PROVISION:
A provision is a liability which can be measured only by using a substantial
degree of estimation.
Treatment : A provision should be recognized when:
(a) An enterprise has a present obligation as a result of past event
(b) It is probable that an outflow of resources embodying economic benefits will be required
to settle the obligation; and
(c) A reliable estimate can be made of the amount of the obligation.
Present Obligation: An obligation is a present obligation if, based on the evidence available, its existence at the balance sheet date is considered Probable, i.e. more likely than not.
Past Event: A Past event that leads to a present obligation is called an obligating event.
CONTINGENT LIABILITY:
1] A contingent liability is
• A possible obligation that arises from past events
• And; existence of which will be confirmed by the occurrence or non occurrence of future
events not wholly within the control of the enterprise
2] A contingent liability is
• A present obligation that arises from past events
• And; not recognized because of lower probability of outflow of resources or non-
availability of reliable estimate
Possible Obligation: An obligation is a present obligation if, based on the evidence available,
its existence at the balance sheet date is considered Not Probable.
Treatment: An enterprise should not recognize a contingent liability.
It should be disclosed in financial statements unless the possibility of
outflow is remote.
CONTINGENT ASSETS:
A contingent assets is a possible asset that arises from past events of the existence of which 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.
Treatment: An enterprise should not recognize a contingent asset.
An enterprise should not be disclosed in financial statements.
It may be disclosed in the report of approving authority, where an inflow
is probable.
Other Important Issues:
1. Provisioning is required for only those liabilities that exist at the balance sheet
date. ( i.e. No provision is required for costs that need to be incurred to operate in
future.)
2. Where details of a proposed new law have yet to be finalized, an obligation arises only
when the legislation is virtually certain to be enacted. For example, huge penalty shall
be imposed on the enterprise if the proposed law is enacted. No provisioning is required
unless the virtual certainty of the enactment of the law is established.
3. Where there are a number of similar obligations (e.g. product warranties) the
probability that an outflow will be required in settlement is determined by considering
the class of obligations as a whole.
4. If the reliable estimate of the liability cannot be made, it should be disclosed as a
contingent liability
5. Where an enterprise is jointly & severally liable for an obligation:
• Provision should be made for the portion on which enterprise has direct liability.
• The balance amount should be disclosed as contingent liability.
6. Gains from the expected disposal of assets should not be taken into account in measuring
a provision.
7. Reimbursement for expenditure of which provision is created, should be recognized when
and only when it is virtually certain that the reimbursement shall be received on
settlement of liability.
Such Reimbursement may be shown as a net figure in Profit & Loss statement but should be presented in balance sheet as a separate asset (i.e. net provision not to be shown)
8. A provision should be used only for expenditures for which the provision was originally
recognized. Provisions should also be reviewed at each balance sheet date and if no
longer required, it should be reversed.
9. Provision should not be recognized for future operating losses as it neither meets the
criteria of liability nor meets the criteria for recognition of provision.
RESTRUCTURING:
A restructuring is a program that is planned and controlled by management and materially changes either:
(a) the scope of a business undertaken by an enterprise; or
(b) the manner in which the business is expected.
Restructuring may include the following:
(a) sale or termination of a line of business;
(b) the closure of business location in a region
(c) eliminating a layer of management;
Treatment: A provision for recognition criteria is recognized only when the recognition criteria for provision is met.
A restructuring provision should include only the direct expenditures arising from the restructuring, which are those that are both;
(a) necessarily entailed by the restructuring; and
(b) not associated with the ongoing activities of the enterprise.
Restructuring provision does not include costs like
(a) retraining or relocating continuing staff
(b) marketing expenses
(c) investments in new systems and distribution networks.
Identifiable future operating losses up to the date of a restructuring and gains on disposal of assets (even if it is included as part of restructuring) are not included in provisions.
DISCLOSURES:
The enterprise should disclose for each class of provision:
(a) the carrying amount at the beginning & end of the period
(b) additional provision made during the period
(c) amount used during the period
(d) amount reversed during the period
(e) nature of obligation & and expected time of incurrence
(f) indication about the uncertainties attached to the provisions
The enterprise should disclose for each class of contingent liabilities:
(a) an estimate of its financial effects
(b) an indication of the uncertainties relating to any outflow
(c) the possibility of any reimbursement
Where any of the information required is not disclosed because it is not practicable to do so, that fact should be stated.
In extremely rare cases, disclosures can be expected to seriously harm the enterprise in a dispute with other parties. In such cases, instead of detailed information, general nature of dispute together with the reason of non-disclosures should be disclosed.
Example 1: Warranties
A manufacturer gives warranties et the time of sale to purchasers of its product. Under the terms of the contract for the manufacturer undertakes to make good, by repairs or replacement, manufacturer defects that become apparent within three years from the date of sale. On past experience, it is probable (i.e. more likely than not) that there will be some claims under the warranties.
Present obligation as a result of a past obligating event- The obligating event is the sale of the product with a warranty, which gives rise to an obligation
An outflow of resources embodying economics benefits in settlement- Probable for the warranties as a whole.
Conclusion – A provision is recognized for the best estimate of the costs of making good under the warranty products sold before the balance sheet date.
Example 2 Contaminated Land- Legislation Virtually Certain to be Enacted
An enterprise in the oil industry causes contaminated but does not clean up because there is no legislation requiring cleaning up, and the enterprise has been contaminating land for several years. At 31 March 2005 it is virtually certain that a law requiring a clean up of land already contaminated will be enacted shortly after the year end.
Present obligation as a result of a past obligating event- he obligating event is the contamination of the land because of the virtually certainty of legislation requiring cleaning up.
An outflow of resources embodying economics benefits in settlement- Probable.
Conclusion - A provision is recognized for the best estimate of the costs of the clean up.
Example 3: Offshore Oilfield
An enterprise operates an offshore oilfield where its licensing agreement requires it to remove the oil rig at the end of production and restore the seabed. Ninety percent of the eventual cost related to the removal of the oil rig and restoration of damage caused by building it, and ten percent arise through the extraction of oil. At the balance sheet date, the rig has been constructed but no oil has been extracted.
Present obligation as a result of past obligating event- The construction of the oil rig created an obligation under the terms of the license to remove the rig and restore the seabed and is thus as obligating event. At the balance sheet date, however, there is no obligation to rectify the damage that will be caused by extraction of oil.
An outflow of resources embodying economics benefits in settlement- Probable.
Conclusion- A provision is recognized for the best estimate of ninety percent of the eventual costs that relate to the removal of the oil rig and restoration of damage caused by building it. There coasts are included as part of the cost of the oil rig. The ten percent of costs that arise through the extraction of oil are recognized as a liability when the oil is extracted.
Example 4: Refunds Policy
A retail store has a policy of refunding purchases by dissatisfied customers, even though it is under no legal obligation to do so. Its policy of making refunds is generally known.
Present obligation as a result of a past obligating event- The obligating event is the sale of the product, which gives rise to an obligation because obligating also arise from normal business practice, custom and a desire to a maintain good business relations or act in an equitable manner
Outflows of resources embodying economic benefit in settlement–Probable, a proportion of goods are returned for refund.
Conclusion – A provision is recognized for the best estimate of the costs of refunds.
Example 5: Legal Requirement to Fit Smoke Filters
Under new legislation, an enterprise is required to fit smoke filters to its factories by 30 September 2005. The enterprise has not fitted the smoke filters.
(a) At the balance sheet date of 31 March 2005
Present obligation as a result of a past obligating event – There is no obligation because there is no obligating event either for the costs of fitting smoke filters or for fines under the legislation
Conclusion – No provision is recognized for the cost of fitting the smoke filters.
(b) At the balance sheet date of 31 March 2006
Present obligations as a result of a past obligating event – There is still no obligation for the costs of fitting smoke filters because no obligating event has occurred (the fitting of the filters). However, an obligation might arise to pay fines o penalties under the legislation because the obligating event has occurred (the non-complaint operation of the factory).
An outflow of resources embodying economic benefits in settlement - Assessment of probability of incurring fines and fines and penalties by non-compliant operation depends on the details of the legislation and the stringency of the enforcement regime.
Conclusion – No provision is recognized for the costs of fitting smoke filters. However, a provision is recognized for the best estimate of any fines and penalties that are more likely than not to be imposed.
Example 6: Staff retraining as a Result of Changes in the Income Tax System
The government introduces a number of changes to the income tax system. As a result of these changes, an enterprise in the financial services sector will need to retrain a large proportion of its administrative and sales workforce in order to ensure continued compliance with financial services regulation. At the balance sheet date, no retraining of staff has taken place.
Present obligation as a result of past obligating event – There is no obligation because no obligating event (retraining) has taken place.
Conclusion – No provision is recognized.
Example 7: A Single Guarantee
During 2004-05, Enterprise A gives a guarantee of certain borrowing of Enterprise B, whose financial condition at that time is sound. During 2005-06, the financial condition of Enterprise B deteriorates and at 30 September 2005 Enterprise B goes into liquidation..
(a) At 31 March 2005
Present obligation as a result of a past obligating event – The obligating event is the giving of the guarantee, which gives rise to an obligation.
An outflow of resources embodying economics benefits in settlement – No outflow of benefits is probable at 31 March 2005.
Conclusion – No provision is recognized. The guarantee is disclosed as a contingent liability unless the probability of any is regarded as remote At 31 March 2006
Present obligation as a result of a past obligating event – The obligating event is the giving of the guarantee, which gives to a legal obligation.
Conclusion – A provision is recognized for the best estimate of the obligation.
Note: This example deals with a single guarantee. If an enterprise has a portfolio of similar guarantee, it will assess that portfolio as a whole in determining whether an outflow of resources embodying economic benefit is probable. Where an enterprise gives guarantees in exchange for a fee, revenue is recognized under AS 9, Revenue recognition.
Example 8: A Court Case
After a wedding in 2004-05, ten people died, possibly as a result of food poisoning from products sold by the enterprise. Legal proceedings are started seeking damages from the enterprise but it disputes liability. Up to the date of approval of the financial statements for the year 31 March 2005, the enterprise’s lawyers advice that it is probable that the enterprise will not be found liable. However, when the enterprise prepares the financial statements for the year 31 March 2006, its lawyer’s advice that, owing to developments in the case, it is probable that the enterprise will be found liable.
(a) At 31 March 2005
Present obligation as a result of a past obligating event – On the basis of the evidence available when the financial statements were approved, there is no present obligation as a result of past events.
Conclusion – No provision is recognized. The matter is disclosed as a contingent liability unless the probability of any outflow is regarded as remote
(b) At 31 March 2006
Present obligation as a result of a past obligating event – On the basis of the evidence available, there is a present obligation.
An outflow of resources embodying economic benefits in settlement – Probable.
Conclusion – A provision is recognized for the best estimate of the amount to settle the
obligation.
Example 9A: Refurbishment Costs – No Legislative Requirement
A furnace has a lining that needs to be replaced every five years for technical reasons. At the balance sheet date, the lining has been in use for three years.
Present obligation as a result of a past obligating event- There is no present obligation.
Conclusion – No provision is recognized.
The cost of replacing the lining is not recognized because, at the balance sheet date, no obligation to replace the lining exits 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.
Example 9B: Refurbishment Costs – Legislative Requirement
An Airline is required by law to overhaul its aircraft once every three years.
Present obligation as a result of a past obligating event – There is no present obligation.
Conclusion – No provision is recognized.
The costs of overhauling aircraft are not recognized as a provision for the same reason as the cost of replacing the lining is not recognized as a provision in example 9A. Even a legal requirement to overhaul does not make the cost of the overhaul a liability, because no obligation exits to overhaul the aircraft independently of the enterprise’s future actions – the enterprise could avoid the future expenditure by its future actions, for example by selling the aircraft.
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