IAS 37 Provisions, Contingent Assets, and Contingent Liabilities Notes

Liabilities and Contingencies

IAS 37 Provisions, Contingent Assets, and Contingent Liabilities

Learning Objectives

By the end of this lecture, you should be able to:

• Explain the definitions and differences between a contingent asset, a contingent liability, and a provision.
• Understand the accounting treatment according to IAS 37 for each of these terms.
• Apply IAS 37 to complex scenarios, including:
  • Expected disposal of assets
  • Expected future operating losses
  • Guarantees
  • Onerous contracts
  • Company restructuring
  • Dismantling and restoration costs

Introduction

• IAS 37 addresses the accounting for uncertainty, mainly concerning expenses and liabilities that may or may not occur. The focus is also on incomes and assets that may or may not materialize, such as:
  • Outcomes of court cases
  • Insurance claims
  • Warranties
• The core idea of this standard is derived from the accruals basis of accounting (matching concept), which necessitates recognizing transactions in the period when the related event occurs.

Uncertain Assets

• The accounting treatment of uncertain assets depends on their probability of occurrence:
  • Remote: Ignore the asset, do not record in financial statements.
  • Possible: Ignore the asset, do not record in financial statements.
  • Probable: Disclose as a contingent asset. No double entry, not included in the Statement of Financial Position (SFP) or Profit & Loss (P&L), but described in the notes.
  • Virtually Certain: Recognize the asset, record it with a double entry:
  • $ext{Dr Asset (usually a receivable)} ext{ x}$
  • ext{Cr P&L} ext{ x}

Disclosure of a Contingent Asset

• A contingent asset, likely to arise from a past event, should disclose:
  • Description of the nature of the contingent asset
  • Estimate of the financial effect
  • Indication of the time scales

Virtually Certain Assets

• Assets classified as ‘virtually certain’ offer measurable, reliable benefits to the company. They must be recorded:
  • $ext{Dr Asset (usually a receivable)} ext{ x}$
  • ext{Cr P&L} ext{ x}

Uncertain Liabilities

• Similar to uncertain assets, the treatment of uncertain liabilities relies on the probability of occurrence:
  • Remote: Ignore the liability, do not record in financial statements.
  • Possible: Disclose as a contingent liability (no double entry).
  • Probable: Recognize if recognition criteria are met, posting a double entry to record a provision.

Disclosure of a Contingent Liability

• A contingent liability arises from a past event and must disclose:
  • Description of the nature of the contingent liability
  • Estimate of the financial effect
  • Indication of the time scales
  • Possibility of reimbursement

Provisions

• A provision is defined as a liability of uncertain timing or amount. Recognition criteria include:
  1. Present obligation due to a past event (legal or constructive)
  2. Probability of an outflow of resources to settle the obligation
  3. Ability to make a reliable estimate of the amount
• If all three criteria are not met, a contingent liability must be disclosed instead.

Legal and Constructive Obligations

• Legal Obligation: A requirement imposed by law (e.g., paying bills, rectifying environmental damage).
• Constructive Obligation: Arises from past practices or published policies.

Measuring a Provision

• Measurement depends on the type of liability and should be based on the best estimate:
  • Single, one-off event: Use the most likely outcome to measure (e.g., a lawsuit for £15,000).
  • Population of homogeneous items: Use ‘expected value’ to measure (e.g., warranty provisions).

Accounting Entries for Provisions

• Provisions are accounted on a rolling basis:
  1. Create the initial provision:
  • ext{Dr P&L expense} ext{ (varies)}
  • $ext{Cr Provision}$
  1. Utilise the provision when cash is paid:
  • $ext{Dr Provision}$
  • $ext{Cr Cash}$
  1. Year-end adjustment to the provision:
  • ext{Dr/Cr P&L expense}
  • $ext{Dr/Cr Provision}$

Example Scenarios

Example 1: Neglect Ltd

• A lawsuit from an employee regarding health and safety standards:
  • Year 20X1: Create a provision for £15,000.
  • Year 20X2: Update provision to £22,000.
  • Year 20X3: Settle for £24,000; additional expense in the P&L for the balance.

Example 2: Fyson Ltd

• Warranty provisions for washing machines:
  • Opening provision of £125,000, estimated costs at year-end.
  • Calculate expected value to determine the required provisions.

Disclosure Note for Provisions

• Companies must disclose:
  • Opening and closing balances on provisions
  • Nature of obligations
  • Anticipated timings
  • Indication of uncertainties

Reimbursement

• If reimbursed when settling a claim, both a provision and an asset should be recorded if virtually certain:
  • Must be shown separately on the SFP; can offset income and expense in P&L.

Specific Scenarios Under IAS 37

• IAS 37 deals with specific situations such as:
  • Expected disposal of assets (no provision needed)
  • Expected future operating losses (no provision made, losses may be avoidable)
  • Guarantees (provisions for probable payments only)
  • Onerous contracts (contract obligations exceed benefits)
  • Company restructuring (need a formal, detailed plan)
  • Dismantling and restoration costs (include in asset costs, capitalized and depreciated).

Example Dismantling Costs

• Obligation to rectify work at the end of an asset's life:
  • Example of costs in oil rigs should be accounted for under IAS 16 (PPE) and IAS 37 (provisions).

Summary of Learning Objectives

You should now be able to:

• Explain contingent assets, contingent liabilities, and provisions with their respective accounting treatments under IAS 37.
• Apply these concepts to complex scenarios involving expected disposals, future losses, guarantees, onerous contracts, restructuring, and restoration costs.