International Accounting Standard 37

PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS

Introduction

1.                  Before IAS 37 there was no accounting standard dealing with provisions. Companies wanting to show their results in the most favorable light make large provisions in years where a high level o underlying profit was generated. These provisions, often known as “big bath provisions” were then available to shield expenditure in future years when perhaps the underlying profits were not as good.

2.                  In other words, provisions were used for profit smoothing. Profit smoothing misleading.

Provision and contingent liability distinguished

In a genera sense, all provisions are contingent because they are uncertain in timing or amount. However, within this Standard the term “contingent” is used for liabilities and assets that are not recognized because their 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 enterprise. In addition, the term “contingent liability” is used for liabilities that do not meet the recognition criteria. This Standard distinguishes between;

Provisions – which are recognized as liabilities (assuming that a reliable estimate can be made) because they are present obligations and it is probable that an outflow of resources embodying economic benefits will be required to settle the obligations; and

Contingent liabilities – which are not recognized as liabilities because they are either:

Possible obligation, as it has yet to be confirmed whether the enterprise has a present obligation that could lead to an outflow of resources embodying economic benefits; or

Present obligation that do not meet the recognition criteria in this Standard (because either it is probable that on outflow of resources embodying economic benefits will be required to settle the obligation, or a sufficiently reliable estimate of the amount of the obligation cannot be made).

Provision

IAS 37 views a provision as a liability

Definition

A provision is a liability of uncertain timing or amount.

A liability is a present obligation of an enterprise arising from past events the settlement of which is expected to result in out-flows of economic benefit.

The IAS distinguishes provisions from other liabilities such as trade creditors and accruals. This is on the basis that for a provision there is uncertainty about the timing or amount of the future expenditure. Uncertainty is sometimes present in the case of certain accruals but it is generally much less than for provisions.

Recognition

IAS 37 states that a provision should be recognized as a liability in the financial statements when:

An enterprise has a present obligation (legal or constructive) as a result of a past event.

It is probable that a transfer of economic benefits will required to settle the obligation.

A reliable estimate can be made of the obligation.

If these conditions are not met then no provision should be recognized.

Meaning of obligation

A legal obligation is an obligation that drives from an enterprise’s action where:

• A contract (through its explicit or implicit terms);

• Legislation; or

• Other operation of law

Constructive obligation is an obligation that drives from an enterprise’s action where:

By an established pattern of past practice, published policies or a sufficiently specific  current statement the enterprise has indicated to other parties that it will accept certain responsibilities, and

As a result the enterprise has created a valid expectation on the part of those other parties that it will discharge those responsibilities.

Present obligation

In rare cases it is not clear whether there is a present obligation. In these cases as past event is deemed to gibe rise to a present obligation if, taking account of all available evidence it is more likely than not that a present obligation exist at the balance sheet date.

In almost all cases it will be clear whether a past event has given rise to a present obligation. In rare cases, for example in lawsuit, it may be disputed whether certain events have occurred or whether a present obligation exists at the balance sheet date by taking account of all available evidence, including, for example, the opinion of experts. The evidence considered includes any additional evidence provided by events after the balance sheet date.

On the basis of such evidence:

Where it is more likely than not that a present obligation exists at the balance sheet date, the enterprise recognizes a provision (if the recognition criteria are met); and

Where it is more likely that no present obligation exists at the balance sheet date, the enterprise discloses a contingent liability, unless the possibility of an outflow of resources embodying economic benefit is remote.

Past event

A past event that leads to a present obligation is called an obligating event. For an event to be an obligation event it is necessary that the enterprise has no realistic alternative to settling the obligation created by the event. This is the case only:

Where the settlement of the obligation can be enforced by law; or

In the case of a constructive obligation, where the event (which may be an action of the enterprise) created valid expectations in other parties that the enterprise will discharge the obligation.

Example of provisions is penalties, clean up cost for unlawful environment damage etc.

Provision may also be made due to commercial pressure or legal requirements for example Fitting Smoke Filter in factory. However, if enterprise avoids these expenditures by its future actions no provision is made.

It is not necessary to identify the party to whom obligation is owned, it may be public.

An event that does not give rise to an obligation immediately may do so at later date, because of changes in the law or because of an act (for example, a sufficiently specific public statement) by the enterprise gives rise to a constructive obligation. For example when environmental damage is caused there may be no obligation to remedy the consequences. However, the causing of the damage will become an obligating event whe a new law requires the existing damage to be rectified or when the enterprise publicly accepts responsibility for rectification in a way that creates a constructive obligation.

Obligation arises when relevant law is virtually certain to be enacted as drafted.

Probable transfer of economic benefits

For the purpose of the IAS a transfer of economic benefit is regarded as ‘probable’ if the event is more likely than not to occur. This appears to indicate a probability of more than 50%. However, the standard makes it clear that where there are number of similar obligations the probability should be based upon considering the population as a whole, rather than one single item.

Example: Transfer of economic benefits

If a company has entered into a warranty obligation then the probability of transfer of economic benefits may well be extremely small in respect of one specific item. However, when considering the population as whole the probability of some transfer of economic benefit is quite likely to be much higher. If there is a greater than 50% probability of some transfer of economic benefit then a provision should be made for the expected amount.

Measurement of provisions

The amount recognized as a provision should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date;

The estimate will be determined by judgment of the enterprise’s management supplemented by the experience of similar transaction.

Allowance is made for uncertainty where the provision being measured involves a large population of items; the obligation is estimated by weighting all possible outcomes by their discounted probabilities, i.e. expected value.

When the effect of the time value of money is material, the amount of provision should be the present value of the expenditure required to settle the obligation. An appropriate discount rate should be used.

The discount rate should be a pre-tax rate that reflects current market assessments of the time value of money. The discount rate (s) should not reflect risks for which future cash flow estimated have been adjusted.

Future events

Future events which are reasonably expected to occur (e.g. new legislation, changes in technology) may affect the amount required to settle the enterprise’s obligation and should be taken into account when calculating provision.

Expected future events may be particularly important in measuring provisions. For example, an enterprise may believe that the cost of cleaning up a site at the end of its life will be reduced by future changes in technology. The amount recognized reflects a reasonable expectation of technically qualified, objective observers, taking account of all available evidence as to the technology that will be available at the time of the clean up.

Expected disposal of assets

Gains from the expected disposal of assets should not be taken into account in measuring a provision.

Reimbursements

Some or all of the expenditure needed to settle a provision might be expected to be recovered from a third party. If so, the reimbursement should be recognized only when it is virtually certain that reimbursement will be received if the enterprise settles the obligation.

The reimbursement should be treated as a separate asset and the amount recognized should not be greater than the provision itself.

The provision expense and the amount recognized for reimbursement may be netted off in the profit and loss account.

Changes in provisions

Provisions should be renewed at each balance sheet date and adjusted to reflect the current best estimate. If it is no longer probable that transfer of economic benefits will be required to settle the obligation, the provision should be reversed.

A provision should be used only for expenditures for which the provision was originally recognized. Setting expenditures against a provision that was originally recognized the purpose would conceal the impact of two different events.

Future operating losses

Provisions should not be recognized for future operating losses. They do not meet the definition of a liability and the general recognition criteria set out in the standard.

Onerous contacts

An onerous contract is a contract entered into with another party under which the unavoidable costs of fulfilling the term of the contract exceed any revenues expected to be received from the goods or services supplied or purchased directly or indirectly under the contract and where the enterprise would have to compensate the other party if it did not fulfill the terms of the contract.

If an enterprise has a contract that is onerous, the present obligation under contract should be recognized and measured as a provision. An example might be vacant leasehold property.

Examples of possible provisions

Sit is easier to see what IAS 37 is driving at if you look at examples of those items, which are possible provisions under this standard.

Warranties

These are argued to be genuine provisions as on past experience it is probable, i.e. more likely than not, that some claims will emerge. The provision must be estimated, however, on the basis of the class as a whole and not on individual claims. There is a clear legal obligation in this case.

Major repairs

In the past it has been quite popular for companies to provide for expenditure on a major overhaul to be accrued gradually over the intervening years between overhauls. Under IAS 37 would argue that this is a mere intention to carry out repairs, not an obligation. The enterprise can always sell the asset in the meantime. The only solution is to treat major assets such as aircraft, ships, furnaces etc as a series of smaller assets where each part is depreciated over shorter lives. Thus any major overhaul may be argued to be replacement and therefore capital rather than revenue expenditure.

Self-insurance

A number of companies have created a provision for self-insurance based on the expected costs of making good fire damage etc instead of paying premiums to an insurance company. Under IAS 37 this provision would no longer be justifiable as the enterprise has no obligation until a fire or accident occurs. No obligation exists until that time.

Environmental contamination

If the company has an environment policy such that other parties should expect the company to clean up any contamination or if the company has broken current environmental legislation then provision for environmental damage must be made.

Decommissioning or abandonment cost

When an oil company initially purchases an oilfield it is put under a legal obligation to decommission the site at the end of its life. Prior to IAS 37 most oil companies make the provision gradually over the life of the field so that no one-year would be unduly burdened with the cost. IAS 37, however, insists that a legal obligation exists on the initial expenditure on the field and therefore a liability exists immediately. This would appear to result in a large charge to profit and loss in the first year of operation of the field. However, the IAS takes the view that the cost of purchasing the field in the first place is not only the cost of the field itself but also the costs of putting it right again. Thus all the costs of abandonment may be capitalized.

Restructuring

This is considered in detail below;

Provisions for restructuring

Definition

IAS 37 defines a restructuring as:

A program that is planned and is controlled by management and materially changes either:

• The scope of a business undertaken by an enterprise: or

• The manner in which that business is conducted.

The IAS gives the following examples of events that may fall under the definition of restructuring.

• The sale or termination of a line business.

• The closure of business locations in a country or region or the relocation of business activities from one country region to another.

• Changes in management structure, for example the elimination of layer of management.

• Fundamental reorganizations that have a material effect on the nature and focus of the enterprise’s operations.

The question is whether or not an enterprise has an obligation-legal or constructive-at the balance sheet date.

• And enterprise must have a detailed formal plan for the restructuring identifying at least.

1. The business or part of a business concerned;

2. The principal locations affected;

3. The location, function and approximate number of employees who will be compensated for terminating their services;

4. The expenditures that will be undertaken; and

5. When the plan will be implemented; and

• It must raise a valid expectation in those affected that it will carry out the restructuring by starting to implement that plan or announcing its main features to those affected by it.

Important 

• A mere management decision is not normally sufficient. Management decisions may sometimes trigger off recognition but only if earlier events such as negotiations with employees’ representatives and other interested parties have been concluded subject only to management approval.

• Where the restructuring involves the sale of an operation then IAS 37 stated that no obligation arise until the enterprise has entered into a binding sale agreement. This is because until this has occurred the enterprise will be able to change its mind and withdraw from the sale even if its intentions have been announced publicly.

Costs to be included within a restructuring provision

1. The IAS states that restructuring provision should included only the direct expenditures arising from the restructuring, which are those that are both:

• Necessarily entailed by the restructuring; and

• Not associated with the ongoing activities of the enterprise.

2. The following costs should specifically not be included within a restructuring provision:

·        Retraining or relocating continuing staff.

·        Marketing

·        Investment in new systems and distribution networks.

Disclosure

Disclosure for provisions falls into two part.

·        Disclosure of details of the change in carrying value of a provision from the beginning to the end of the year.

·        Disclosure of the background to the making of the provision and the uncertainties affecting its outcome.

Contingent liabilities

Definition

IAS 37 defines a contingent liability as:

• A possible obligation that arise 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 enterprise’s control; or

• A present obligation that arises from past events but is not recognized because;

ü      It is not probable that transfer of economic out flow will be required to settle the obligation; or

ü      The amount of the obligation cannot be measured with sufficient reliability.

• As a rule of thumb, probable means more than 50% likely. If an obligation is probable, it is not contingent liability instead a provision is needed.

Treatment of contingent liabilities

Contingent liabilities should not be recognized in financial statements but they should be disclosed. The required disclosures are:

• A brief description of the nature of the contingent liability.

• An estimate of its financial effect.

• An indication of the uncertainties that exist.

• The possibility of any reimbursement.

Contingent assets

Definition

IAS 37 defines a contingent asset as:

• A possible asset that arise from past events and whose existence will be confirmed by the occurrence of one or more uncertain future events not wholly within enterprise’s control.

• A contingent asset must not be recognized. Only when the realization of the related economic benefit is virtually certain. At that point, the asset is no longer a contingent asset and recognition is appropriate.

Disclosure: contingent liabilities

A brief description must be provided of all material contingent liabilities unless they are likely to be remote. In addition, provided;

• An estimate of their financial effect

• Details of any uncertainties

Disclosure: contingent assets

Contingent assets must only be disclosed in the notes if they are probable. In that case brief description of the contingent asset should be provided along with an estimate of its likely financial effect.

‘Let out’

IAS 37 permits reporting entities to avoid disclosure requirements relating to provisions, contingent liabilities and contingent assets if they would be expected to seriously prejudice the position of the enterprise in dispute with other parties. However, this should only by employed in extremely rare cases. Details of the general nature of the provision/contingencies must still be provided, together with an explanation of why it has not been disclosed.

Example 1

An entity operates profitably from a factory that it has leased under an operating lease. During December 2005, the entity relocates its operations to a new factory. The lease on the old factory continues for the next four years, it cannot be cancelled and the factory cannot be re-let to another user. The entity’s year-end is 31 December 2005.

1. Is there any present obligation?

• There is legal obligation

• The company has entered into a lease agreement

• The lease is an operating lease

• The obligation is to pay the lease rentals over the lease period

• This is not providing for future losses

• It is providing for losses on what may be described as an onerous contract

2. What provision, if any, should be recognized?

·        Provision should be made for the lease rentals payable

·        Provision should be made for the present value of the whole of the rentals payable

·        The debit of the provision may be dealt with as deferred expenditure in the balance sheet

·        The deferred expenditure should be amortised over the period of the operating lease

·        An annual finance cost should be recognized in respect of the unwinding of the discount

·        This would be debited to the income statement and credited to the provision each year

Example 2

On 12 December 2005, the board of an entity decided to close down a division.

                                 i.            Assuming that not steps were taken to implement the decision and the decision was not communicated to any of those affected by the balance sheet date of 31 December 2005, explain the appropriate accounting treatment

• A board decision to discontinue does not constitute an obligation

• No steps have been taken to implement the decision

• There is no detailed, formal plan

• There has been no communication of the decision to affected employees, suppliers and customers

• No provision should be made at the balance sheet date

• The recognition criteria of IAS 37 have not been satisfied

                               ii.            Explain the appropriate accounting treatment for the closure if a detailed plan had been agreed by the board on 20 December 2005, and letters sent to notify customers. The staff of the division has received redundancy notices.

·        There is now a constructive obligation to proceed with the closure

·        There is detailed plan

·        There is board approval of the plan

·        The plan has been announced to affected parties

·        Provision should be made for the costs foreseen if a reliable estimate can be made

·        Disclosure is necessary under IFRS 5 for the revenue and profit or loss of the discontinued operation for the current year

·        The provision for closure costs would consist of an estimate of the direct costs of closure – no provision is made for the estimated profit or loss for the division from the year-end to the date of anticipated closure

·        The provision should be separately disclosed under profit from discontinuing operations

Example 3

An entity operates an offshore oilfield where its licensing agreement requires it to remove the oil rig at the end of the production period and restore the seabed. 90% of eventual costs of this work relate to the removal of the oilrig and restoration of damage caused by building it, and 10% through the extraction of oil.

At the balance sheet date, the rig has bee constructed but no oil has been extracted.

When the obligations do arises in respect of the two portions of the cost?

·        There is a license

·        The is a obligation to restore the seabed

·        The obligation for 90% of the costs exists at the balance sheet date

·        This because the rig has been constructed at the balance sheet date

·        There is no obligation in respect of 10% of the costs at the balance sheet date

·        This because no oil has been extracted as at the balance sheet date

 How should these be dealt with in the financial statements?

• A provision should be established in respect of 90% of the costs at the balance sheet date
• The present value of the amount payable should be provided
• Provision should be made for current prices discounted at current market rates
• The debit for the provision should be capitalized as a part of the cost of the rig
• The cost of the rig would be depreciated over use and the provision for this part of decommissioning costs would therefore be recognized in the income statement over the whole period of the extraction.

• A provision would not be established for 10% of the costs at the balance sheet date.
• And annual provision should be established in relation to this proportion of the costs in future years.

• Debit income statement and credit provision with 10% of the costs in the proportion: oil extracted in period/estimate of total oil extraction.

Example 4

During the year ended 30 November 2005, Company H purchased an oil company, Company P. As part of the sale agreement, oil has to be supplied to Company P’s former holding company at an uneconomic rate for a period of 5 years. As a result, a provision of $135 million has been set up for future operating losses. The provision relates solely to the uneconomic supply of oil.

Additionally, Company P is exposed to environmental liabilities arising out of its past obligation to carry out the restoration work.

Liabilities for environmental costs are provided for when the group determines a formal plan of action on the closure of an inactive site. It has been decided to provide for #120 million in respect of the environmental liability on the acquisition of Company P. Company H has a reputation for ensuring the preservation of the environment in its business activities.

Discuss whether the provision has been accounted for correctly under IAS 37.

Example 5

Genpower Ltd is a company involved in the electricity generation industry. It operates a number of unclear power stations for which environmental clean-up costs can be large item of expenditure. The company operates in some countries where environmental costs have to be incurred as they are written into the licensing agreement and in other countries where they are not a legal requirement. Details of a recent contract Genpower Ltd entered into are.

A new unclear power station has been built at a cost of $200 million and was brought into commission on 1 October 2004. The license to produce electricity at this station is for 10 years. This is also the estimated economic life of the power station. The term of the license require the power station to be demolished at the end of the license. It also requires that the spent nuclear fuel rods (a waste product) have to be buried deep into the ground and the area “sealed” such that no contamination can be detected. Genpower Ltd will also have to pay for the cost of cleaning up any contamination leaks that may occur from the water cooling system that fuel rods when they are in use. Genpower Ltd estimates that the cost of the demolition of the power station and the fuel rod “sealing” operation will be $180 million in 10 years’ time. The present value of these costs at an appropriate discount rate is $120 million. From past experience there is a 30 % chance of a contaminating water leak occurring in any 12-months’ period. The cost of cleaning up a leak varies between $20 million and $40 million depending on the severity of the contamination.

Extracts from the company’s draft financial statements to 30 September 2005 relating to the contract after applying the company’s normal accounting policy for this type of power station are:

Income statement charge	$m
- Non-current asset depreciation (power station) 10% x $200m	20
- Provision for demolition and “sealing costs” 10% x $180m	18
- Provision for cleaning up contamination owing to water leak	9
(30% x an average of $30m)
	47

Balance sheet tangible non-current assets
- Power station at cost	200
- Depreciation	20
	180
Balance sheet non-current liabilities
- Provision for environmental costs ($18m + $ 9m)	27

Note: no contamination from water leakage occurred in the year to 30 September 2005. Genpower ltd is concerned that its current policy does not comply with IAS 37 and has asked your advice.

i.                     Comment on the acceptability of Genpower Ltd’s current accounting policy and redraft the extracts from the financial statements in the line with the regulations of IAS 37. Ignore the unwinding of the discount.

ii.                   Assuming that Genpower Ltd was operating the nuclear power station in a country that does not legislate in respect of the above types of environmental cost; explain the effect that this would have on your answer to 1 above.