Provisions, Contingent Liabilities and Contingent Assets

IAS 37

Provisions, Contingent Liabilities and Contingent Assets

IAS 37

Definitions
  • A legal obligation is an obligation that derives from: a contract, legislation, or other operation of law
  • A constructive obligation is an obligation that derives from an entity’s 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
Provisions
  • Provision = a liability of uncertain timing or amount
  • A provision shall be recognized when:
    1. an entity has a present obligation (legal or constructive) as a result of a past event; and
    2. it is probable that an outflow of resources will be required to settle the obligation; and
    3. a reliable estimate can be made of the amount of the obligation
  • probable = more likely than not (greater than 50% chance of happening)
  • if any one of these criteria are not met, it is considered a “contingent liability” and is disclosed
Present obligation
  • If it is not clear whether there is a present obligation:
    • a past event is deemed to give rise to a present obligation if it is more likely than not that a present obligation exists at the end of the reporting period
Past event
  • 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:
    1. where the settlement of the obligation can be enforced by law; or
    2. in the case of a constructive obligation, where the event creates valid expectations in other parties that the entity will discharge the obligation.
Measurement
  • A provision is recognized at the best estimate of the amount required to settle the present obligation at the end of the reporting period
  • Where the provision being measured involves a large population of outcomes, the obligation is estimated by using expected value.
  • Where there is a continuous range of possible outcomes, and each point in that range is as likely as any other, the mid-point of the range is used
    • If one point is more likely, then that point becomes the best estimate
  • Provisions are measured before tax
Contingent liabilities
  • A contingent liability is:
    • 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
    • a present obligation that arises from past events but is not recognized because:
      1. it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or
      2. the amount of the obligation cannot be measured with sufficient reliability
  • 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 assets
  • contingent asset = 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
  • example is a claim that an entity is pursuing through legal processes, and the outcome is uncertain
  • contingent assets are not recognized
  • A contingent asset is disclosed, if the inflow of economic benefits is probable
  • Contingent assets are continually assessed, and if the inflow of economic benefits become virtually certain, it is no longer considered a “contingent asset” and it is recognized as an asset
Reimbursements
  • Where the amount required to settle a provision is expected to be reimbursed by another party, the reimbursement is recognized when it is virtually certain that reimbursement will be received
  • The reimbursement shall be treated as a separate asset on the balance sheet (cannot offset)
  • The amount recognized for the reimbursement shall not exceed the amount of the provision
  • the expense relating to a provision may be presented net of the amount recognized for a reimbursement
Changes in provisions
  • provisions need to be reviewed at the end of every reporting period, if needed, it should be adjusted to reflect the current best estimate (done prospectively)
  • if no longer a provision (per the definition), it should be reversed
Application of the recognition and measurement rules
Onerous contracts
  • onerous contract = is a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it
  • i.e. you are going to lose money on this contract no matter what
  • the present obligation under the contract shall be recognized and measured as a provision (the debit entry is a loss)
  • provision set up = net cost = unavoidable cost – economic benefits
  • the unavoidable cost of meeting the obligation is the lesser of:
    1. cost of fulfilling the contract
    2. penalties from failing to fulfill the contract
Restructuring
  • A restructuring is a program that is planned and controlled by management, and materially changes either:
    1. the scope of a business undertaken by an entity; or
    2. the manner in which that business is conducted.
  • The following are examples of restructuring:
    1. sale or termination of a line of business;
    2. closing or relocating business locations
    3. changing management structure, for example, eliminating a layer of management
  • recognize a provision when the following two criteria are met:
    1. the entity has a detailed formal plan for the restructuring identifying at least:
      • the business or part of a business concerned;
      • the principal locations affected;
      • the location, function, and approximate number of employees who will be compensated for terminating their services;
      • the expenditures that will be undertaken; and
      • when the plan will be implemented; and
    2. has raised a valid expectation in those affected that it will carry out the restructuring by:
      1. starting to implement that plan; or
      2. announcing its main features to those affected by it.
  • When both criteria are met, it is deemed to be a constructive obligation, and a provision is set up
  • A restructuring provision shall include only the direct expenditures arising from the restructuring, which are those that are both:
    1. necessarily entailed by the restructuring; and
    2. not associated with the ongoing activities of the entity.
Decommissioning or Restoration Liability (Asset Retirement Obligations)
  • Similar to asset retirement obligation covered under ASPE 3110
  • Decommissioning/restoration is recognized as a
    • Liability (per IAS 37 – provisions); and
    • As part of Property, Plant and Equipment (IAS 16)
  • Reduction in liability due to passage of time (i.e. discounting) is recognized as “interest expense”
  • A liability can occur from legal obligations or constructive obligations
Comparison to ASPE
  • contingencies is covered under ASPE section 3290 – Contingencies
  • under ASPE, the term provision is not used; instead the term contingent liability is used, even where an amount is recognized as a liability
  • under ASPE, the concept of constructive obligation does not apply
  • under ASPE a contingent liability is recognized when probability of loss is likely (rather than probable); threshold for IFRS is lower
  • under ASPE, when there is a range and no best estimate, take minimum amount
  • under ASPE, no need to review contingent liability @ end of every period
  • under ASPE, contingent assets are disclosed when likely to be realized
  • under ASPE, no detailed guidance on Restructuring – since constructive obligation doesn’t apply, we would likely recognize it when there is a legal obligation
  • Under ASPE, onerous contracts and reimbursements are not covered

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