PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS

<< EVENTS AFTER THE BALANCE SHEET DATE

ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS 1 >>

Advance Financial Accounting (FIN-611)

LESSON # 28

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.

140

Advance Financial Accounting (FIN-611)

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:

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:

141

Advance Financial Accounting (FIN-611)

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

Liabilities

Accruals

Provisions

(certain)

(virtually certain)

(uncertain)

Present

Present obligation

Status

obligation

Arising from

Past events

Outflow of

resources

Probable

embodying

economic benefits

Uncertain

(However

Measurement of

Certain

Virtually certain

amount

reliable estimate

can be made)

Dr.

Loss

Dr. Expense

Dr. Purchases

(Expenses)

Accounting

Cr.

treatment

Cr. Creditors

Cr. Provision for

Accrual/Owings

the Loss

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.

Case 1

Case 2

Case 3

Possible

Present obligation

Status

obligation

Arising from

Past events

Will be confirmed

Outflow of

resources

upon

the

Probable

Not probable

embodying

occurrence

142

Advance Financial Accounting (FIN-611)

economic benefits

non-occurrence of

future events, not

in the control of

the entity

a] Future events

a] Probability is

not remote

are not remote

be b] Probability is

Cannot

Amount

measured reliably remote

b] Future events

are remote

a] Disclosed in

notes

Accounting

Disclosed in notes

treatment

b] Not disclosed

b] Not disclosed in

in notes

notes

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.

Stage

Liabilities

Assets

Recognize

Certain

Virtually certain

Recognize

(Accruals/Owings)

Uncertain

Do not recognize

(Probable/Provisio

Recognize

Disclose only

Do not recognize

Contingent

Do nothing

Disclose only

Remote

Do nothing

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.

143

Advance Financial Accounting (FIN-611)

Recognizing different transactions/events in Accordance with IAS 37:

Expense/Loss

Measurement

Status/Recognize

Accounting entry

amount

(Status)

Certain

Identified as

Dr. Expense

(Invoice/supporti

Liability

present

documents

Cr. Payable

obligation

based)

Virtually certain

Dr. Expense

Identified as

(Invoice/supporti

Accrued liability

Cr.

present

ng documents

obligation

Accrual/Owings

based)

Uncertain

(amount can be

Dr.

Expense

Identified as

estimated reliably

(Loss)

present

Provision liability

with

probable

Cr. Provision for

obligation

outflow

loss

resources)

Uncertain

(amount can not

estimated

Identified as

reliably although

Contingent

entry.

present

there

liability

Disclose only

obligation

probability

outflow

resources)

Uncertain

(without

any

Identified as

Contingent

entry.

present

probability

liability

Disclose only

obligation

outflow

resources)

Uncertain

(possible outflow

of resources are

Unidentified

Contingent

entry.

(possible

based on future

liability

Disclose only

obligation)

events not in

control of the

entity)

Unidentified

No entry.

(remote

Uncertain

No recognition

disclosure

obligation)

144

Advance Financial Accounting (FIN-611)

Accrued

Provision

Contingent

Creditors

Expense

liability

Liability

Virtually

Certain

Uncertain

Possible

certain

1: Present

obligation

2: Arising

from past

events

Probable

outflow of

resources

embodying

economic

benefit in

future

4: Reliable

estimation

As per

of the

iouprev

Invoice

amount

received

(can be

Invoice

measured

reliably)

Losses

against

Expense

warranty

No entry

5: Expense/Resources

A/C

Dr.

only

Accounting

Provision disclosure disclosure disclosure

Payable A/C

Accrual

treatment

for is required is required is required

A/C

Warranty

Cr.

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

145

Advance Financial Accounting (FIN-611)

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:

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

146

Advance Financial Accounting (FIN-611)

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.

147

Advance Financial Accounting (FIN-611)

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.

148

Advance Financial Accounting (FIN-611)

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

149

Advance Financial Accounting (FIN-611)

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:

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.

150

Table of Contents: