A ‘contingent liability’ is an obligation of sufficient uncertainty that it does not qualify for recognition as a provision, unless it is acquired in a business combination. The uncertainty may arise due to any of the following reasons:
- It is a possible obligation (i.e. one whose existence will be confirmed by the occurrence or non-occurrence of uncertain future events not wholly within the control of the entity). For example, if an entity is jointly and severally liable for an obligation, then the portion of the obligation that is expected to be met by other parties is an example of a possible obligation.
- It is a present obligation, but it is not more likely than not that there will be an outflow of resources embodying economic benefits, so that the probability of an outflow is 50 percent or less.
- An example is a claim against an entity if the entity concludes that it is liable but that it is likely to defend the case successfully.
It is a present obligation, but its amount cannot be estimated reliably. These cases are expected to be extremely rare. [IAS 37 10, IAS 37 29]
‘Contingent liabilities’ are present obligations with uncertainties about either the probability of outflows of resources or the amount of the outflows, and possible obligations whose existence is uncertain.
If a present obligation relates to a past event, the possibility of an outflow is probable (i.e. more likely than not) and a reliable estimate can be made, then the obligation is not a contingent liability, but instead is a liability for which a provision is required. [IAS 37 14]
when a provision is measured at its best estimate, which is less than the amount that could be payable, the difference between the two amounts is not a contingent liability, and there is no requirement to disclose the possible additional obligation. [IAS 1 125, IAS 37 85(b)]
Changes in the carrying amount of the reimbursement right other than from contributions to and payments from the fund are recognised in profit or loss in the period in which they occur. An obligation to make additional contributions is treated as a provision or contingent liability, as applicable. A residual interest in a fund that exceeds the right to reimbursement, such as a contractual right to distributions when decommissioning has been completed, may be an equity instrument. [IFRIC 5 5]
If crystallisation of a contingent liability would affect an entity’s ability to continue as a going concern, then additional disclosures are required. [IAS 1 25]
There are limited exceptions to the recognition and/or measurement principles for contingent liabilities, deferred tax assets and liabilities, indemnification assets, employee benefits, reacquired rights, share-based payment awards and assets held for sale.
IFRS 3 Business combinations: Contingent liabilities
Contingent liabilities are not recognised in the statement of financial position unless they were assumed in a business combination. In a business combination, a contingent liability is recognised if it is a present obligation that arises from past events and its fair value can be measured reliably. [IFRS 3 23]
[IFRS 3 56] After initial recognition and until the liability is settled, cancelled or expires, the acquirer shall measure a contingent liability recognised in a business combination at the higher of:
- the amount that would be recognised in accordance with IAS 37; and
- the amount initially recognised less, if appropriate, the cumulative amount of income recognised in accordance with the principles of IFRS 15 Revenue from Contracts with Customers.
This requirement does not apply to contracts accounted for in accordance with IFRS 9.
Subsequent measurement and accounting
In general, items recognised in the acquisition accounting are measured and accounted for in accordance with the relevant IFRS subsequent to the business combination. However, as an exception, there is specific guidance for the following – When a contingent liability recognised in the acquisition accounting subsequently becomes a provision, it is recognised at the higher of the fair value recognised at the date of acquisition less amortisation (if appropriate) and the then-current provision amount.
Company A acquires company B. Both companies provide health services. Company B has been sued for malpractice resulting in patient’s death. Company B has not created a provision in its books. Lawyers of company B believe, that probability of winning the case is high. Due to company’s reputation and risk of losing the case, management of Company A decided to settle out of court. How should the acquirer account for the contingent liability?
As of acquisition date, in the combined statement Company A should recognize a liability in the amount of expected settlement.
Papyrus is the defendant in legal proceedings brought by a customer that alleges that Papyrus supplied defective goods. Management’s assessment, based on its interpretation of the underlying sales contract and independent legal advice, is that the basis for the customer’s claim has little merit and it is not probable that an outflow will be required to settle the claim. Management’s assessment of the fair value of this contingent liability, taking into account the range of possible outcomes of the judicial process, is €20 thousand (see Note 40).
A subsidiary is defending an action brought by an environmental agency in Europe. Although liability is not admitted, if the defence against the action is unsuccessful, then fines and legal costs could amount to €950 thousand, of which €250 thousand would be reimbursable under an insurance policy. Based on legal advice, management believes that the defence against the action will be successful. [IAS 1 125, IAS 37 86]
As part of the acquisition of Papyrus, the Group recognised a contingent liability of €20 thousand in respect of a claim for contractual penalties made by one of Papyrus’s customers (see Note 34(C)).
Contingent liabilities, such as guarantees and warranties, do not appear on balance sheet but need to be disclosed in the Notes to the financial statements to enable users to have a complete picture of the undertaking’s financial position. A contingent liability is disclosed unless the possibility of an outflow of resources embodying economic benefits is remote.
An entity discloses a brief description of the nature of each class of contingent liabilities and, when it is practicable, an estimate of the financial effect, an indication of uncertainties relating to the amount and timing of the outflow and any possible reimbursement. [IAS 37 86, IAS 37 91]
Banks usually have contingent liabilities to be reported. Banks issue a number of documents on behalf of clients for which they anticipate being reimbursed by clients. These include:
- Documentary and commercial letters of credit;
- Acceptances (time drafts endorsed by the bank);
- Standby letters of credit (also called demand guarantees).
There is a risk that the bank may not be repaid in full. As a result, such documents outstanding at the balance sheet date are listed as contingent liabilities.
Banks also issue guarantees for various purposes. Guarantees outstanding at the balance sheet date are also listed as contingent liabilities. Banks may not anticipate claims against the guarantees, but list them to recognise the risk that claims may arise.
IFRS 7 requires banks to disclose guarantees in additional ways:
Guarantees and IFRS 7 – collateral and other credit enhancements obtained
When an entity obtains financial or non-financial assets during the period by taking possession of collateral it holds as security, or calling on other credit enhancements ((examples of the latter being guarantees, credit derivatives, and netting agreements that do not qualify for offset in accordance with IAS 32)), and such assets meet the recognition criteria in other Standards, an entity shall disclose:
- the nature and carrying amount of the assets obtained; and
- when the assets are not readily convertible into cash, its policies for disposing of such assets, or for using them in its operations.
Guarantees and IFRS 7 – credit risk
Activities that give rise to credit risk and the associated maximum exposure to credit risk include, but are not limited to, granting financial guarantees. In this case, the maximum exposure to credit risk is the maximum amount the entity could have to pay if the guarantee is called on.
Loan commitments are also listed as contingent liabilities. The bank has contracted to provide a loan to a client, but has yet to disburse some, or all, of the funds under the contract. Loan commitments include the amount of overdrafts that are not currently being used.
The bank must have facilities in place to finance the loans when they are to be disbursed.
IFRS 7 requires banks to disclose loan commitments in additional ways:
- Loan commitments and IFRS 7 – scope of IFRS 7
IFRS 7 applies to recognised and unrecognised financial instruments. Recognised financial instruments include financial assets and financial liabilities that are within the scope of IFRS 9. Unrecognised financial instruments include some financial instruments that, although outside the scope of IFRS 9, are within the scope of IFRS 7 (such as some loan commitments).
- Loan commitments and IFRS 7 – credit risk
Activities that give rise to credit risk and the associated maximum exposure to credit risk include, but are not limited to, making a loan commitment that is irrevocable over the life of the facility, or is revocable only in response to a material adverse change. If the issuer cannot settle the loan commitment net in cash, or another financial instrument, the maximum credit exposure is the full amount of the commitment.This is because it is uncertain whether the amount of any undrawn portion may be drawn upon in the future. When an entity is committed to make amounts available in installments, each installment is allocated to the earliest period in which the entity can be required to pay. For example, an undrawn loan commitment is included in the time band containing the earliest date it can be drawn down.
- Loan commitments and IFRS 7 – interest rate risk
Interest rate risk arises on interest-bearing financial instruments recognised in the balance sheet (for example loans and receivables and debt instruments issued) and on some financial instruments not recognised in the balance sheet (for example some loan commitments).
- Loan commitments and IFRS 7 – liquidity risk
IFRS 7 requires the entity to describe how it manages the liquidity risk inherent in the maturity analysis of financial liabilities. The factors that the entity might consider in providing this disclosure include, but are not limited to, whether the entity:
- expects some of its liabilities to be paid later than the earliest date on which the entity can be required to pay (as may be the case for customer deposits placed with a bank);
- expects some of its undrawn loan commitments not to be drawn.
Other contingent liabilities of banks include the outcome of lawsuits filed against the banks.
Contingent liability Contingent liability
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