Provisions, contingencies and events after the reporting period

The decisions on recognition, measurement and classification of liabilities affects the figures used in several key ratios
Most are straightforward but some decisions require the use of judgment about amounts or the probability of future events this opens up the potential for manipulation

ABC plc is being sued for 7 million for the damage caused to a customer by the malfunction of an allegedly faulty component supplied by the company last year. ABC plc plans to contest the claim.
Each side estimates their legal costs as 0.5 million

If ABC plc loses the legal case against it will have to pay whatever compensation is ordered and costs for both parties.
If ABC plc wins, it will not pay compensation and will recover legal costs from the customer At the year end the outcome is uncertain

At the year end should ABC plc set up (recognise) a liability of up to 8 million in the statement of financial position and an equal expense in the statement of comprehensive income? If so, where should the amounts be shown and what should entries be called?

The answer impacts on all profitability and solvency ratios

Recognition Measurement Classification Disclosure

Covered by IAS 37. Provisions, Contingent

Liabilities and Contingent Assets.

Provision A liability of uncertain timing or amount Contingent liability A possible obligation depending on whether some uncertain future event occurs, or A present obligation but payment is not probable or the amount cannot be measured reliably

In order for a provision to be recognised, three conditions must be met 1. An entity has a present obligation (legal or constructive) as a result of a past event; 2. It must be probable that a payment (or other outflow of economic benefits) will be required to settle the obligation; and 3. It must be possible to estimate the obligation reliably. If these conditions are not met, then the Provision cannot be recognised in the Financial Statements

An obligation that derives from an entitys actions where: 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; and As a result the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities. IAS 37

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The company has announced to staff that it will match contributions made by staff to a natural disaster appeal. The events have taken place the disaster and the promise to match the contributions Morally and to avoid bad publicity, the company must make the payments.
Any other examples you can think of?

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The amount recognised as a provision should be the best estimate of the amount needed to settle the obligation Probability analysis can be used to determine the expected value when there is a range of possible outcomes Amounts should be discounted down to their NPV (if time value of money is material) If the amount of the obligation cannot be measured with sufficient reliability, disclose as a contingent liability
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If recognised classify as provisions in either: Current liability can be determined with reasonable accuracy and is payable within 1 year OR Non-current liability - can be determined with reasonable accuracy and is payable after 1 year

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Provision Show the movement between the opening and closing provision as a note Contingent liability No entries are made in the accounts themselves, but the circumstances and an estimate of the financial consequences are disclosed in the notes to the accounts.

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A contingent asset is never recognised in the accounts If future benefits are probable it should be disclosed in the notes If future benefits are merely possible or remote, no disclosure is made

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How should events be recorded that are material, but happen after the end of the reporting period?

Are they relevant to last years accounts?

The period after the year end but before the accounts are finalised, SIGNED, is of great importance in clarifying issues surrounding year end uncertainties Guidance on the responsibilities of directors for events in this period is given in IAS 10
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An event, which could be favourable or unfavourable, that occurs between the end of the reporting period and the date when the financial statements are authorised for issue.

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Those that provide evidence of conditions that existed at the end of the reporting period (adjusting events after the end of the reporting period); and
Those that are indicative of conditions that arose after the end of the reporting period (non-adjusting events after the end of the reporting period )
IAS 10

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Receipt of information after the end of the reporting period indicates an asset was impaired at the end of the reporting period bad debts, NRV of inventory The settlement after the end of the reporting period of a court case clarifying the obligation at the end of the reporting period .

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The information is reflected in the accounts in the same way as if it had been known at the end of the reporting period
Bad debts written off or provided for Inventory written down to NRV is lower than cost Provision made for payments due under a legal case

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A major business combination after the end of the reporting period Destruction of property by fire after the end of the reporting period
Start of major litigation arising solely out of events that occurred after the end of the reporting period

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If non-adjusting events are material, nondisclosure could influence the economic decision of users taken on the basis of the financial statements Accordingly an entity shall disclose for each material category of non-adjusting event after the end of the reporting period :
The nature of the event: and An estimate of its financial effect, or a statement that such an estimate cannot be made IAS 10

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Attempt to ensure all relevant year end liabilities are recognised

Prevent companies setting up unnecessary provision when profits are high, in order to charge expenses against those provisions when profits are lower and profit smoothing Ensure that bad news occurring after the end of the reporting period is not hidden from users
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In practice, judgment is still required to decide when a provision or contingent liability should be recognised Measurement can be difficult It can be difficult to decide if additional information after the end of the reporting period relates to condition which existed at the end of the reporting period, or arose after it.

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Prepare answers to the tutorial worksheet and come along prepared to discuss your answer

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John Dunn Chapter 11

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