Provisions, Contingent

Liabilities and Contingent Assets

Beverly NielsenLaura Bopp

Magan Berman

Definition of a Provision

❑ The Conceptual Framework defines a liability as: ❑ a present obligation❑ arising from a past event❑ that is expected to result in an outflow of

economic resources❑ A provision is a subset of liabilities, defined in

IAS 37 as❑ a liability of uncertain timing or amount

❑ A present obligation exists only where the entity has no reasonable alternative but to settle the obligation

Introduction to IAS 37

❑ IAS 37 addresses the recognition, measurement and presentation of: ❑ Provisions (excluding those covered by another IAS)

❑ Contingent assets and liabilities

❑ Restructuring provisions

❑ Onerous contracts

Executive Summary

Contingency differences

IFRS US GAAP

StandardIAS 37, Provisions, Contingent Liabilities and Contingent Assets ASC 450, Contingencies

Definition of probable More likely than not Likely

Amount of range of outcomes Midpoint in range Minimum in range

DiscountingRequires that the liability be discounted

Generally does not allow discounting

Present Obligation

❑ A present obligation may be:❑ Legal – arising from a contract❑ Equitable – arising from normal business practice or custom❑ Constructive – arising from established pattern of past

practice

❑ A present obligation exists only where the entity has no realistic alternative but to make the sacrifice of economic benefits to settle the obligation

Distinguishing Provisions From Other

Liabilities❑ Key distinguishing factor is the uncertainty

relating to either the timing or the amount

❑ Typical provisions :❑ Warranty

❑ Restructuring

❑ Onerous contracts

❑ Employee benefits are not provisions under IAS 37

Contingent Liabilities

Contingent liabilities are either:

(a) A possible obligation whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly in control of the entityeg. a guarantee on a loan for another entity

OR…

Contingent Liabilities

(b) A present obligation that fails the recognition criteria because:

❑ it is not probable an outflow of resources will be required to settle the obligation or

❑ the amount cannot be measured reliably eg. a lawsuit where amount of damages is uncertain

❑ Contingent liabilities are not recognized in the financial statements but must be disclosed in the notes to the financial statements

Outcome Probability Accounting Treatment

Virtually certain At least 90% Report as liability (provision)

Probable (more likely than not)

51-89% probable Report as liability (provision)

Possible but not probable 5-50% Disclosure required

Remote Less than 5% No disclosure required

Contingent Liabilities Guidelines

Illustration 13-16, Intermediate Accounting IFRS Edition, Wiley, 2nd edition

Disclosure

❑ IAS 37 paras 84- 92 outline the disclosure requirements❑ Disclosure for each class of provision required❑ Disclosure for each class of contingent liability required❑ Disclosure of nature of contingent assets❑ Exemptions permitted in rare cases (para 92)

❑ Many analysts consider the contingent liabilities note to be one of the most important

Decision Tree

Contingent Assets

❑ Possible asset arising from a past event whose existence will be confirmed by the occurrence/non-occurrence of one or more uncertain future events not within the control of the entity

❑ Contingent assets are not recognized in the statement of financial position but must be disclosed in the notes to the financial statements where an inflow of benefits is probable

Recognition Criteria For Provisions

❑ Three criteria:

❑Present obligation as a result of a past event

❑Probable outflow of resources to settle

❑Amount of obligation can be reliably estimated

Measurement of Provisions

❑ “Best estimate” of provision amount recognized ❑ Requires professional judgements ❑ Is calculated using ‘expected value’ estimation❑ Measured before tax

❑ Estimates should be discounted to present value where material

ContingenciesLoss Contingency – Definition of Probable and Range

IFRS

► Probable is defined as “more likely than not” (more than a 50% chance of occurring).

► The midpoint of the range is used to measure the provision.

US GAAP

► Defines probable as “likely” (this has been generally interpreted as greater than a 70% chance of occurring)

► Where there is a continuous range of possible outcomes and each point in the range is as likely as any other to occur, under ASC 450-20-30-1, the minimum amount in the range is used to measure the provision.

Example 1: An entity sells webcams with a warranty under which customers are covered for the cost of repairs of any manufacturing defects that become apparent within the first six months after purchase. The company has only recently started operations and thus cannot estimate what percentage of webcams will likely be returned. They do know that if defects were detected in all products sold, repair costs would range from $2 million for minor repairs to $4 million for major repairs.

Range of Possible Outcomes Example

► Assuming all other criteria are met, how much should the entity book related to warranty repairs using US GAAP and IFRS?

► Show any required journal entries.

Example 1 solution:

US GAAP

The minimum point of the range, $2.0 million, should be recorded.

Warranty expense $2,000,000Warranty liability $2,000,000

IFRS

The midpoint of the range, $3.0 million, should be recorded.

Warranty expense $3,000,000Warranty liability $3,000,000

Since the entity only had a range to work with, the treatment using the two sets of standards is different. If no particular outcome within the range is better than another, then for US GAAP the entity would book the minimum of the range, whereas for IFRS the entity would book the midpoint range.

Range of Possible Outcomes Example

Example 2: Use the same facts in example 1, except now assume the entity is able to perform an analysis on the historical data of returns and estimates (based on historical data), finding that 75% of the goods sold will have no defects, 20% of the goods sold will have minor defects and 5% of the goods sold will have major defects.

Range of Possible Outcomes Example

► Assuming all other criteria are met, how much should the entity book related to warranty repairs using US GAAP and IFRS?

► Show any required journal entries.

Example 2 solution:

For both US GAAP and IFRS, $600,000 should be recorded. The most likely outcome is $600,000 explained as follows: (20% of $2 million for minor repairs = $400,000) + (5% of $4 million for major repairs = $200,000) + (75% without defects and, therefore, no impact on the estimate).

Warranty expense $600,000Warranty liability $600,000

Probable Liability Example

Measurement of Provisions

❑ Should account for expected cash outflows only, disregarding any expected cash inflows

❑ Reimbursements must be virtually certain (not just probable) to be recognized

❑ Must review provisions at each end of reporting period

Definitions, Recognition & Measurement Rules

Future operating losses:❑ Excluded from the calculation of provisions

Onerous contracts:❑ Those that have more unavoidable cost than they

expect the economic benefits to be❑ The present obligation under an onerous contract

must be recognized as a provision

Definitions, Recognition & Measurement Rules

Restructuring provisions:

❑ The most controversial aspect of IAS 37

❑ Restructuring provisions can be recognized as part of an acquisition of another business (IFRS 3)

❑ IAS 37 addresses non business combination restructuring

Restructuring Provisions

May occur due to:

❑ Sale or termination of a line of business

❑ The closure of business locations in a country region or relocation of business activities

❑ Changes in the management structure

❑ Fundamental reorganizations

Restructuring Provisions

❑ Essential conditions to recognize a restructuring provision:

❑ Must have a present obligation to restructure

❑ Costs must be directly and necessarily caused by the restructuring

❑ If the restructuring involves the sale of an operation, a binding sale agreement is needed

Restructuring Provisions – Present Obligation

❑ Present obligation is considered to arise when the entity has a detailed plan identifying at least:

❑ The business (or part thereof) concerned❑ The locations affected❑ The employees affected❑ The expenditures that will be undertaken❑ The timing of implementation

Restructuring Provisions – Present Obligation

❑ Must have raised a valid expectation by those affected that it will carry out the plan by commencing restructuring or making an announcement to those affected

❑ In the case of restructuring provisions arising as part of an acquisition of another business, the provisions must be recognized in the books of the acquiree

Restructuring Provisions – Qualifying Costs

❑ Costs must be directly and necessarily caused by the restructuring and should not be associated with the ongoing operations

❑ Examples of qualifying costs include:❑ The costs of terminating leases and other contracts❑ Costs associated with employees dismantling plant❑ Employee redundancy costs

❑ Costs specifically excluded include:❑ Employee retraining and relocation costs❑ Marketing costs

The Future of IAS 37

2005: IAS 37 had a lot of proposed revisions❑New definitions of contingencies❑New recognition and measurement criteria

However, the revisions were not made but they could in the future

Questions?