In this session we shall look at the purpose of IAS 37 and how provisions, contingent liabilities and contingent assets are defined and treated in the financial statements
IAS 37 Provisions, Contingent Liabilities and Contingent Assets
IAS 37 looks at how a company should deal with uncertainty; how we determine whether or not an asset or liability exists where there is uncertainty and how we should deal with uncertainties over the value or timing of assets or liabilities.
Provisions
IAS 37 states that “a provision is a liability of uncertain timing or amount”. So, we know that a liability exists but may be unsure as to the amount that will be paid and/or when the payment will be made.
It is the level of uncertainty that makes a provision different from other types of liability. For example, if a company has taken out a bank loan there is little uncertainty as to the amounts to be repaid and the dates those payments should be made. Similarly, a company will know how much is payable to its suppliers and when those amounts are due. The position can be slightly different when dealing with some types of accrued expenses as these may have been estimated but the uncertainty is of a lower order than that of a provision.
Conditions for recognising a provision
Present obligations can arise as a result of:
- A legal or contractual obligation
- For example, banks in recent years have been legally obliged to compensate customers who had been sold PPI inappropriately
- A constructive obligation which arises due to the past practices of a company
- For example, many companies have a policy of refunding customers for returned products even where there is no legal requirement to do so. Unless the company announces a change in the policy, we can assume that it will be bound to continue with the policy
Examples of events that may require a provision
- Warranties, e.g. a warranty offered by a company to repair products if they fail within a particular period
- Site contamination, e.g. a company has agreed to decontaminate a piece of land once production on the site has ended
- Customer refunds
- Restructuring the business. Note that provisions for restructuring costs can only be made where there are detailed plans in place which the company has begun to implemented
Question
Which of the following describes a situation that requires a provision?
a)At its financial year-end, a company includes an estimate for the bank charges it had incurred but had yet to be billed for
b) At its year-end an online clothing retailer includes an estimate for the amount of goods sold and dispatched in its final month that it believes will be returned to it after the year-end
c) Before its year-end, a company is ordered by the Courts to pay damages to a customer. The amount is paid after the year-end.
d) A car manufacturer has included an estimate for the costs to be incurred in recalling and repairing a range of vehicles containing a known fault
e) A chemicals company causes land contamination in a country where there is no environmental legislation. However, the company has a well known environmental policy in which it states it will clean up any contamination caused by the company.
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(b), (d) and (e) describe provisions
(a) describes an accrued expense, (c) is not a provision as the liability is known – the Court case has been completed by the year-end
(e) provides an example of a provision arising from a constructive obligation
Measuring a provision
The provision should be included in the financial statements at the company’s best estimate of its value. If payment is expected in several years’ time, its value should be discounted to its present value.
Illustration 1
Ajax Ltd has purchased a ship that is used to transport chemicals. It is liable to pay for the ship to be decontaminated and scrapped at the end of its useful life (estimated to be 20 years in the future).
Ajax Ltd knows that a present obligation exists but there is considerable uncertainty over the value of an obligation that is so far into the future. Its best estimate of the present value of its obligations is £3m.
In order to record this provision, Ajax Ltd will add £3m to the cost of the ship and the company should take this amount into account when calculating ship’s depreciation. Ajax Ltd will also include £3m as a provision in its non-current liabilities.
Illustration 2
Castor Ltd is being sued by several customers for supplying defective goods before its year-end. The company has admitted liability and is currently negotiating the amount of damages to be paid to the customers. Its best estimate of the damages and associated legal costs to be paid is £250,000
When preparing its financial statements, Castor Ltd will include £250,000 as an expense in its Statement of Profit or Loss and as a provision in its Statement of Financial Position.
Question
A company has purchased some land for £9,680,000 that it intend to quarry. The land will be used for 15 years at the end of which, the company has agreed to improve the site by creating a lake and landscaping the remaining land. The cost of completing these improvements is forecasted to be £1,000,000 and this amount has a present value of £481,000.
a) What is the value of the provision to be recorded?
b) What is the cost of the land to be recorded in the Statement of Financial Position?
a) A provision should be made for the present value of the estimated obligation; i.e. £481,000
b) The cost of the land is the purchase price plus the provision; i.e. £10,161,000
Contingent Liabilities
Unlike a provision, a contingent liability is a possible obligation that arises from past events. Its existence will only be confirmed in the future by events that are not wholly in the company’s control. For example:
- A company is being sued by a supplier for £1m. The company believes that it is more likely than not that it will win the Court Case but admits that there remains the possibility that it will lose and have to pay damages to the supplier
Alternatively, a contingent liability may occur when a present obligation exists but a payment is not probable, or where the amount of the obligation cannot be measured with sufficient reliability.
Treatment of contingent liabilities
The contingent liability should not be recognised in the financial statements. So it will not appear as an expense in the Statement of Profit or Loss or as a liability in the Statement of Financial Position.
Unless the possibility of payment is remote (i.e. very low) we should include a note to the financial statements about the contingent liability. The note should disclose:
- The nature of the contingency
- Uncertainties affecting the ultimate outcome
- An estimate of the potential financial impact
Illustration
Hippolytus Ltd is being sued for £5m by Phaedra plc, who claims that it has used several of its patents without its consent.
Hippolytus Ltd has taken legal advice on the matter and believes that it is unlikely that it will have to pay anything and even if the Courts found in favour of Phaedra plc’s claim, the payment would be around £1m, significantly lower than the amount claimed.
As Hippolytus Ltd believes the claim is possible but not probable, it will not include any amount in respect of this claim in its financial statements but it will include the following information in the Notes to the Financial Statements. The note will detail that:
- It is being sued for the use of another company’s patents but that it believes it will win the case
- The matter may be decided in the Courts
- In the unlikely event of the company losing the case, an estimated payment of £1m would result
Decision tree
Below is a diagram based on a decision tree taken from the IFRS Standards Blue Book Part B. This summarizes the process by which provisions and contingent liabilities are identified and treated.
Question
Let’s say that the Government has proposed that it will create a law requiring Financial Advisers to compensate their clients for any losses where they have advised those client to invest money in a certain investment scheme. A firm of financial advisers has estimated that if the proposed law is passed by Parliament it will have to pay compensation of around £2m. How should this be treated in the financial statements?
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The situation described is a contingent liability as there is a possible obligation if the law is passed through Parliament (something that that the company would have no control over). Given that it is the Government that is proposing this legislation it cannot be considered to be a remote possibility. The company should therefore include a note to the financial statements providing information about the nature of the contingency, the uncertainties that are involved and an estimate of the potential financial impact. The company should not however include the cost and potential liability in its Statement of Profit or Loss or the Statement of Financial Position.
Contingent assets
A contingent asset is a possible asset arising from past events. Its existence will only be confirmed by the occurrence of one or more uncertain events in the future which are not wholly within the company’s control.
Treatment of contingent assets
Contingent assets should not be recognised as an asset in the Statement of Financial Position. If it is probable (i.e. more likely than not) that an asset exists then a note will be included in the accounts that provide details of:
- The nature of the contingency
- Uncertainties affecting the ultimate outcome
- An estimate of the potential financial impact
[Note that an asset that is virtually certain of being received is not a contingent asset but is an actual asset and would be recognised as such]
Illustration
Iasus Ltd is suing Atalanta plc for £80,000 for the supply of defective goods. Iasus Ltd believes it has a strong case and is likely to win.
As it is not certain that an amount will be received from Atalanta plc, Iasus Ltd will not record the amount as an asset in its financial statements. It will however disclose the following information in a note to the financial statements:
- Details of the legal suit
- That there is some uncertainty as to the eventual outcome and that the matter may be decided in the Courts
- That the company expects to be awarded £80,000 when the matter is resolved
