In this workout, we've been told that a company has generated 100 of revenue and incurred 70 of costs in each year from year one to year three. At the end of year one, management decides to recognize a restructuring provision of 5, and this provision is then released during year three, and we've been asked to calculate the company's operating profits in each of the three years. In each one to three. We can see in the table below that the revenues and costs of this company have already been input into this table. So all we need to do now is to add in the effects of the provision and calculate operating profits. So let's start off with a restructuring provision. And in row 15 we can see we've got the provisions balance for each year, and the increase in the provisions balance of 5 is going to give rise to our restructuring cost for the year. So that's a cost of 5.

So now when we calculate the operating profit, it's simply a matter of taking the revenues and subtracting the costs and also the restructuring costs as well to give operating profit of 25. Now, let's roll forward the calculations for year two, and we can see that in year two there are no restructuring costs incurred because there's no change in the provisions balance and the operating profit is 30. And then in year three, when the provision is released, that actually gives an income item, which is included with an operating profit giving total operating profit of 35. If we step back and look at the trend in operating profit, this is actually growing each year rather than remaining stable. And this is all because of the effects of the provision. It's effectively been used to defer earnings into future years, and this highlights a major risk associated with provisions. They can be used to defer or smooth earnings, and it's really tough for the auditors to challenge as provisions are inherently reliant on the judgments and estimates of management.

So how can we spot if management on manipulating the provision balances? Well, as we can see here, this typically manifests itself in elevated provision balances in the balance sheets. We'll then subsequently see high levels of provisions being released to earnings. And these are non-cash income items. So we'll see these as a non-cash adjustment in the cashflow statement where profits are being reconciled to operating cash flows.