CkBooks Online – Free Online Books

IAS – 37 PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS

DEFINITIONS:

The following terms are used in this Standard with the meanings specified:

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. Definition of liability can be divided into three parts:

• Present obligation
• Arising from the past event
• Probable outflow of resources in future

Provision:

A provision is a liability of uncertain timing or amount. For a provision following points must be kept in mind:

• Present obligation
• Arising from the past event
• Probable outflow of resources in future
• Amount can be estimated reliably.

Provision is created for two motives:

• One to reduce Assets
• Second to create a liability against losses

Provision that is created for reduction in assets is of two types:

1. Provision against receivables (also known as contra to receivables – Provision for doubtful debts)
2. Provision against the expiry of economic benefits of fixed assets (Provision for depreciation/amortization).

IAS 37 does not talk about the provisions created to reduce the carrying amount of assets. It only talks about the provision that is created to recognize a liability against probable losses.

Obligation Event:

An obligating event is an event that creates a legal or constructive obligation that results in an entity having no realistic alternative but to settle that obligation.

• Legal Obligation:

A legal obligation is an obligation that derives from:

a) A contract (through its explicit or implicit terms); b) Legislation; or c) Other operations of law.

• Constructive Obligation:

A constructive obligation is an obligation that derives from an entity’s actions where:

a) By an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities.

b) As a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.

Contingent Liability:

A contingent liability is:

a) A possible obligation 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; or

b) A present obligation that arises from past events but is not recognized because:

i. It is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation.

ii. The amount of the obligation cannot be measured with sufficient reliability;

Contingent Assets:

A contingent asset 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.

Treatment of Liabilities, Accruals & Provisions:

Liabilities can be categorized as:

1. Certain liability example is Creditors against supplies
2. Virtually certain liability example is Accruals against expenses
3. Uncertain liability example is Provision against expected losses

Virtually certain: Something that involve a minor degree of estimation. An example of such would be the amount payable in Utility Bills. The expense on the bill is for one month; however the meter is read a couple of days after the month including charges for those extra days as well.

Identifying Contingent Liabilities:

Following table will help to identify whether the obligation is a contingent liability or not in accordance with the definition of IAS 37.

Accounting Requirements for recognizing Liabilities and Assets:

Recognizing liabilities and assets means to record relevant accounting heads in the books of accounts. IASB frame work and relevant Accounting Standards provide guidelines for recognizing liabilities and assets at different stages.

Following table will explain that which type of liabilities and assets will be treated in what way.

Do nothing:

‘Do nothing’ means that the event is to be ignored while preparing the financial statements. Even a disclosure of the same is not required in the notes to the accounts.

Recognizing different transactions/events in Accordance with IAS 37:

Provisions and Other Liabilities:

Provisions can be distinguished from other liabilities such as trade payables and accruals because there is uncertainty about the timing or amount of the future expenditure required in settlement. By contrast:

a) Trade payables are liabilities to pay for goods or services that have been received or supplied and have been invoiced or formally agreed with the supplier; and

b) Accruals are liabilities to pay for goods or services that have been received or supplied but have not been paid, invoiced or formally agreed with the supplier, including amounts due to employees (for example amounts relating to accrued vacation pay).

Although it is sometimes necessary to estimate the amount or timing of accruals, the uncertainty is generally much less than for provisions. Accruals are often reported as part of trade and other payables, whereas provisions are reported separately.

Relationship between Provisions and Contingent Liabilities:

This Standard distinguishes between:

a) Provisions – which are recognized as liabilities (assuming that a reliable estimate can be made) because they are present obligations and it is probable that an outflow of resources embodying economic benefits will be required to settle the obligations; and

b) Contingent liabilities – which are not recognized as liabilities because they are either:

i. Possible obligations, as it has yet to be confirmed whether the entity has a present obligation that could lead to an outflow of resources embodying economic benefits; or

ii. Present obligations that do not meet the recognition criteria in this Standard (because either it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation, or a sufficiently reliable estimate of the amount of the obligation cannot be made).

RECOGNITION:

Provisions:

A provision shall be recognized when:

a) An entity has a present obligation (legal or constructive) as a result of a past event; b) It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and c) A reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision shall be recognized.

Present 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 account of all available evidence, it is more likely than not, that a present obligation exists at the balance sheet date.

In almost all cases it will be clear whether a past event has given rise to a present obligation. In rare cases, for example in a law suit, it may be disputed either whether certain events have occurred or whether those events result in a present obligation. In such a case, an entity determines whether a present obligation exists at the balance sheet date by taking into account of all available evidence, including for example, the opinion of experts. The evidence considered includes any additional evidence provided by events after the balance sheet date. On the basis of such evidence:

a) Where it is more likely than not, that a present obligation exists at the balance sheet date, the entity recognizes a provision (if the recognition criteria are met); and

b) Where it is more likely that no present obligation exists at the balance sheet date, the entity discloses ability, unless the possibility of an outflow of resources embodying economic benefits is remote.

Past Events:

A past event that leads to a present obligation is called an obligating event. For an event to be an obligating event, it is necessary that the entity has no realistic alternative to settling the obligation created by the event. This is the case only:

a) Where the settlement of the obligation can be enforced by law; or b) In case of a constructive obligation, the event creates valid expectations in other parties that the entity will discharge the obligation.

Probable Outflow of Resources Embodying Economic Benefits:

For a liability to qualify for recognition there must be not only a present obligation but also the probability of an outflow of resources embodying economic benefits to settle that obligation. For the purpose of this Standard, an outflow of resources or other event is regarded as probable if the event is more likely than not to occur i.e. the probability that the event will occur is greater than the probability that it will not. Where it is not probable that a present obligation exists, an entity discloses a contingent liability, unless the possibility of an outflow of resources embodying economic benefits is remote.

Reliable Estimate of the Obligation:

The use of estimates is an essential part of the preparation of financial statements and does not undermine their reliability. This is especially true in the case of provisions, which by their nature are more uncertain than most other balance sheet items.

Contingent Liabilities:

An entity shall not recognize a contingent liability. A contingent liability is disclosed unless the possibility of an outflow of resources embodying economic benefits is remote. Contingent liabilities may develop in a way not initially expected. Therefore, they are assessed continually to determine whether an outflow of resources embodying economic benefits has become probable. If it becomes probable that an outflow of future economic benefits will be required for an item previously dealt with as a contingent liability, a provision is recognized in the financial statements of the period in which the change in probability occurs (except in the extremely rare circumstances where no reliable estimate can be made).

Example-1:

Extract from Notes to the Accounts:

a) Guarantees issued by banks on behalf the company;

b) Claims against the company were not acknowledged as debt by the company. As the management is confident that the matter would be settled in her favor; consequently no provision has been made in the financial statements in respect of the disputed liabilities.

Contingent Assets:

An entity shall not recognize a contingent asset. Contingent assets usually arise from unplanned or other unexpected events that give rise to the possibility of an inflow of economic benefits to the entity. An example is a claim that an entity is pursuing through legal processes, where the outcome is uncertain. Contingent assets are not recognized in financial statements since this may result in the recognition of income that may never be realized. However, when the realization of income is virtually certain, then the related asset is not a contingent asset and its recognition is appropriate. A contingent asset is disclosed where an inflow of economic benefits is probable.

Example-2:

The company has filed a suit against SA Ltd. claming damages amounting to Rs. 600,000. The legal advisors of the company are of the opinion that the company will win the case.

MEASUREMENT:

Best Estimate:

The amount recognized as a provision shall be the best estimate of the expenditure required to settle the present obligation at the balance sheet date. The estimates of outcome and financial effect are determined by the judgment of the management of the entity, supplemented by experience of similar transactions and in some cases, reports from independent experts. The evidence considered includes any additional evidence provided by events after the balance sheet date.

Example-3:

An entity sells goods with a warranty under which customers are covered for the cost of repairs of any manufacturing defects that become apparent within the first six months after purchase. If minor defects were detected in all products sold, repair costs of Rs. 1 million would result. If major defects were detected in all products sold, repair costs of Rs. 4 million would result. The entities past experience and future expectations indicate that, for the coming year, 75 percent of the goods sold will have no defects, 20 percent of the goods sold will have minor defects and 5 percent of the goods sold will have major defects. In accordance with 3.1.4.2, an entity assesses the probability of an outflow for the warranty obligations as a whole.

The expected value of the cost of repairs is:

(75% of Nil) + (20% of Rs. 1 m) + (5% of Rs. 4 m) = Rs. 400,000.

CHALLANGES IN PROVISION:

Provision shall be reviewed at each balance sheet date and adjusted to reflect the current best estimate. If it is no longer probable that an outflow of resources embodying economic benefits will be required to settle the obligation, the provision shall be reversed.

USE OF PROVISIONS:

A provision shall be used only for expenditures for which the provision was originally recognized. Only expenditures that relate to the original provision are set against it. Setting expenditures against a provision that was originally recognized for another purpose would conceal the impact of two different events.

Example-8:

A damage claim of Rs. 15 million for breach of contract has been served on the company. The company’s legal counsel is of the view that it is probable that the damages will be awarded to plaintiff. So, the company makes a provision. In the next year the case is decided in the favor of the plaintiff. The company has to pay Rs. 12 million. Another suit filed against the company is also decided in this year. The company has to pay Rs. 2 million in respect of this case.

Required: How will you account for above two payments?

Solution:

i. The first payment of Rs. 12 million shall be charged to provision and remaining provision should be reversed.

Provision for claim 15,000,000 Cash 12,000,000 Profit & Loss (Reversal of provision) 3,000,000

ii. The second payment of Rs. 2 million shall be charged to P & L Account separately. Damages Expenses (P & L A/c) 2,000,000

Cash 2,000,000

Application of the Recognition and Measurement Rules:

Future Operating Losses:

a) Provisions shall not be recognized for future operating losses. b) Future operating losses do not meet the definition of a liability and the general recognition criteria set out for provisions.

c) An expectation of future operating losses is an indication that certain assets of the operation may be impaird. An entity tests these assets for impairment under IAS-36 Impairment of Assets.

Onerous Contracts:

If an entity has a contract that is onerous, the present obligation under the contract shall be recognized and measured as a provision.