F2 Advanced Financial Reporting

Module: 20

Provisions, Contingent

Liabilities and Contingent Assets

1. Introduction

Origin story

The year is 1998 and companies all over the world are getting up to no good!

Some are setting aside profits from a particularly successful year to be

released in a later, less profitable period, to soften the blow (something

known as profit smoothing).

Others are grouping together a whole range of unrelated provisions into one

large 'exceptional item' to be charged in a year of poor performance making it

even worse (a 'big bath' provision). Why would anyone do this? Because

next year's profits will look even bigger and the top execs get a nice big

bonus!

Enter the IFRS Foundation with IAS 37 Provisions, Contingent Liabilities and

Contingent Assets, with the objective of ensuring that appropriate

recognition criteria and measurement bases are applied to provisions,

contingent liabilities and contingent assets. No more profit smoothing. No

more 'big bath' provisions. Let's take a look at how it works.

Key principle

A provision is an amount of money set aside by a company for an

expected future cost. The goal of this standard (IAS 37) is to limit exactly

what is an acceptable provision so that they aren’t used inappropriately. The

key principle established by the standard is that a provision should be

recognised only when there is a liability. The standard thus aims to ensure

that only genuine obligations are dealt with in the financial statements.

For instance, general future expenditure (e.g. next year's electricity bill),

even where authorised by the board of directors or equivalent governing

body, does not count for use as a provision. The standard essentially makes

it very difficult for a company to set up a provision for anything other than a

true liability related to the current year's operations (e.g. a legal case in court

this is likely to be lost).

2. Provision

s Definition

Provision

A provision is defined as a liability of uncertain timing or amount.

A provision might be made for staff bonuses relating to the current financial

year but paid in the next financial year. The timing of the bonus payments is

known but the exact amount is not as it depends on staff performance.

However, a good estimate can be made based on previous year's bonus

payments which are always around 5% of total pay. A provision can be set up

to allow for a reasonable estimate of the liability and this charged in the

current year.

Liability

The first stage in recognising a provision is to make sure that it is at least a

liability.

Let's re-familiarise ourselves with the official definition of a liability:

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.

At the end of the accounting year staff bonuses will represent a genuine

liability due to services provided during that accounting year.

Recognition

By looking more closely at the different elements in these two definitions, we

can derive some basic conditions for the recognition of a provision:

1. Present obligation of the entity arising from past events

So, this means that the amount must be related to some prior activity of the

entity, usually the purchasing of good/services for some future period. It must

also be a present obligation, which means it has yet to be paid.

The staff bonuses do relate to the current period but have yet to be paid, so

are a present obligation.

An obligation can be a number of things, but in this context, there are two

main kinds that are relevant to provisions:

• Legal obligations - those arising from contracts and legislation, e.g. a

contractual obligation to pay a sum of money for services received or a

bonus based on performance on contractually agreed terms.

• Constructive obligations – those arising from a created expectation

by the entity, e.g. a discretionary staff bonus.

2. The settlement is expected to result in an outflow from the entity

This one is fairly straightforward. The payment will be the outflow, usually of

cash or some monetary consideration, from the entity to a third party. The

outflow needs to be more probable than not and so only outflows that are

highly likely would qualify as a provision.

For example, let's say the staff bonus is only paid when staff targets are

exceeded, and this historically does not happen often. In this case, the

evidence suggests that a cash outflow is less likely than it is likely, and so

any amount set aside could not be recognised as a provision.

3. The timing or amount is uncertain

This final aspect applies only to provisions.

It is yet not known or specified at what time the liability is to be repaid and equally,

it is not yet known exactly how much the liability will amount to.

However, the entity must be able to make a reliable estimate of the amount of

the obligation.

The staff bonuses fall into this criterion nicely. The timing of the bonus

payments is likely to be known (soon into the new financial year) but the

exact amount is not as it depends on staff performance.

Another example might be the case of ongoing construction work that has

gone beyond the original time and has incurred more costs. There may be a

good estimate of the time and costs, but it is ultimately uncertain and so a

provision can be made.

Unless all three of the above conditions can be met, then an item cannot be

recognised as a provision.

Example

2% Breakdowns

K Ltd, a car dealership, sells cars to customers with a warranty covering the

cost of repairs undertaken up to 2 years after purchase. It is estimated that

98% of vehicles sold will not require repairs. Should a provision be made?

If each sale were considered individually, no provision would be made as

there is only a 2% probability of the goods being returned for repair.

However, if sales are considered as a whole, there is a high likelihood of 2% being

returned for repair. Therefore, a provision should be made for the expected cost

of repairs to 2% of the goods sold in the 2 years.

How Fresh is Your Fast Food?

POT Ltd are a fast food restaurant with a number of restaurants around the

country. Their slogan is “Our fresh food will improve your mood”.

Approximately 1 in 1,000 customers makes a complaint each year that their

food was not as advertised. Should a provision be made?

In this case, there is a probable outflow of cash, since the customer would

expect a refund. Also, there is a reliable estimate for the amount (the

average amount spent by 1 in 1,000 customers, over the course of a year).

However, it is difficult to establish whether there is a genuine obligation

here. There is certainly no legal obligation and no real constructive

obligation if there is no official policy for refunds. If we assume that the

slogan creates enough of an expectation for it to constitute a constructive

obligation, then a provision would be made in this case.

Debit is not always an expense

When a provision is recognised, the debit entry for a provision is usually an

expense. e.g. in our earlier example of staff bonuses there would be a debit

as an expense for the bonus.

However, the debit is not always an expense sometimes it can be an

asset. For example, a provision is often set up for an obligation for

environmental clean-up when a new mine is opened, or an offshore oil rig is

installed. So, rather than this clean up cost being an expense, it will go

towards the overall cost of the asset (the oil rig, in this case).

3. Contingent liabilities

Definition

A contingent liability is a probable obligation arising from past events

but will only be realised (or unrealised) based on certain future events

that are not yet certain.

Accounting

A contingent liability is not recognised in the financial statements. The

contingent liability is disclosed, however, in the notes to the accounts.

Therefore, users of the financial statements can be aware of it, but it cannot

be used by the company to manipulate figures in the statements.

Elements

Let's examine the elements that would make something a contingent liability.

Uncertainty

So, the essence of this concept is that it is a debt that you may or may not

have to pay, depending on how things pan out. The fact that it depends on

some other event happening makes it contingent and thus it will not be a

provision.

For example, if you make a £20 bet that it will rain at some point during the

day, you have a contingent liability, and so no amount is recognised. This is

because it is an obligation that you may or may not have to pay, because it

depends on some future event that is beyond your control.

Improbable

This concept is based around the idea that a present obligation is not

recognised as a provision if it is not probable that an outflow will be

required to clear the obligation.

So, if you made a £20 bet that the sun will rise in the morning, then this is a

contingent liability and would not be recognised, since the likelihood of the sun

not rising tomorrow is very low and so there isn't much chance that you'll

have to pay the £20.

Lack of reliable method measurement

This final aspect of the definition includes obligations that lack a reliable

method for measurement. Therefore, if you bet that it will not rain today and

if it does you agree to pay £1 for every raindrop that falls, then it is a

contingent liability and cannot be recognised, because there is no reliable

way to measure how much you would need to pay if it did rain.

Example

Ditie Inc is a company that have introduced a brand new line of record

players. Since the company primarily produce guitar amplifiers, this is a

relatively unknown territory for them.

The new product is set to launch at the start of 20X6. In the 20X5

statements, senior management want to recognise a liability for the cost of a

potential recall of the product. Can this be done?

Answer

The answer is no. In this case, it is uncertain as to whether the product will

need to be recalled. In fact, the company should be planning for no recall.

This qualifies as a contingent liability and cannot be recognised in the

financial statements.

4. Contingent assets

Having found out what happens when we mix liabilities and uncertainty, what

happens with assets and uncertainty?

Definition

A contingent asset is just the opposite of a contingent liability. The given definition

is:

A possible asset that arises from past events and 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.

So, if someone offers to give you £20 if it rains tomorrow evening, this will

be a contingent asset, since it depends on whether or not it rains tomorrow,

which is wholly out of the control of the two of you. Thus it cannot be

recognised as a real asset.

Accounting

A contingent asset is not recognised in the financial statements. The

contingent asset is disclosed, however, in the notes to the accounts.

Therefore, users of the financial statements can be aware of it, but it cannot

be used by the company to manipulate figures in the statements.

Example

Chalk Inc files a lawsuit against Cheese Inc for the use of a patented design

without permission in the production of one of Cheese Inc's most profitable

products.

Both companies have excellent lawyers and the case continues for a long

time. At the end of the financial year, the case is still not settled and will got

to court in the following year. There is no indication as to which way the case

will go.

Chalk Inc has already incurred expenses for the cost of court proceedings

and lawyers. However, if they win the case, they will be awarded £90m. How

can this be recognised in the financial statements?

Answer

The court costs will be expensed, since they are current liabilities and thus

this will be recognised in the statements.

However, the £90m lawsuit cannot be recognised, since it meets the

conditions for a contingent asset, i.e. the existence of the assets depends on

future events (the court case) that are not yet certain.

5. Disclosures

Once again, now we can describe and spot contingent liabilities and assets,

our job is to understand how to present them in the accounts.

As we have seen previously we do not recognise either contingent

liabilities or assets in the financial statements directly, but we do

disclose the nature of the asset or liability.

Let's examine how we do this.

Contingent assets and contingent liabilities

Description of nature of contingent liability/asset

This will be a description that covers the reason why the asset/liability exists.

So, going over our previous examples of a lawsuit, it may be a description

of the details of the lawsuit.

An estimate of its financial effect

The amount of the asset/liability will be estimated in the most reliable way

possible, thus showing the effect of it on other items in the statements,

particularly the assets and liabilities. This can also have an effect on some of

the key financial ratios. In the case of a lawsuit the opinion of lawyers might

be used to assess the likely result, or reference to other similar cases might

be used.

An indication of uncertainties relating to amount or timing of

outflow/inflow

Here there would be an outline of why the amounts are uncertain e.g. if it is an

issue with the amount or timing, then an explanation of the nature/cause of

the uncertainty will be provided. In the case of the lawsuit the explanation

would relate to the uncertainty of winning the case and the reasons for that.

The possibility of reimbursement for contingent liabilities

Finally, an estimate may be given for a contingent liability as to the chances of

repayment being required. In other words, an actual probability will be

calculated for the likelihood of the liability crystallising. In the case of a

lawsuit again legal opinion could be used, or probabilities of similar past

cases. If it was the recall of a product then probabilities based on previous

product releases could be used.

6. Selected examples

Onerous contracts

An onerous contract is one in which the costs of carrying out the contract

is higher than any return from that contract. For instance, if you enter

into a building contract with expected revenue of £300,000, but costs

unexpectedly escalate and are likely end up being £500,000, that would

make it an onerous contract because you are committed to a £200,000 loss.

A provision can be set up for these contracts. The rule is that the provision

must be the lesser of the cost of fulfilling the contract and any penalties

for not completing the contract. For example, if the cost of the work in

the above example is £200,000, but the cot of cancelling the contract is

£100,000, then it is more sensible to exit the contract and the provision would

be for the £100,000 exit costs.

Example

SH Ltd has three years remaining on a five year contract with PG Ltd, who

provide an IT server. However, SH have had to abandon their IT project due a

lack of profitability. The cost of the full contract to SH Ltd has increased to

£450,000. The cost of cancelling the contract at this stage would be

£500,000.

Well, in this case, a provision of £450,000 should be made (the least net

cost being fulfilling the existing contract) and recorded as:

£'000 £'000

Dr

Cr

Expense (Income statement)

Provision

450 450

As the subsequent payments for the contract are made, the entry

requirements become (using a £10,000 payment as an example):

Dr

Provision

£'000

10

£'000

Cr Cash 10

This has the effect of reducing the provision until it runs down to zero. Note

that no further expense is incurred in subsequent periods, the expense is

shown in the period in which the liability arises.

Decommissioning costs

Some assets have significant decommissioning costs at the end of their life.

A nuclear power station is an example. When agreement was made to build

Hinkley Point C, a power station in the UK, build costs were estimated at

£18bn. That might be expected. However expectations were that it would

cost almost half that amount (£7.2bn) to decommission it at the end of its life.

As you can see decommissioning costs can be significant and can't be

ignored and as such a provision is made.

The decommissioning costs of the asset are 'capitalised' and expensed

over the life of the asset (as part of the depreciation charge).

To record the provision:

Dr Asset (Increasing the cost of the asset)

Cr Provision (Setting up a provision)

The provision should be based on the present value of the expected

decommissioning costs. If, for example the power station was expected to

cost £10bn to decommission in 30 years time then a 30 year discount rate

would be used. That can make a big difference to the amount that is

provided for. At a 10% discount rate a 30 year discount factor is 0.15, making

the amount to be provided for in this case just £1.5bn.

Where discounting is used, the carrying amount of a provision is increased in

each period to reflect the passage of time, after all, in our example it is

£10bn that actually needs to be paid out and not £1.5bn. This increase is

recognised as borrowing cost and expensed each year. The value of the

provision therefore increases each year throughout the asset's life reflecting

the fact that the final outlay is getting closer.

Proposed dividends

It is not acceptable to include dividends declared after the statement of

financial position date as liabilities at the year end. They are simply

disclosed in a note to the accounts.

If dividend is declared before the year end, they must be shown in the

statement of changes in equity and accrued for as a liability.