Contingent Assets and liabilities

Contingent Assets and Liabilities

Contingent Liabilities

  • Normal Provision:

    • If a liability is already at 100%, it's a normal provision under the conceptual framework, and IAS 37 doesn't need to be considered.
    • IAS 37 is relevant when outcomes are uncertain.

  • Definition of Contingent Asset:

    • A possible asset whose existence will be confirmed by the occurrence or non-occurrence of an uncertain future event.
    • A contingent asset doesn't yet exist; its existence depends on another event occurring.

  • Probability of Outcomes:

    • Similar to liabilities the scale range from 0 to 100%.
    • Liabilities are recognized when they are more likely than not (probable), generally considered above 50%.
    • Contingent assets are only disclosed when probable (at least 50% and above) in a note.
    • If less likely than not (less than 50%), or remote, no action is taken.

  • Recognition of Contingent Assets:

    • Recognize only when virtually certain (around 95% and above).
    • The provided percentages are for understanding and not directly from the standard.

  • Example: Insurance Claims:

    • In the accounting cycle, it's often assumed that insurance claims will be paid (virtually certain).
    • Under IS 37, insurance claims need to be assessed to determine if they are virtually certain.

  • Summary:

    • 0-50%: Do nothing.
    • 50-95%: Disclose.
    • 95-100%: Recognize.

Provisions vs. Contingent Liabilities and Assets

  • Recognition:

    • Only a provision can be recognized (journal entry).
    • Contingent liabilities and assets cannot be recognized because they don't yet exist.
    • Their existence depends on uncertain future events.

  • Provision Recognition Criteria (3 Requirements):

    • A present obligation as a result of a past event.
    • It must be probable that there will be an outflow of economic benefits from the entity (more likely than not).
    • The amount must be measured reliably.

  • Present Obligation:

    • Must arise from a past event.
    • The standard prevents recognizing future losses or costs that haven't occurred yet.

  • Disclosure:

    • Contingent liabilities must be disclosed if there isn't a present obligation at year-end.

  • Events After Reporting Period:

    • IAS 10 should be referenced when classifying a contingency liability or a provision.
    • Classify upfront based on available facts at year-end.
    • Reassess based on new information.

  • Moving Between Probabilities:

    • Accounting treatments change based on where you are within the probability spectrum.
    • You can move from a provision to a contingent liability or vice versa as new information arises.

  • Obligating Event:

    • Consider whether the obligation is legal or constructive.

  • Future Operating Costs:

    • Provisions for future operating costs or losses are not allowed because there isn't a present obligation from a past event.
    • Provide only if there's an obligation due to a past event, independent of future actions or behaviors.

  • Provisions for Warranties:

    • Warranties attract IS 37 provisions. When you sell goods/services with a warranty, the warranty results in a present obligation if the goods malfunction.
    • For a large number of warranties, you can group them and provide one provision for the entire population without identifying each individual liability.

  • Reassessment:

    • Reassess categories as new information arrives.
    • Events that don't initially create a liability can create one later.
    • You can move from having a liability to having none (derecognize).

  • Unfinalized Legislation:

    • In South Africa, only enacted legislation applies.
    • Unfinalized legislation doesn't create a present obligation until signed into effect.

  • Probability of Outflow:

    • Needs to be more likely than not.

Measurement

  • Measurement and Recognition:

    • Measurement is closely related to recognition.
    • Initial measurements help achieve reliable measurement under the recognition criteria.

  • IAS 16 Example:

    • Cost of future economic benefits must be measured reliably.

Measurement of Provisions

  • Best Estimate:

    • Use the best estimate of the amount expected to leave the business to settle the provision on the reporting date.
    • Involves judgments, consulting experts, and considering past experiences.
    • Consider events after the reporting period (IAS 10).

  • Methods:

    • Probability Weighted Method.
    • Single Liability Method.

Probability Weighted Method

  • Calculate a weighted average amount using probabilities and associated amounts.
  • ProvisionAmount=∑(Probability×Amount)Provision Amount = \sum (Probability \times Amount)
  • The probabilities must sum up to 100%.
  • Example:
    • 75% chance of $0, 20%$ chance of $1,000,000, 5%$ chance of $4,000,000.
    • Provision = (0.75×0)+(0.20×1,000,000)+(0.05×4,000,000)=400,000(0.75 \times 0) + (0.20 \times 1,000,000) + (0.05 \times 4,000,000) = 400,000
  • This method can calculate the closing balance or additional provision needed.

Single Liability Method

  • Take the probability with the highest outcome.
  • Example:
    • 80% chance of paying $500,000, 20%$ chance of paying $1,000,000.
    • Provision = $500,000.

Choosing the Right Method

  • Large Population, Large Range of Possible Outcomes:
    • Use the Probability Weighted Method.
  • Limited Population:
    • Management has a choice between Probability Weighted and Single Liability methods.

Real-World Considerations

  • Stakeholders may have differing interests regarding which amount to record.
  • Record a higher liability to reduce profit disclosure (debit provision expense, credit provision).
  • Reverse excess provision if the company starts doing badly (debit provision, credit provision expense).

Time Value of Money

  • Adjust future amounts to present terms.

Reimbursements

  • IAS 16 vs. IAS 37:

    • Amounts received from insurers don't go into an asset realization account; separate the loss event from the subsequent reimbursement.
    • Paragraphs 53-58 of IAS 37 state that reimbursements must be recognized as a separate asset.

  • Journal Entry:

    • Debit insurance debtor, credit insurance income (outside loss on disposal).
Provisions and Insurance Recoupment
  • If an entity is insured for a provision, the asset recognized cannot exceed the provision amount.
  • Correct Journal Entry:
    • Debit insurance debtor, credit the provision expense (not insurance income).
    • Forces you to reduce the actual expense created when the liability was created.

Future Operating Losses

  • Don't recognize future operating losses because there is no present obligation from a past event.
  • Provisions are created with the intention of using them when a loss event occurs.
  • When the loss event happens, use the provision (debit provision, credit bank/inventory/PPE at carrying amounts).

Disclosure

  • Reconciliation:

    • For each class of provision, disclose a reconciliation between the opening and closing balances.
    • Carrying amounts at the start.
    • Carrying amounts at the end.

  • Reconciliation includes:

    • Additional provisions made during the year.
    • Amounts used during the period.
    • Unused amounts reversed.
    • Effect of the time value of money (finance cost).

*Note: The PPE notes is in the disclosure pack