OBJECTIVE
The objective of this standard is to ensure that the appropriate recognition rules and measurement bases are applied to provisions, contingent liabilities and contingent assets. The standard also sets out the disclosure to be made to ensure that sufficient information is available to assist users in understanding the nature, timing and amount of any provisions, contingent liabilities and contingent assets.
DEFINITIONS
A Provision is a liability of uncertain timing or amount.
A liability is a present obligation of an entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefit.
An “obligating” event is an event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation.
A legal obligation is an obligation that derives from: a) A contract,
- Legislation or
- Operation of law.
A constructive obligation is an obligation that derives from an entity’s actions where:
- By an established pattern or past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities, and
- As a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.
A contingent liability is:
- A possible obligation that arises 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 control of the entity, and
- A present obligation that arises from past events but is not recognised because:
- It is not probable that an outflow of resources embodying economic benefits will be required to settle the obligations, or
- The amount of the obligation cannot be measured with sufficient reliability.
A contingent asset is a possible asset that arises 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 control of the entity.
An onerous contract is a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.
A restructuring is a programme that is planned and controlled by management, and materially changes either:
- The scope of the business undertaken by an entity, or
- The manner in which that business is conducted.
A provision differs from other liabilities due to the uncertainty as to the timing and amount of the expenditure involved.
RECOGNITION
A provision is recognised when all of the following conditions are met: a) An entity has a present obligation as a result of a past event,
- It is probable that there will be an outflow of economic benefits to settle the obligation,
- A reliable estimate of the amount of the obligation can be made.
Contingent Liability
If the possibility of an outflow of economic benefit is remote then the entity does not need to disclose the contingent liability.
If the possibility of an outflow of economic benefit is probable and a reliable estimate of the amount can be made then a provision should be made.
Contingent Asset
A contingent asset is the possibility of an inflow of economic benefits. Where the possibility is virtually certain the contingent asset should be recognised.
If the possibility of the inflow of economic benefits is probable then details of the contingent asset should be disclosed.
Both contingent assets and contingent liabilities should be reviewed continually to ensure that are accurately presented in the financial statements.
MEASUREMENT
The amount of the provision presented in the financial statements will be the best estimate of the amount of the expenditure required to settle the present obligation as at the Statement of Financial Position date. These estimates are based on the judgement of the management of the entity with reference to their past experience of similar transactions and, on some occasions, the advice of experts.
In calculating the best estimate of a provision consideration should be given to any risks and uncertainties that exist. This does not justify the creation of excessive provisions or a deliberate overstatement of liabilities.
Future events that may affect the amount required to settle an obligation shall be reflected in the amount of the provision where there is sufficient objective evidence that they will occur.
Where some or all of the expenditure required to settle a provision is expected to be reimbursed by another party, the reimbursement shall be recognised when, and only when, it is virtually certain that reimbursement will be received. The reimbursement shall be treated as a separate asset. The amount recognised for the reimbursement shall not exceed the amount of the provision. In the Statement of Comprehensive Income , the expense relating to a provision may be presented net of the amount recognised for a reimbursement.
CHANGES IN PROVISIONS
Provisions should be reviewed annually at the Statement of Financial Position date to ensure that it represents the best estimate. If there is no longer a requirement for the provision, that is, we do not expect that there will be an outflow of economic benefit, we should reverse the provision.
USES OF PROVISIONS
A provision should only be used for expenditure for which the provision was originally established.
APPLICATIONOF THE RECOGNITION AND MEASUREMENT RULES
Future Operating Losses
No provision shall be made for future operating losses.
Onerous Contracts
If an entity has an onerous contract then the present obligation under the contract should be recognised and measured as a provision.
Restructuring
The following are examples of events that are considered to be restructuring: a) Sale or termination of a part of the business,
- Closure of business in a country or region or the relocation of business activities from one country or region to another,
- Change in management structure,
- Fundamental reorganisation that have a material effect on the nature and focus of the entity’s operations.
A constructive obligation to restructure arises only when an entity: a) Has a detailed plan for restructuring, identifying at least:
- Business or part of business concerned,
- Principal locations affected,
- Location, function, and approximate number of employees who will be
compensated for termination of their services,
- Expenditure to be undertaken and
- when the plan will be implemented and
- Has raised 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.
A decision by the Board of Management prior to the Statement of Financial Position date to implement a restructuring plan does not of itself constitute a constructive obligation unless they have started to implement the restructuring plan or they have announced the main features of the plan to those affected.
No obligation arises for the sale of an operation until the entity is committed to the sale, that is, there is a binding sale agreement.
A restructuring provision shall include only the direct expenditure arising from the restructuring, which is both necessarily entailed by the restructuring and not associated with the on-going activities of the entity.
DISCLOSURE
For each class of provision an entity must disclose:
- The carrying amounts at the beginning and end of the period,
- Additional provisions made in the period, including an increase to existing provisions,
- Amounts used during the period,
- Unused amounts reversed during the period and
- Any increase during the period in the discounted amount arising from the passage of time and the effect of any change in the discount rate.
Comparative information is not required.
An entity shall disclose for each class of provision:
- A brief description of the nature and timing of any expected outflow of economic
benefit,
- Details of any uncertainties about the amount and timing of these outflows, it may be necessary to disclose any major assumptions made concerning future events,
- Amount of any expected reimbursement, stating the amount of any asset that has been recognised for that expected reimbursement.
For each Contingent liability where the possibility of the settlement is not remote the entity should provide a brief description of the nature of the contingent liability, and where practicable:
- An estimate of the financial effect,
- An indication of the uncertainties relating to the amount or timing of any outflow,
- The possibility of any reimbursement.
For each contingent asset disclose:
- A brief description of the nature of the contingent asset,
- An estimate of the financial effect.
EXAMPLES – RECOGNITION
Warranties
The obligating event is the sale of the product with a warranty. It is probable that there will be an outflow of resources. A provision is recognised for the best estimate of the cost of correcting the defects on goods sold prior to the Statement of Financial Position date.
Contaminated Land – Legislation virtually certain to be enacted
It is probable that there will be an outflow of resources as the enactment of the legislation is virtually certain and therefore an obligating event. It is necessary to recognise a provision for the best estimate of the cost to clean up the contaminated land.
Contaminated Land – No environmental legislation but company has a widely publicised environmental policy to clean up any contamination
The company has an obligation to clean up the contaminated land as a result of its past practice. The likelihood that there will be an outflow of resources to correct the contamination is probable. The entity will recognise a provision for the best estimate of the costs of the clean-up.
Offshore Oilfield
A licensing agreement requires it to remove the oil rig at the end of the production and restore the seabed. Ninety per cent of the eventual costs relate to the removal of the rig and the restoration of the damage to the seabed, the remaining ten per cent arises through the extraction of the oil.
The obligating event is the construction of the oil rig and its removal and restorationof the seabed. The likelihood attaching to the event is highly probable. A provision should be raised for the best estimate of the cost of removing the oil rig and restoring the sea bed, that is, the ninety per cent of the eventual costs. The balance is recognised as a liability when the oil is extracted.
Refunds Policy
A retail company refunds dissatisfied customers even though this is not required by legislation. The obligating event is the sale of goods to customers who have an expectation based on past experience that they will receive a refund if they are unhappy with their purchases. The likelihood that the company will have to refund customers is probable. A provision is recognised for the best estimate of the cost of the refunds.
Closure of a Division – No implementation before the Statement of Financial Position
Date
There is no obligating event as no action has been taken at the Statement of Financial Position date so therefore no provision can be raised.
Closure of a Division – Communication / Implementation before Statement of Financial Position Date
The fact that the company has communicated its plans to close a division. As a result of the communication it is highly probable that the division will be closed. A provision should be recognised, this should represent the best estimate of the cost involved in closing the division.
Staff retraining as a result of changes in the Statement of Comprehensive Income
For example, changes in Income Tax Legislation: certain companies will need to retrain their administrative staff to ensure compliance with the legislation. At the Statement of Financial Position date no retraining has taken place. There is no obligating event because no retraining has taken place, so no provision is recognised.
Onerous Contract
A company has moved during the year to new premises but their old premises still has 4 years remaining on its lease. The company cannot cancel the lease and they cannot sublet the premises. The obligating event is the signing of the original lease agreement and this gives rise to a legal obligation. A provision is recognised for the best estimate of the unavoidable lease payments.
Refurbishment Costs – No legislative Requirement
A furnace has a lining that needs to be replaced every five years for technical reasons. At the Statement of Financial Position date, the lining has been in use for three years. There is no obligating event as at the Statement of Financial Position date as the lining exists independently of the company’s future actions – even the intention to incur the expenditure depends on the company deciding to continue operating the furnace or to replace the lining. Instead of a provision being recognised, the depreciation of the lining takes account of its consumption, that is, it is depreciated over five years. The re-lining costs then incurred are capitalised with the consumption of each new lining shown by depreciation over the subsequent five years. There is noevent so no provision is recognised.
Refurbishment Costs – Legislative Requirement
An airline is required by law to overhaul its aircraft once every three years. There is no event so therefore no provision is recognised.
The rationale is the same as in the previous example of Refurbishment costs where there is no legislative requirement.
