CHAPTER 14

PROVISIONS, CONTINGENT
LIABILITIES AND CONTINGENT ASSETS

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14.1 INTRODUCTION

A number of problems have arisen in the past with respect

to provisions
Inconsistency in accounting treatment (e.g. restructuring,
warranties, environmental)
Earnings smoothing with big bath provisions with no real
substance
Intentions rather than firm obligations
Lack of detailed disclosure
Therefore guidance essential

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14.2 RECOGNITION

A provision should be recognised when:

an entity has a present obligation (legal or constructive)

as a result of a past event;

it is probable that a transfer of economic benefits will be

required to settle the obligation; and

a reliable estimate can be made of the amount of the

obligation.

If these conditions are not met, no provision should be

recognised

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Present obligation

A present obligation is one that exists at the reporting date

as a result of a past event
See Chapter 14, Examples 14.1 14.3

There are two types of present obligation legal and

constructive
See Chapter 14, Examples 14.4 and 14.5

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Present obligation legal

This is an obligation that derives from:

A contract (through explicit or implicit terms)

Legislation
Other operation of law

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Present obligation constructive

This is an obligation that derives from an entitys actions

where:
By 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
and a the part of those other parties that it will discharge
those responsibilities.

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Example 14.1: Self insurance

An entity expects to pay 100,000 in damages based on

previous experience.

As there is no present obligation/obligating event until an

accident occurs, no provision is recognised. Although it could
be argued that there is a constructive obligation due to past
experience.

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Example 14.2: Refurbishment costs (no legislative requirement)

A furnace has a lining that needs to be replaced every five years for
technical reasons. At the reporting date, the lining has been in use for three
years.

Is there a present obligation as a result of a past obligating event?

There is no present obligation.

Conclusion
No provision is recognised. The cost of replacing the lining is not recognised
because, at the reporting date, no obligation to replace the lining exists
independently of the companys future actions even the intention to incur
the expenditure depends on the company deciding to continue operating the
furnace or to replace the lining. Instead of a provision being recognised, the
depreciation of the lining takes account of its consumption, i.e. it is
depreciated over five years. The re-lining costs then incurred are capitalised
with the consumption of each new lining shown by depreciation over the
subsequent five years.

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Example 14.3: Refurbishment costs (legislative requirement)

An airline is required by law to overhaul its aircraft once every three years.

Is there a present obligation as a result of a past obligating event?

There is no present obligation.

Conclusion
No provision is recognised. The costs of overhauling aircraft are not
recognised as a provision for the same reasons as the cost of replacing the
lining is not recognised as a provision in the previous example. Even a legal
requirement to overhaul does not make the costs of overhaul a liability,
because no obligation exists to overhaul the aircraft independently of the
entitys future actions. The entity could avoid the future expenditure by its
future actions, for example by selling the aircraft. Instead of a provision
being recognised, the depreciation of the aircraft takes account of the future
incidence of maintenance costs (i.e. an amount equivalent to the expected
maintenance costs is depreciated over three years).

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Example 14.4: legal present obligation provision for warranties

A manufacturer gives warranties at the time of sale to purchasers of its

product. Under the terms of the contract for sale the manufacturer
undertakes to make good, by repair or replacement, manufacturing defects
that become apparent within three years from the date of sale. On past
experience, it is probable (i.e. more likely than not) that there will be some
claims under the warranties.

Is there a present obligation as a result of a past obligating event?

The obligating event is the sale of the product with a warranty, which gives
rise to a legal obligation.

Is there an outflow of resources embodying economic benefits in

settlement? Probable for the warranties as a whole.

Conclusion A provision is recognised for the best estimate of the costs of

making good under the warranty products sold before the reporting date.

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Example 14.5: Constructive present obligation refunds policy

A retail store has a policy of refunding purchases by dissatisfied customers,

even though it is under no legal obligation to do so. Its policy of making
refunds is generally known.

Is there a present obligation as a result of a past obligating event?

The obligating event is the sale of the product which gives rise to a
constructive obligation because the conduct of the store has created a valid
expectation on the part of its customers that the store will refund purchases.

Is there an outflow of resources embodying economic benefits in

settlement? Probable that a proportion of goods are returned for refund.

Conclusion A provision is recognised for the best estimate of the costs of

refunds.

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Past event

An event that creates a legal or constructive obligation that

results in an entity having no realistic alternative to settling that
obligation

The event must cause an obligation now, not at a later date

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Example 14.6: Contaminated land (Legislation virtually certain
to be enacted)

An entity in the oil industry causes contamination but cleans up only when
required to do so under the laws of the particular country in which it
operates. One country in which it operates has had no legislation requiring
cleaning up and the entity has been contaminating land in that country for
several years. At 31 December 2012, it is virtually certain that a draft law
requiring a clean-up of land already contaminated will be enacted shortly
after the year end.

Is there a present obligation as a result of a past obligating event?

The obligating event is the contamination of the land because of the virtual
certainty of legislation requiring cleaning up.

Is there a probable transfer of economic benefits? Yes, probable.

Conclusion
A provision is recognised for the best estimate of the costs of the clean-up.

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Restructuring

i.e. practical application of present obligation and past event

Sale or termination of a line of business

Closure of business locations or relocation of business
activities

Changes in the management structure

Fundamental reorganisations that have a material effect on
the nature and focus of operations

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Restructuring

A restructuring provision should include only the correct

expenditures arising from the restructuring i.e. those that
are both:
Necessarily entailed by the restructuring; and
Not associated with the ongoing activities of the entity.
Costs that cannot be included in a restructuring provision:
Retraining or relocating continuing staff
Marketing, or
Investment in new systems and distribution networks

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Sale or termination of a line of business

No obligation arises for the sale of an operation until the

entity is committed to its sale

e.g. there is a binding sale agreement at the reporting date (if

virtually certain, disclose but do not adjust)

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Closure of business locations or relocation of
business activities
Recognise a provision only when the entity has (at the reporting
date):
A detailed formal plan for the restructuring
Raised a valid expectation in those affected that it will carry out
the restructuring by starting to implement that plan or announcing
its main features to all those affected by it

The formal plan should identify at least:

The business or part of the business concerned
The principal locations affected
The allocation, function, and approximate number of employees
who will be terminated
The expenditures that would be undertaken
When the plan will be implemented

See Chapter 14, Examples 14.7 and 14.8

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Future operating losses

Provisions should not be recognised for future operating

losses

Future operating losses do not meet the general definition of

a liability and the general recognition criteria for provisions

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Probable transfer of economic benefits

Regarded as a probable if the event is more likely than not

to occur

i.e. the probability that the event will occur is greater than that
the probability that it will not

See Chapter 14, Examples 14.4 14.6

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Reliable estimate of the obligation

An estimate of the obligation, based upon a the range of

possible outcomes is acceptable

Where no reliable estimate can be made, the liability

cannot be recognised and should be disclosed as a
contingent liability

See Chapter 14, Examples 14.7 14.9

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Example 14.7: Closure of a division (no communication)

On 12 December 2012 the board of an entity decided to close

down a division. Before the reporting date (31 December 2012)
the decision was not communicated to any of those affected
and no other steps were taken to implement the decision.

Is there a present obligation as a result of a past obligating

event? There has been no obligating event and so there is no
obligation (i.e. no communication).

Conclusion No provision should be recognised at 31

December 2012.

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Example 14.8: Closure of a division (with communication)
On 12 December 2012, the board of an entity decided to close down
a division making a particular product. On 20 December 2012 a
detailed plan for closing down the division was agreed by the board.
Letters were sent to customers warning them to seek an alternative
source of supply and redundancy notices were sent to the staff of the
division.

Is there a present obligation as a result of a past obligating

event? The obligating event is the communication of the decision
to the customers and employees, which gives rise to a constructive
obligation from that date because it creates a valid expectation that
the division will be closed.

Is there an outflow of resources embodying economic benefits

in settlement? Probable.

Conclusion A provision is recognised at 31 December 2012 for the

best estimate of the costs of closing the division.

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Example 14.9: Legal obligation
Under new legislation, an entity is required to fit smoke filters to its factories
by 30 June 2012. The entity has not yet fitted the smoke filters as at 31
December 2011.

(a) At the reporting date of 31 December 2011

Is there a present obligation as a result of a past obligating event?
There is no obligation as there is no obligation to fit the filters or pay the
fines. Therefore no provision required.

(b) At the reporting date of 31 Dcember 2012

Is there a present obligation as a result of a past obligating event?
There is still no obligation for the costs of fitting smoke filters because no
obligating event has occurred (i.e. the fitting of the filters). However, an
obligation might arise to pay fines or penalties under the legislation because
the obligating event has occurred (i.e. the non-compliant operation of the
factory). Therefore, a provision should be recognised for the best estimate of
any fines and penalties that are more likely than not to be imposed at 31
December 2012.

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Changes in provisions

Provisions should be reviewed at each reporting date date

and adjusted to reflect the current best estimate

If it is no longer probable that a transfer of economic

benefits will be required to settle the obligation, the
provision should be reversed

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Reimbursement

Unless it is virtually certain that the reimbursement will be

received, it should not be recognised.

In the SFP, the reimbursement should be treated as a

separate asset and not netted against the liability

In the SPLOCI P/L, any expenses relating to a provision

can be netted against the related reimbursement

See Chapter 14, Table 14.1

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Onerous contracts

This is a contract in which the unavoidable costs of meeting

the applications under it exceed the economic benefits
expected to be received from it

The present obligation under onerous contracts should be

recognised and measured as a provision

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Example 14.10: Onerous contract

An entity operates profitably from a factory that it has leased

under an operating lease. During December 2012 the entity
relocates its operations to a new factory. The lease on the old
factory continues for the next four years, it cannot be cancelled
and the factory cannot be sub-let.

Present obligation? Yes signing of lease

Probable outflow? Yes costs exceed benefits
Reliable estimate? Yes future lease payments would be known
Conclusion Therefore recognise a provision

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Contingent liabilities

A present obligation that arises from past events that is not

recognised because either:
It is not probable (i.e. it is only possible) that a transfer
of economic benefits will be required to settle the
obligation; or
The amount of the obligation cannot be measured with
sufficient reliability

Contingent liabilities should not be recognised in the

accounts but should be disclosed in the notes, unless the
possibility of a transfer of economic benefits is remote

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Example 14.11: Court case
After a wedding in 2011, 10 people died, possibly as a result of food
poisoning from products sold by the entity. Legal proceedings are
started seeking damages from the entity, but it disputes liability.
Up to the date of authorisation of the financial statements for the year
to 31 December 2011, the entitys lawyers advise that it is probable
that it will not be found liable. However, when the entity prepares the
financial statements for the year to 31 December 2012, its lawyers
advise that, owing to developments in the case, it is probable that it
will be found liable.
Requirement
What is the required accounting treatment:
(a) at 31 December 2011?
(b) at 31 December 2012?

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Example 14.11: Court case

Solution
At 31 December 2011:
On the basis of the evidence available when the financial
statements were approved, there is no obligation as a result of
past events. No provision is recognised. The matter is
disclosed as a contingent liability unless the probability of any
transfer is regarded as remote.
At 31 December 2012:
On the basis of the evidence available, there is a present
obligation. A transfer of economic benefits in settlement is
probable. A provision is recognised for the best estimate of
the amount needed to settle the present obligation.

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Contingent liability in a business combination

The general rule under IAS 37 is that a contingent liability

is not recognised in the financial statements.

The only exception to this is in a business combination

(See IFRS 3 Business Combinations Chapter 26). A
contingent liability is recognised by the acquirer if it is a
present obligation that arises from past events and its fair
value can be measured reliably. The amount of the
contingent liability is also taken into account in the
calculation of goodwill or premium on acquisition.

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Contingent asset

A possible asset arising from past events 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

No recognition of a contingent asset (unless certain)

If economic inflow is probable, disclose:

Description of the nature of contingent asset
Estimate of the financial effect

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14.3 MEASUREMENT
Best estimate of the expenditure required to settle the
present obligation at the reporting date (See Chapter 14,
Example 14.10)

Estimates of outcome and the financial effect are determined

by the judgement of management, supplemented by
experience of similar transactions

Risks and uncertainties should be taken into account in

reaching the best estimate (See Chapter 14, Example 14.13)

Where the effect of the time value of money is material, the

amount of a provision should be the present value of the
expenditures expected to be required to be settle the
obligation (See Chapter 14, Example 14.14, Issue 5)

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Example 14.13: Risk and uncertainty
Parker plc sells goods with a warranty under which customers are
covered for the cost of repairs of any manufacturing defect that
becomes apparent within the first six months of purchase. The
companys past experience and future expectations indicate the
following pattern of likely repairs.

Percentage of Goods Sold Defects Cost of Repairs million

75% None -
20% Minor 1.0
5% Major 4.0

Requirement: Calculate the expected cost of repairs.

Solution
The cost is found using expected values (75% x nil) + (20% x
1.0m) + (5% x 4.0m) = 400,000.

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14.4 DISCLOSURE
For each class of provision:
A brief description of the nature of the obligation, and the
expected timing of any resulting transfers of economic
benefits
An indication of the uncertainties about the amount or
timing of those transfers of economic benefits
Carrying amount at beginning and end of period
Additional provisions made in the period
Amounts used during the period
Unused amounts reversed during the period
Increase during the period in the discounted amount
arising from the passage of time and the effect of any
change in the discount rate
The amount of any expected reimbursement
Comparative information is not required

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14.4 DISCLOSURE

For each class of contingent liability:

Description of the nature of the contingent liability
Estimate of its financial effect
Indication of the uncertainties relating to the amount or
timing of any outflow
Possibility of any reimbursement
No recognition of a contingent liability

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14.4 DISCLOSURE

For each class of contingent asset:

If probable, a brief description of the nature and financial
effect

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 Start Now try Example 14.14
No No
Present obligation
Possible
as a result of an
obligating event? obligation?

Yes Yes

No Yes
Probable
Remote?
outflow?

Yes No
No (rare)
Reliable
estimate?

Yes
Disclose
Provide Do nothing
contingent liability

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