Future operating losses – Example on recognising and measuring provisions
An entity determines that it is probable that a segment of its operations will incur future operating losses for several years.
Present obligation as a result of a past obligating event—there is no past event that obliges the entity to pay out resources.
Conclusion—the entity does not recognise a provision for future operating losses. Expected future losses do not meet the definition of a liability. The expectation of future operating losses may be an indicator that one or more assets are impaired—see Impairment of Assets.
Before the introduction of IAS 37, there was little meaningful guidance on when a provision must be made and therefore it led to potential accounting abuse. This lack of guidance caused problems where some companies could make and then subsequently release provisions in order to smooth profits. It was particularly used by new management in companies whereby they would set aside large provisions for restructuring in their first year thereby reducing profits and then release any unneeded provisions in later years thereby increasing profits. Users of financial statements therefore found it difficult to determine the real underlying profits in companies due to the charging or releasing of provisions.
The objective of this Standard is to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets and that sufficient information is disclosed in the notes to enable users to understand their nature, timing and amount.
Definition Future operating losses
A provision is a liability of uncertain timing or amount. A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
Recognition Future operating losses
The recognition criteria are the same as those in the framework for all liabilities.A provision should be recognised when:
- an entity has a present obligation (legal or constructive) as a result of a past event;
- It is probable that an outflow of economic resources will be required to settle the obligation, and
- A reliable estimate can be made of the amount of the obligation.
If any one of these conditions is not met, no provision may be recognised. Future operating losses
Provisions are reviewed each year and adjusted to reflect current best estimate, if it is no longer probable that an outflow of resources embodying economic benefits will be required, the provision is reversed. Future operating losses
Present obligations and obligating events Future operating losses
A past event which leads to a present obligation is called an obligating event. An obligating event is an event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation.
In rare cases, it is not clear whether there is a present obligation. In these cases, a past event is deemed to give rise to a present obligation if, taking into account all available evidence, it is more likely than not that a present obligation exists at the end of the reporting period.
Legal and constructive obligations Future operating losses
An obligation can either be legal or constructive. Future operating losses
A legal obligation is one that derives from a contract, legislation or any other operation of law.
A constructive obligation is an obligation that derives from the actions of an entity where:
- From an established pattern of past practice, published policies or a specific statement the entity has indicated to other parties that it will accept certain responsibilities; and
- As a result the entity has created a valid expectation in other parties that it will discharge those responsibilities.
An intention to make a payment is not enough on its own to justify a provision. There must be an actual obligation to make a payment.
This is important, for example, in the accounting for repairs or refurbishments known to be required in future. Let us assume that a building’s lease agreement includes the requirement that the owner has to repaint the exterior every three years and this is estimated at a cost of €30,000. The company owing (the lessee) would prefer, for profit smoothing purposes, to allocate the cost equally over the three years rather than recognise all of the cost in the third year. This would require a provision of €30,000 to have been created, at €10,000 p.a., over three years. At the end of year three the provision would have been reduced affected by €10,000 p.a. over each of the three years.
IAS 37 does not permit this approach, because there is no obligation to incur this cost until the three years have elapsed. In the first two years, this would be future obligation which could be avoided if for example the building was sold before the third year. IAS 37 requires the full cost to be recognised in the third year and not equally over the three years.
See also: The IFRS Foundation