IAS 37 – PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS (F3):
LEARNING OBJECTIVES
I.DEFINITIONS
II.PROVISION RECOGNITION
III.THRESHOLD of IAS 37
IV.EXAMPLE FOR IAS 37
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I. DEFINITIONS
A provision is a liability where the timing or the amount is uncertain.
A contingent liability is a liability that may result, but depends (or is contingent) on the outcome of uncertain events.
For example, the company may have been taken to court, but the outcome of the case is not yet known. If they lose the case then they may have to pay a fine. There is therefore a potential liability, but it is not certain. The question is as to whether or not we show the potential liability in the accounts.
A contingent asset is where there may be an asset resulting for the company, but, again, it is not certain.
II. PROVISION RECOGNITION
Provision:
Provision should be recognized when:
-An entity has a present obligation (legal or constructive) as result of past event.
-A reliable estimate can be made of the amount of the obligation, and
-It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation.
If any one of these conditions is not met, no provision may be recognized .
Contingent liability is:
-Possible obligation that arises from past events…
-A present obligation that arises from past events but is not recognized because :
- It is not probable that an outflow of resources…
- The amount of obligation cannot be measured with sufficient reliability.
III. THRESHOLD of IAS 37
Provision: If the payment is probable (i.e. more than 50% likely) then the liability should be recognised in the financial statements.
Contingent Liability: If the payment is possible (i.e. between 5% and 50% likely) then the liability is not recognised in the financial statements, but should be disclosed by way of a note.
No Provision nor contingent liability: If the payment is remote (i.e. less than 5% likely) then it is not recognised in the financial statements and nor is it disclosed by way of a note.
Asset: If virtually certain (i.e. more than 95% likely) then it is not a contingent asset and should be recognised.
Contingent Asset: If probable (i.e. more than 50% likely) then it should be disclosed by way of a note to the financial statements.
No Asset nor Continent Asset: If the likelihood is only either possible or remote (i.e. less than 50%) then no recognition and no disclosure by way of note.
IV. EXAMPLE FOR IAS 37
Example- During the year to 31 March 20×9, a customer started legal proceedings against a company, claiming that one of the food products that it manufactures has caused several members of this family to become seriously ill. The company’s lawyers have advised that this action will probably not succeed.
Should the company disclose this in its financial statement?
Solution: contingent liability
Example:
Produce has a policy of making refunds to dissatisfied customers if the return their goods within 90 days of purchase. She is preparing her accounts for the year ended 31 December 20×4. During the last three months of the year she made sales of $95,000. in theory it is possible that she might have to refund all these sales. However, she knows that in practice only about 3% of the goods sold actually turn out to be faulty. She recognizes a provision for $2,850 ( 95,000 x 3%)
Example:
A business is legally obliged to clear up a derelict and polluted site. The cost will depend on how polluted the site is. There is a 60% chance of it being polluted, which will cost $120,000 to clean-up. There is a 25% chance of there being an average amount of pollution, costing $100,000 to clear up, and a 15% chance that the pollution will be mild and will only cost $60,000 to clear up.
The provision = 120,000 x 60% + 100,000 x 25% + 60,000 x 15% =$106,000
Source: Kaplan and BPP