PROVISIONS AND CONTINGENCIES

Question 1

What were the issues pre IAS 37?

Answer 1

Dave rise to inconsistencies and provided significant scope for earnings manipulation.
Provisions and liabilities were often recognised based on an intention rather than and obligation to make expenditure.
BIG BATH accounting, where several items are aggregated into one large provision and reported as an exceptional item was on the rise.
Big bath provisions could be made when profits are high, and released when profits are low.
COMMON after acquisitions and when there was a change of management.

Question 2

What is the objective of IAS 37?

Answer 2

Ensure that appropriate recognition criteria and measurement bases are applied.
Ensure that sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount.
The key principle established by IAS 37 is that a provision should be recognised only when there is a liability. i.e. a present obligation arising from past events

Question 3

LIABILITY

Answer 3

“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.”

Question 4

LIABILITY RECOGNITION TESTS

Answer 4

Must pass definition test and recognition test.
A liability is recognised in the statement of financial position when:
1) it is probable that an outflow of resources will result from the settlement of a present obligation.
2) the amount involved can be reliably measured.

Question 5

PRESENT OBLIGATION - legal obligation

Answer 5

Evidence that a liability exists. e.g. under the law of contract there will be a binding obligation to make payment for goods and services.

Question 6

PRESENT OBLIGATION -CONSTRUCTIVE OBILGATION

Answer 6

Expectation of a duty under normal practice, e.g. the established practice of a company may lead customers to expect some additional benefits.

Question 7

PAST EVENTS

Answer 7

A liability arises because of something that has happened in the past - results in an obligation.
When a company offers to repair goods under a warranty agreement, the liability exists from the time that the warranty is offered.
The company will have to make an estimate of the liability: a provision.

Question 8

PROVISION

Answer 8

present obligation
requiring PROBABLE transfer of economic benefit
Can be reliably measured.
Can be defined as a liability but with uncertain timing and amount.

Question 9

CONTINGENT LIABILITY

Answer 9

Does not meet the criteria for recognition as a liability;
No reliable estimate of how much
Not probable that there will be transfer of economic benefits
Not certain that there is an obligation.
Thus a CL cannot be recognised; may be disclosed by way of note. (or not disclosed if the outflow of economic benefits is remote)

Question 10

OUTFLOW OF ECONOMIC BENEFITS

Answer 10

Cash is the usual economic benefit which is used in the settlement of obligations.
it is also possible to have a liability settled by replacement with another obligation
E.g. a bank overdraft which is replaced by a bank long term loan.

Question 11

Examples of things provisions can be made for.

Answer 11

Reorganisation costs
Warranties
Environmental costs
Major refits/refurbishments
Decommissioning costs
Legal cases against the company
Deffered tax
Losses on contracts

Question 12

CONTINGENT ASSET

Answer 12

“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 withing control of the enterprise.”
Usually arise from unplanned or other unexpected events that give rise to the possibility of an inflow of economic benefits to the entity.
SHOULD NOT BE RECOGNISED because it could result in a profit that may never be realised.

Question 13

When can an asset be recognized?

Answer 13

An asset can only be recognised when is it is no longer contingent and the future economic benefits are certain.

Question 14

When is a provision recognised?

Answer 14

An enterprise must recognise a provision if, and only if: -
A present obligation (legal or constructive) has arisen as a result of a past event (the obligating event)
Payment is probable
The amount can be estimated reliably

Question 15

OBLIGATING EVENT

Answer 15

is AN EVENT THAT CREATES A LEGAL OR CONSTRUCTIVE OBLIGATION AND, THEREFORE, RESULTS IN AN ENTERPRISE HAVING NO REALISTIC ALTERNATIVE BUT TO SETTLE THE OBLIGATION.

Question 16

POSSIBLE OBLIGATION

Answer 16

I.E. a contingent liability, is disclosed but not recognised. However, disclosure is not required if payment is remote.

Question 17

How should provisions be recognised?

Answer 17

Should be the best estimate of the expenditure required to settle the present obligation at the statement of financial position date.

Question 18

How are provisions for one off events recognised?

Answer 18

e.g. restructuring, environmental clean up, settlement of a law suit) are measured at the most likely amount.

Question 19

How are provisions for large populations of events?

Answer 19

e.g. warranties, customer refunds

are measured at a probability-weighted expected value.

Question 20

What are the issues with measurement for provisions?

Answer 20

Future events that may affect the amount required to settle an obligation should be reflected in the amount of a provision where there is sufficient objective evidence that they will occur.
First step is to determine whether or not a provision has to be recognised
OR
A contingent liability
OR
nothing should be done

Question 21

When should a provision be provided? (decision tree)

Answer 21

Present obligation as a result of an obligating event - yes
Probable outflow - yes
Probable estimate - yes
Provide

Question 22

When should nothing be done? (decision tree)

Answer 22

Present obligation as a result of an obligating event - no
possible obligation - no
Do nothing

Question 23

When should a contingent liability be disclosed? (decision tree)

Answer 23

Present obligation as a result of an obligating event - no
Possible obligation - Yes
Remote - no
Disclose contingent liability

OR

Present obligation as a result of an obligating event Yes
Probable outflow - No
Remote - No
Disclose

OR (RARE)
Present obligation as a result of an obligating event - yes
probable outflow? yes
Probable estimate NO
Disclose

Question 24

FUTURE OPERATING LOSSES

Answer 24

Do not meet the definition of a liability as there is no present obligation and therefore no liability.

Question 25

ONEROUS CONTRACTS

Answer 25

One in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. Onerous contracts will normally be for the long term supply of goods of services/
IAS 37 requires that the present obligation under the onerous contract be measured and recognised as a provision
The contract has to be loss making. A contract which is merely uneconomic in terms of earning a below average expected rate of return is not classified as onerous.

Question 26

How is a contingent liability disclosed?

Answer 26

A brief description of its nature
Estimate of financial effect
Indication of uncertainties relating to timing or outflow.
Possibility of reimbursment

Question 27

How is a contingent liability disclosed?

Answer 27

Only if inflow of economic benefits is probable
Disclosure required
brief description of nature
Estimate of financial effects (where practicable).