The objective of IAS 37 is to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets and that sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount. The key principle established by the Standard is that a provision should be recognised only when there is a liability i.e. a present obligation resulting from past events.
Provision
A provision may be defined as a liability the amount or timing of which is uncertain. Provisions are measured at the best estimate of the expenditure required to settle the present obligation, and reflects the present value of expenditures required to settle the obligation where the time value of money is material.
Examples include warranties; legal or constructive obligations etc.
A provision is recognized when:
Liabilities include a present obligation arising as a result of past events it is expected that its settlement will result in an outflow of economic resources. The liability may be a legal obligation or a constructive obligation
A legal obligation is an obligation that could be contractual or arise due to legislation or result from other operation of law.
A constructive obligation stems from the entity’s actions, to induce others that the entity will accept certain responsibilities and creates a valid expectation that it will settle those responsibilities.
Contingent Liability
A contingent liability is
When to record a contingent liability?
Probable – Record this type of liability when there is a probability that the event or loss may occur and when we can reasonably estimate the amount of the loss occurred to a certain range.
Reasonably Possible –Disclose the existence of this liability as a note to the accounts if the obligation or the liability is reasonably possible but not probable.
Remote – There is no need to record or reveal this contingent liability if the chances of its occurrence are remote.
Contingent Asset
A contingent asset is a possible asset arising from past events and will be confirmed on the occurrence or non-occurrence of one or more uncertain and uncontrollable future events. A company involved in a lawsuit with the expectation to receive compensation has a contingent asset because the outcome of the case is not yet known and the amount is yet to be determined.
A business may disclose the existence of a contingent asset in the notes accompanying the financial statements when the inflow of economic benefits is probable. When the realisation of income is virtually certain, then the related asset is not a contingent asset and its recognition is appropriate.
Example 1
A company’s directors have been advised that there is a 30% chance that they will lose a legal case over the sale of faulty goods to a customer. How should it be treated in the financial statements?
Answer :
It should not be included in the financial statements but will be disclosed as a note to the financial statements
Example 2
After a fund raising dinner by a local club in 2020, four people died, possibly as a result of food poisoning. The New Catering plc was sued by local authorities for providing bad quality food products. The company’s legal team advised that the case is not filed on strong grounds and it is probable that company will not be found liable. However, by the approval of financial statements for 2021 its lawyers reckon that, owing to developments in the case, it is probable that the company will be found liable.
Explain the accounting treatment for the above in the books of New Catering plc as at 31 December 2020 and at 31 December 2021
Answer:
At 31 December 2020, as there is no obligation as a result of past events so no provision needs to be recognized. This will be disclosed in the notes as a contingent liability unless the probability of any transfer of economic resources is remote.
At 31 December 2021, as transfer of economic resources is probable so on account of a present obligation a provision needs to be recognized.
Example 3
A former employee has filed a case to claim damages of $20 000 against the company for his unlawful termination. The legal advisors are of the view that the case is so weak to succeed. The legal charges of $4 000 were agreed with the lawyers as fee for the case. How this claim and legal charges should be reported in the financial statements?
Answer :
Legal charges of $4 000 will be provided for as this amount will have to be paid irrespective of the outcome of the case. A contingent liability for $20 000 will be disclosed as a note to the financial statements. There is no need to make any provision as the claim is unlikely to succeed.
