Financial Reporting
Provisions and Contingencies
Provisions, contingent liabilities and contingent assets can often cause confusion among accountants, particularly in deciphering when to recognise a provision or disclosing a contingency. This article looks at the provisions laid down in FRS 12 and IAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’ and FRS 21 / IAS 10 ‘Events After the Reporting Date’ and discusses when and when not to recognise a provision.
Definitions
A provision is a liability that is of uncertain timing or amount, to be settled by the transfer of economic benefits.
A contingent liability is:
(a) A possible obligation arising from past events whose existence will be confirmed only by the occurrence of one or more uncertain future events not wholly within the entity’s control, or.
(b) A present obligation that arises from past events but is not recognised because it is not probable that a transfer of economic benefits will be required to settle the obligation or because the amount of the obligation cannot be measured with sufficient reliability.
A contingent asset is a possible asset arising from past events whose existence will be confirmed only by the occurrence of one or more uncertain future events not wholly within the entity’s control.
Recognition of a Provision
FRS 12 and IAS 37 are identical in nature and contain 3 criteria which must be met before a provision can be recognised in the financial statements. These criteria are:
(a) The 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.
(c) A reliable estimate can be made of the amount of the obligation.
Figure 1
Company A has decided to close its international branches and consolidate its international operations into its domestic operations. It puts a full announcement to the international staff out on 20 November 2009. It has calculated the redundancy provisions and has included the redundancy provision in the financial statements for the year ended 31 December 2009.
Company A has an obligation as a result of a past event: the announcement on 20 November 2009 of the redundancies.
It is probable (i.e. more likely than not) that an outflow of economic benefits will be required to settle the obligation: the redundancy payments.
A reliable estimate can be made of the amount of the obligation: the redundancy calculations.
Company A has therefore met all three criteria laid down in FRS 12 / IAS 37 and therefore a provision can be made.
Contingent Liabilities
Contingent liabilities are not recognised in the financial statements. Instead contingent liabilities are disclosed within the notes to the financial statements. Under FRS 12 and IAS 37, 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 recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation, or.
(ii) the amount of the obligation cannot be measured with sufficient reliability.
Figure 2
Alicia Limited has made a provision for damages amounting to £10,000 in its financial statements for the year ended 31 December 2009 in respect of a legal claim brought against the company by one of its customers. The legal advisers have advised that at the balance sheet date they are uncertain as to the potential outcome of the case.
Alicia Limited should not recognise a provision for damages of £10,000 because it is not ‘probable’ that an outflow of resources will be required to settle the case. The legal advisers are not sure as to the outcome of the case. In this case, disclosure of a contingent liability in the notes to the financial statements should be made.
Contingent Assets
Contingent assets should only ever be recognised if it is virtually certain that an entity will realise the contingent asset.
Summary
Contingent Liabilities
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There is a present obligation that probably requires a transfer of economic benefits to settle. |
There is a possible obligation or a present obligation that may, but may not, require a transfer of economic benefits to settle. |
There is a possible obligation or a present obligation where the likelihood of a transfer of economic benefits is remote. |
|
A provision is required and disclosures are required for the provision. |
No provision is recognised but disclosure as a contingent liability is required. |
No provision is recognised and no disclosure is required. |
Contingent Assets
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Inflow of economic benefits is virtually certain. |
Inflow of economic benefits is probable but not virtually certain. |
Inflow is not probable. |
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The asset is not contingent, thus provision should be made. |
No asset is recognised but disclosures are made in the notes. |
No asset is recognised and no disclosure is made. |
Dividends and Bonus Provisions
Where dividends and bonus provisions are concerned, confusion often lies in when it is appropriate to recognise them. HMRC are also particularly keen on practitioners applying the accounting standards in this area correctly because where the standards have been correctly applied, tax relief is granted on the bonus plus the employers national insurance contributions.
FRS 21 ‘Events After the Balance Sheet Date’ was issued on 20 May 2004 and replaced SSAP 17 ‘Accounting for Post Balance Sheet Events’. FRS 21 removes the requirement to recognise dividends proposed after the balance sheet date. The international equivalent, IAS 10 ‘Events After the Reporting Date’ is identical in nature.
Figure 3
Lucas Limited is the parent of a group. Gabriella Limited is a wholly owned subsidiary of Lucas Limited and the board of Gabriella Ltd announced on 4 January 2010 that it will pay dividends in relation to the year ended 31 December 2009 on 11 January 2010.
In applying FRS 21 (IAS 10), Lucas Limited should not recognise a debtor in its financial statements for the year ended 31 December 2009 because the dividend has been declared subsequent to the year end. In addition, Gabriella Limited did not have an obligation (legal or constructive) to pay the dividend (FRS 12 / IAS 37).
It is often the case that the board of directors of a company will pay profit-related bonuses to its directors/staff. Clearly in many cases the profits of a company will not be ascertained until some time after the year end and in many cases, companies will have a prescribed formula for calculating the bonuses.
Figure 4
Over the years, Company B has paid profit-related bonuses to its directors based on a percentage of pre tax profits. The financial statements for the year ended 31 December 2009 have been completed on 28 February 2010 and the directors have made a provision for bonuses.
Company B has a constructive obligation to pay the bonuses in accordance with FRS 12 (IAS 37) because past practice has always been to pay profit-related bonuses and therefore the directors ‘expect’ to be paid a profit-related bonus. It is this ‘expectation’ and past practice which allows Company B to provide for the bonus.
Had Company B not paid profit-related bonuses at the year end in previous years, thus not giving rise to an expectation on the part of the directors, then they should not provide for the bonuses because they would not have a constructive obligation.
Steve Collings FMAAT ACCA DipIFRS is audit and technical manager at LWA Ltd and a partner in AccountancyStudents.co.uk. He is also the author of ‘The Core Aspects of IFRS and IAS’ and lectures on financial reporting and auditing issues.
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