounting for restructuring reserves
The restructuring reserve is not a tax-deductible expense. For corporate tax calculation purposes, the tax base must be increased by the amount of the restructuring reserve. Expenses become tax-deductible when they are actually incurred in relation to the restructuring process – i.e. in the period in which they incur. On those grounds, a temporary tax difference, i.e. a deferred tax asset, arises in respect of the restructuring reserve in the calculation of a deferred tax, similarly as in the accounting for other tax non-deductible reserves.
Furthermore, we would like to note that a reserve for various items related to employee remuneration in restructuring may not necessarily include its current component of social security and health insurance, such as when severance pay is concerned. For this reason, we consider it necessary to pay attention to individual items of which the reserve is composed.
Creation and use of reserve as a non-cash transaction
I addition, we would also like to emphasise that although the creation and use of a restructuring reserve affects the entity’s profit or loss, it does not have a direct influence on an increase or decrease in financial resources. The line ‘Change in provisions and reserves’ in the statement of cash flows, part Cash flows from ordinary activities (operating activities), prepared using the indirect method must be adjusted by the amount corresponding to the creation and use of the reserve.
Approach to the presentation in the financial statements
The balance, creation and use of reserves have their required positions in the balance sheet, or the profit and loss account. If the restructuring in the reporting period in which the restructuring reserve is recognised for the first time has implications to other areas (such as depreciation or recognition of provisions for fixed assets or inventory), it is appropriate to disclose relevant information on the effect of the restructuring in the notes to the financial statements in a comprehensive and cohesive manner, including a summary of implications for other areas concerned. Furthermore, restructuring will, by its nature, be usually an extraordinary activity, i.e. the costs of restructuring (and also revenues, if any) will typically be presented as extraordinary – in the operating or financial areas, according to their nature.
The restructuring process entails uncertainty and significant expenses, substantially affecting the entity’s operation. In creating the restructuring reserve, the prudence concept as one of the basic accounting principles needs to be taken into account. Simultaneously, the calculation of the amount of the reserve shall only include expenses which are necessary for realising the restructuring and do not relate to the entity’s ongoing activities.
The article is part of dReport – December 2018, Accounting news.