Accounting

Accounting for Provisions, Contingent Liabilities and Contingent Assets (IAS 37)

Applicable Standard

  • IAS 37: Provisions, Contingent Liabilities and Contingent Assets

Provisions

Definitions

  • Liability
    • Present obligation as a result of past events
    • Expected to result in an outflow of economic benefits
    • Reliable estimate can be made of the amount
  • Provision
    • Liability of uncertain timing or amount

Recognition Criteria for a Provision

  • Present obligation (legal or constructive) as a result of past events
    • Note that for an environmental provision can only be recognised if the environment damage has already happened.
  • Probable (> 50% probability)
  • Reliable estimate can be made of the amount

Accounting Treatment of Provisions

  • Increase in provisions is charged to Income Statement, and recognised in the Balance Sheet
  • Future movements in provision is recorded in Income Statement.
  • For provisions that are PV-ed, the provision increases each year as the discount is unwound. The discount that is unwound (i.e. the increase in liability) is recorded as a Finance Charge in the Income Statement. Example:
    • Expected outflow of $110 at end of year 1, and outflow of $121 at end of year 2.
    • At time 0
      • Initial value = PV at 10% discount rate = 110/1.1 + 121/(1.1^2) = 100 + 100 = 200.
      • Initial recognition, Dr Provision (Income Statement), Cr Provision (Balance Sheet) with 200.
    • 1 year later
      • Finance charge = Interest rate * Provision value = 10% * 200 = 20.
      • Dr Finance Charge (Income Statement), Cr Provision (Balance Sheet) with 20.
      • Outflow of 110, so Cr Provision (Income Statement), Dr Provision (Balance Sheet) with 110.
      • Closing Provision value = 200 + 20 – 110 = 110.
    • 2 years later
      • Finance charge = Interest rate * Provision value = 10% * 110 = 11.
      • Dr Finance Charge (Income Statement), Cr Provision (Balance Sheet) with 11.
      • Outflow of 121, so Cr Provision (Income Statement), Dr Provision (Balance Sheet) with 121.
      • Closing Provision value = 110 + 11 – 121 = 0.
  • Special case: Compulsory costs related to Non-Current Assets
    • E.g. clean up costs at the end of the asset’s life
    • Instead of debiting Income Statement, the Non-Current Assets (in Assets) is debited, i.e. the cost of the asset increases. Hence the clean-up cost is capitalized into the cost of the asset.
    • Accounting entries
      • Dr Non-Current Assets (Balance Sheet)
      • Cr Provision (Balance Sheet)
    • The non-current asset is then depreciated per normal.
    • The Finance Charge affects the Provision account, not the Non-Current Asset account.

Valuation of Provisions

  • For a single obligation, best estimate of most likely outcome.
  • For a large number of obligations, calculate the final expected value of the net obligation.
  • If time value of money is material, provisions should be PV-ed using a pre-tax market rate that reflects the risk of the liability.

Contingent Liabilities

Definition

  • Possible obligation that arises from past events
  • Occurrence not wholly within the control of the entity.
  • Either not probable (<= 50% probability) or amount cannot be measured with sufficient reliability

Accounting Treatment

  • Not recognised in Balance Sheet or recorded in the ledger accounts.
  • If the probability is ‘possible’, should be disclosed in the notes
  • If the probability is ‘remote’, can be ignored.

Contingent Assets

Definition

  • Same as contingent liability but an asset instead.

Accounting Treatment

  • If the probability is ‘probable’, should be disclosed in the notes [note that this is stricter than for contingent liabilities. For contingent assets, it still cannot be disclosed when it is ‘possible’, only when it is ‘probable’] 
  • If the probability is ‘possible’ or ‘remote’, can be ignored.
  • If the probability is ‘virtually certain’, it should be recognised as an asset.

-END-

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Discussion

One thought on “Accounting for Provisions, Contingent Liabilities and Contingent Assets (IAS 37)

  1. What should I entry if the entity is in a litigation for something, and it is probable that the entity will lose the case?

    Posted by YuRiz | February 13, 2017, 7:49 am

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