Provisions and contingent liabilities – 2 know it all!

Provisions and contingent liabilities

A provision shall be recognised when: Provisions and contingent liabilities

  1. an entity has a present obligation (legal or constructive) as a result of a past event;Provisions and contingent liabilities
  2. it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
  3. a reliable estimate can be made of the amount of the obligation.

If these conditions are not met, no provision shall be recognised. But a disclosure for a contingent liability could be required (see below).

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Provisions are liabilities of uncertain timing or amount. This uncertainty makes them different from accruals or payables, where the timing and amount are known or the uncertainty is insignificant. The level of uncertainty for accruals may sometimes be so high that they become less distinct from provisions. However, this distinction between provisions and other liabilities is important as provisions require specific disclosures to be made.

Where, as a result of past events, there may be an outflow of resources embodying future economic benefits in settlement of: (a) a present obligation; or (b) a possible obligation whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.
There is a present obligation that probably requires an  outflow of resources. There is a possible obligation or a present obligation that may, but probably will not, require an outflow of resources. There is a possible obligation or a present obligation where the likelihood of an outflow of resources is remote.
A provision is recognised (IAS 37 14) No provision is recognised (IAS 37 27) No provision is recognised (IAS 37 27)
Disclosures are required for the provision (IAS 37 84 – 85). Disclosures are required for the contingent liability (IAS 37 86) No disclosure is required (IAS 37 86)

Present obligation (see IAS 37 15-22) arises from past event(s) that results in an entity having no realistic alternative to settling that obligation. It is the case when the obligation can be enforced by law (legal obligation) or the event, including action by the entity itself, creates valid expectations in other parties that the entity will settle the obligation (constructive obligation).

If entity can avoid the obligation by its future actions, there is no present obligation. For example, law requirement orProvisions economic reality may require the entity to take specific action in the future. But the present obligation arises only after the entity has actually taken this action (IAS 37 18-19). Provisions and contingent liabilities

Expected future operating losses are not a present obligation and therefore no provision is recognised for them. Care must be taken not to include future operating losses in measurement of provision that is recognised for other specific obligation. It is worth noting that expectations of future operating losses can be a significant indicator that assets are impaired (either ‘general’ under IAS 36 or specific under other applicable specific standards).

Entity A is a company operating in transportation industry. During the year 20X0, a law was enacted that requires all cargo cars to have special exhaust filters installed by June 20X1. The transportation authority is entitled to impose a fine on the owner of $ 10,000 for each car that doesn’t have exhaust filters installed as required. Entity A prepares annual financial statements as at 31 December 20X1 and it did not install the filters as required by law, despite owning 50 cargo cars. Provisions and contingent liabilities

Analysis at 31 December 20X0

There is no present obligation with respect to exhaust filters or potential fines. Entity A has not installed the filters, so it doesn’t owe money to anyone. There is also no present obligation with respect to potential fines to be imposed by the transportation authority, because the deadline for installation is June 20X1. Even if Entity A does not plan to install filters, the decision is still fully under control of the entity.

For example, it can sell its cargo cars before June 20X1 and use rented cars instead. Business rationale of such a decision is not taken into account when deciding whether present obligation exists as at the reporting date. As long as Entity A can avoid the obligation by its future actions, there is no present obligation as at 31 December 20X0.Provisions and contingent liabilities

Analysis at 31 December 20X1

There is no present obligation with respect to exhaust filters, but there is a present obligation with respect to potential fines to be imposed by the transportation authority. Entity A still didn’t install the filters, so it doesn’t owe money to anyone. But the deadline has passed and the transportation authority is entitled to impose a fine of $ 10,000 for each cargo car owned by Entity A.

Future actions of Entity A, such as installing required filters next year or using rented cars instead of owning them, will not change the fact that the authority can impose fines relating to the July-December 20X1 period, i.e.  the period when Entity A did not comply with the requirements. Provisions and contingent liabilities

Constructive obligation

Constructive obligation arises when entity has created a valid expectation on third parties that it will settle certain responsibilities. Constructive obligation arises from entity’s own actions and usually does not result from law or contracts signed with third parties. A valid expectation is created by an established pattern of past practice, published policies or a sufficiently specific statement made to third parties. See also the paragraph on restructuring below for specific application of the notion of constructive obligation.

Case provisions: present (constructive) obligation

On December 20X0, the board of directors of Entity A decides to give a 3-year warranty for all products manufactured by Entity A, including those sold before December 20X0. The law requires Entity A to give only a 2-year warranty and this is what Entity A has given so far.

The policy of 3-year warranty is made public in January 20X1 through extensive advertising and official terms and conditions are made available for download on entity’s website. On 10 March 20X1, Entity A authorises its financial statements for the year ended 31 December 20X0.

There is no present obligation as at 31 December 20X0 as Entity A did not create a valid expectation on third parties (customers) at that date. Valid expectations were created in January 20X1 and this is when present obligation arose. This is non-adjusting event after the reporting period and it does not impact valuation of provision as at 31 December 20X0.

The second condition needed for recognition of a provision is that it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation (see IAS 37 23-24). Probable means that the probability is above 50%.

For a large number of similar obligations, such as warranties, probability is determined for the class of obligations as a whole. So even if the probability for one specific obligation is well below 50%, the provision is still recognised for the whole class as it is probable that the settlement, taken as a whole, will require outflow of resources. Provisions and contingent liabilities

A reliable estimate of the amount of the obligation is the third condition needed for recognition of a provision (see IAS 37 25-26). Provisions are, by their nature, more uncertain than other liabilities, but IAS 37 explicitly states that it will be only rare cases where no reliable estimate can be made.

Claims and litigation are the most challenging area for reliable estimate of provisions, but entities need to develop aProvisions way of calculation of a related provision. Proper disclosure in the notes will explain assumptions and uncertainties inherent in measurement.

Measurement of provisions is covered in IAS 37 36-58. Provisions are measured at the best estimate of the expenditure required to settle the obligation at the end of the reporting period. IAS 37 points to ‘the amount that an entity would rationally pay to settle the obligation’ but in practice, provisions are most often measured at the amount that entity expects to ultimately pay to the other party concerned with the case (i.e. transfer to a third party is usually not considered when measuring a provision).

Only direct incremental expenditures necessary to settle the obligation are included in the value of the provision. Future costs, such as expected lawyers’ fees, are not included in the provision until the legal services are rendered.

Contingent Liabilities

A contingent liability is either

  1. a possible obligation arising from past events whose existence will be confirmed only by the occurrence of one or more uncertain future events not wholly within the control of the entity; or
  2. a present obligation that arises from past events but is not recognised because
    1. It is not probable that an outflow of economic benefits will be required to settle the obligation; or
    2. The amount of the obligation cannot be measured with sufficient reliability.

Recognition

A contingent liability is not recognised. A contingent liability is disclosed unless the possibility of an outflow of economic benefits is remote i.e. generally less than 5% chance.

Disclosure

For each class of contingent liability, an entity must disclose at the end of the reporting period, all of the following:

  1. the nature of the contingent liability
  2. an estimate of its financial effect
  3. an indication of the uncertainties relating to the amount or timing of any outflow
  4. the possibility of any reimbursement.

Case contingent liability – Accounting treatment

1. X Limited. issued a one year guarantee for on equipment that it sells to its customer. At the company’s year end, the company is being sued by one of its customers for refusing to repair equipment within the guarantee period.

X Limited is of the view that the fault is not covered by the guarantee as it believes that it has arisen because the customer incorrectly followed the instructions on using the equipment, X Limited’s company lawyer has advised that it is more likely than not that they will be found liable. This would result in the company being forced to repair the equipment plus pay legal expenses amounting to approximately €20,000.

At the end of the reporting period, X Limited disputes liability (and therefore, whether a present obligation exists). However, given that more likely than not it will be found guilty, based on the lawyers advice, a present obligation is assumed to exist. Given that a single obligation is being measured, a provision is made for the outflow of the most likely outcome i.e. a provision is recognised for €20,000.

2. The company also manufactures another line of equipment which it sells to wholesalers. The company sold 2,000 items of this type this year, which also has a one year guarantee if the equipment fails. Based on past experience, 10% of items sold are returned for repair. In each case, 40% of the items returned are able to be repaired at a cost of €100, while the remaining 60% need significant repair at a cost of €300.

Assessment

A present obligation exists at the end of the reporting period based on historical evidence of items being repaired under the guarantee agreement.

Here, a large population of items is involved. A provision is therefore made for the expected value of the outflow:

2,000 x 10% x 40% x €100

€8,000

2,000 x 10% x 60% x €300

€36,000

€44,000

Case contingent liability – Disclosure required?

During the year to 31 December 20X5, a customer started legal proceedings against a company, claiming that one of the food products that it manufactures had caused several members of his family to become seriously ill. The company’s lawyers have advised that this action will probably not succeed.

Assessment

Legal advice is that the claim is unlikely to succeed. It is unlikely that the company has a present obligation to compensate the customer and therefore no provision should be recognised. There is, however, a contingent liability. Unless the possibility of a transfer of economic benefits is remote, the financial statements should include a brief description to disclose the nature of the contingent liability, an estimate of its financial effect and an indication of the uncertainties relating to the amount or timing of any outflow.

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Provisions and contingent liabilities

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