Question

Explain why an accounting standard in relation to the recognition and measurement of provisions was necessary with reference to the guidance in IAS 37 “Provisions, Contingent Liabilities and Contingent Assets”. (Maximum word count 160 words)

Answer 1

The definition of a provision is key to the standard. A provision is a liability of uncertain timing or amount, meaning that there is some question over either how much will be paid or when this will be paid. In the past, these uncertainties may have been exploited by companies trying to ‘smooth profits’ in order to achieve the results they believe that their various stakeholder may want.

For example, let’s take a fictional company, Rey Co. At the start of the year, Rey Co sets a profit target of $10m for the year ended 31 December 20X8. The chief accountant of Rey Co has reviewed the profit to date and realises they are likely to achieve profits of $13m. The accountant knows that if Rey Co- reports a profit of $13m, directors will not get any more of a bonus than if they reported $10m. He also knows that the profit target will be set at $14m in the next year.

To avoid this, the accountant may be tempted to make some provisions for some potential future expenses of $3m, with the impact of making the profit seem lower in the current period. As the double entry for a provision is to debit an expense and credit the liability, this would potentially reduce the profit down to $10m. Then in the next year, the chief accountant could reverse this provision, by debiting the liability and crediting the profit or loss. This is effectively an attempt to move $3m profit from the current year into the next period.

Clearly this is not good for the users of the financial statements, as they would have been manipulated and given a false impression of the performance of the business. This is where IAS 37 is used to ensure that companies report only those provisions that meet certain criteria.

IAS 37 stipulates the criteria for provisions, contingent liabilities and contingent assets which must be met in order for a provision to be recognised, so that companies should be prevented from manipulating profits. According to IAS 37, 3 criteria are required to be met before a provision can be recognised. These are: -

· Present obligation from a past event

This rule has two parts, first the type of obligation, and second, the requirement for it to come from a past event (something must have already have happened to create the obligation).

o Type of obligation

The obligation could be a legal or contractual one, arising from a court case or some kind of contractual arrangement. Most candidates are able to spot this in exams, identifying the presence of a potential obligation of this type. The second type of obligation is one called a constructive obligation. This is where a company establishes an expectation through an established course of past practice.

o Past event

The obligation needs to have arisen from a past event, rather than simply something which may or may not arise in the future.

· Reliable estimate

In an exam, it is unlikely that there will not be a reliable estimate. Likewise it is unlikely that an entity will be able to avoid recording a liability when there is an obligation by claiming there is no way of producing an estimate of the amount. The main rule to follow is that if the item is a one-off item, the best estimate will be the most likely outcome. If the item is made up of a number of items, such as a warranty provision for repairing goods, the expected value should be calculated using the probability of all events happening.

· Probable outflow

The final criteria required is that there needs to be a probable outflow of economic resources. There is no specific list of what % likelihood is required for an outflow to be probable. A probable outflow simply means that it is more likely than not that the entity will have to pay money out.

If it appears that there is a possible outflow then no provision is recorded. In this situation, a contingent liability would be reported. A contingent liability is simply a disclosure note shown in the notes to the accounts. There is no double entry recorded in respect of this. Instead, a description of the event should be given to the users with an estimate of the potential financial effect. In addition to this, the expected timing of when the event should be resolved should also be included.

Similar to the concept of a contingent liability is the concept of a contingent asset. This relates to a potential inflow of economic resources which could come into the entity. Like a contingent liability, a contingent asset is simply disclosed rather than a double entry being recorded. Again, a description of the event should be recorded in addition to any potential amount related to this. The key difference is that a contingent asset is only recorded if there is a probable future inflow, rather than a possible one. The table below shows the treatment for an entity depending on the likelihood of an item happening.

· The time value of money

If the time value of money is material, generally if the potential outflow is payable in one year or more, the provision should be discounted to present value initially. Subsequently, the discount on this provision would be unwound over time, to record the provision at the actual amount payable. The unwinding of this discount would be recorded in the statement of profit or loss as a finance cost.

· Restructuring costs

Restructuring costs associated with reorganising divisions provide two issues. The first is to assess whether an obligation exists at the reporting date. The key here is whether the restructuring has been announced to the affected employees. If the employees have been informed, then an obligation exists and a provision must be made. If the employees have not been informed, then the company could change its mind. Therefore there is no present obligation to incur the costs associated with this.

The second issue consideration is which costs should be included within the provision. These costs should exclude any costs associated with any continuing activities. Therefore any provision should only include items such as redundancies and closure costs. Ongoing costs such as the costs of relocating staff should be excluded from the provision and should instead be expensed as they are incurred.

· Onerous contracts

Onerous contracts are those in which the costs of meeting the contract will exceed any benefits which will flow to the entity from the contract. As soon as an entity is aware that a contract is onerous, the full loss should be provided for as a liability in the statement of financial position.

· Dismantling costs associated with assets

So far, all of the items considered in this article have involved the provision being recorded as a liability with the debit being shown as an expense in the statement of profit or loss. The exception to this is if an entity creates an obligation for future costs due to the construction of a non-current asset. In this case, the provision should be included within the original cost of the asset, as this is directly attributable to the construction of that asset.

· Future operating losses

Future operating losses do not meet the criteria for a provision, as there is no obligation to make these losses. Therefore there cannot be included in the financial statements.