In practice, the issue concerning provisions for assets/liabilities and contingent assets/liabilities can be a confusing one.
Care needs to be taken to not only account for provisions and contingencies correctly, but also to recognise any provisions at an appropriate amount; particularly where there may be associated tax implications as HM Revenue and Customs may disallow excessive provisions where tax relief has been obtained on the excess.
Prior to the introduction of accounting standards concerning the accounting requirements for provisions, companies were quite able to ‘massage’ the profits or losses and report figures which were desirable rather than actual (in other words the focus would be on the bottom line and then companies would work upwards). This particular method of profit manipulation was coined ‘big bath accounting’ and was quite common before accounting standards in this area where introduced.
A typical scenario using big bath accounting would be where a company calculated ‘actual’ profits and management would then decide that this level of profit was too high because next year shareholders would expect even higher profits. Management would then create a provision for expenditure which had not actually occurred, or been committed, and this would have the effect of reducing profit to what management would deem to be acceptable, and which would also increase the company’s liabilities. In the subsequent financial year (or years) when profits were not as high as what shareholders would like to see, part, or all, of the provision was released and it is for this reason that accounting standards (FRS 12 Provisions, contingent liabilities and contingent assets and IAS 37 Provisions, Contingent Liabilities and Contingent Assets) were introduced.
The requirements of FRS 12 have, more or less, been carried over into FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland and there is little in the way of difference between the requirements of Section 21 Provisions and Contingencies in FRS 102 and FRS 12.
Provisions for liabilities
It is important to understand that the term ‘provision’ is interchangeable in accounting. AAT members will have come across items such as ‘provisions for bad debts’ or ‘provisions for depreciation’ in practice or during their studies. In this context, the term ‘provision’ is the adjustment to carrying values in the financial statements. This is not the same as a provision under Section 21.
In respect of provisions for liabilities, FRS 102 says that a ‘provision’ is a liability that is of uncertain timing or amount.
The fact that a provision is defined as a liability of uncertain timing or amount is why reference is made at the start of this article to care being taken when recognising such liabilities because professional judgement will often be needed to calculate such provisions.
In order for an entity to recognise a provision for a liability, there are three criteria which must be met (note: all three criterion have to be met before a provision can be recognised):
- the entity has an obligation at the reporting date as a result of a past event;
- it is probable (i.e. more likely than not) that the entity will be required to transfer economic benefits in settlement; and
- the amount of the obligation can be estimated reliably.
Where the above criteria cannot be met, a provision cannot be recognised in the financial statements and a contingent liability must be disclosed.
The key driver in the recognition of a provision is in a) above – i.e. the reporting entity must have an obligation at the reporting date. An obligation can be created in two ways:
- there is a legal obligation; or
- there is a constructive obligation.
A legal obligation is an obligation that can be enforced by law. Normally it is obvious when a company has a legal obligation (for example by way of agreement or a court order). Provisions can also be made for normal day-to-day transactions, such as a provision for goods and/or services received by the year-end but not yet invoiced, i.e. an accrual.
A reporting entity cannot base a provision on its future actions. Paragraph 21.6 of FRS 102 is strict on its approach to an entity’s future actions because such actions do not meet the definition of a provision and the entity has not got an obligation at the balance sheet date for its future actions, regardless of how likely, or unlikely, they are to occur. An obligation arises because of an obligating event and hence it follows that the obligating event must have occurred at, or by, the balance sheet date in order to give rise to a provision.
Example – No obligating event at the balance sheet date
A company operates in the brick industry and has an overseas depot which operates in a country that has recently introduced legislation that now mandates the use of air filters for such companies in their buildings by 31 December 2016. The number of air filters to be fitted is determined by the size of each building. The company has calculated that it will need 250 air filters and at the year-end 31 December 2016 the company had not fitted the filters. The finance director has made a provision for liabilities for the cost of the air filters on the basis that it is now a legal requirement and that the company will inevitably have to fit the filters. In this example, the obligating event is the fitting of the air filters.
The provision should not be recognised in the 31 December 2016 accounts because at the balance sheet date no obligating event had occurred.
On 31 December 2017, the company had still not fitted the air filters. Again, there is still no obligating event despite a year passing. There could well be good reason, however, to make a provision for fines and penalties which may be levied under the legislation because in this respect an obligating event has arisen (the non-compliance with legislation).
Paragraphs 2.20(a) and (b) to Section 2 Concepts and Pervasive Principles says that a ‘constructive obligation’ is an obligation that derives from an entity’s actions when:
- by an established pattern of 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.
Example – Bonus payment
A company has been trading for 20 years and has a long-established practice of paying bonuses to its management team using a pre-determined formula based on year-end profits if they exceed a certain threshold. This threshold has not increased for the last ten years and the directors have intimated that they have no intention of increasing or decreasing the threshold.
Monthly management accounts are prepared with reasonable accuracy by an AAT accountant and at the year-end 31 December 2016, these showed a relatively high level of profitability. The company accountant has made an accrual for a bonus together with the associated employer’s national insurance contribution.
The company has created a constructive obligation by way of an established pattern of past practice by paying bonuses. It is this past practice which has given rise to a constructive obligation because it has created an expectation in the mind-sets of management that they will receive a bonus. As the company has a constructive obligation, it is permissible to recognise the bonus provision in the 31 December 2016 year-end accounts.
The example above illustrates the situation whereby management have a valid expectation because of the entity’s past practice. Care, however, must be taken to ensure that the obligation can be demonstrable as a constructive obligation. If the company’s past practice was NOT to pay a bonus year on year, then it would be difficult to make such a provision unless there was adequate documentation in place prior to the year-end (for example a board resolution declaring the bonus).
Recognising a provision in the accounts
FRS 102 says that where a provision qualifies for recognition, it should be recognised at the best estimate of the amount that will be required to settle the obligation. When a provision involves a large population of items, paragraph 21.7(a) to FRS 102 requires the estimate to reflect the weighting of all possible outcomes by their associated probabilities.
Example – Provision for defective goods
A company sells electrical products such as dishwashers, washing machines, TVs and audio equipment. It sells goods to the general public with a warranty which covers customers for the costs of repairs that occur during the first six months from the date of purchase. The company is preparing financial statements for the year-ended 31 December 2015 and it has calculated that if all the products sold contained minor defects, the costs of repair would be £1 million. If major defects occurred in all the products, the costs of repair would be £4 million.
Management have concluded that past experience, and future expectations, suggest that for the coming year 75% of the goods sold will contain no defects, 20% will contain minor defects and 5% will have major defects.
The provision for the year-ended 31 December 2015 can be calculated as follows:
Paragraph 21.12 of FRS 102 says that a contingent liability is either a possible, but uncertain, obligation or a present obligation which is not recognised within the entity’s financial statements because it fails to meet the recognition criteria for a provision. Contingent liabilities are not recognised in an entity’s financial statements, although the exception to this rule relates to contingent liabilities that have been assumed by the acquirer of an acquiree in a business combination and for which the provisions in paragraphs 19.20 and 19.21 of FRS 102 will apply (Section 19 deals with business combinations and goodwill).
Contingent liabilities must be disclosed as such within the entity’s financial statements, unless the possibility of an outflow of economic resources is considered to be remote.
Example – contingent liability
A company has made a provision for damages amounting to £10,000 in its financial statements for the year-ended 31 December 2016 in respect of a legal claim brought against the company by one of its customers. The legal advisers have advised the company that at the reporting date they are uncertain as to the potential outcome of the case. The case is material to the company.
The company should not recognise a provision for damages because it is not ‘probable’ that an outflow of resources will be required to settle the case. The legal advisers are unsure as to the outcome of the case. In such situations, disclosure of a contingent liability in the notes to the financial statements should be made.
A contingent asset is directly the opposite of a contingent liability and, again, is not reflected within the financial statements of an entity. Contingent assets will only become provisions and hence be recognised in the financial statements if it is ‘virtually certain’ that an entity will realise the contingent asset (for example an insurance company agreeing to pay out a claim to the company).
In practice there are some subjective areas concerning provisions and contingencies and it is important that AAT members and Licensed Accountants have a sound understanding of when a provision is not a provision, but is instead a contingency and vice versa. When a provision meets the recognition criteria, care should be taken to ensure that it is not disproportionately over or understated in the accounts because not only might this be misleading, but it could also raise additional concerns by HM Revenue and Customs.
Steve Collings is the audit and technical partner at Leavitt Walmsley Associates Ltd.