Accounting for Provisions and Contingent Liabilities

LO: Describe the background to AASB137

Objective:
The objective of this Standard 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 enable users to
understand their nature, timing and amount.
The key principle established by AASB137 is that a provision should
be recognised when there is a liability, i.e. a present obligation
resulting from past events. Only genuine obligations are dealt with
in the financial statements planned future expenditure, even when
authorised by the board of directors or equivalent governing body, is
excluded from recognition.
LO: Identify which items are included within the scope of the
standard
Scope (See AASB 137, para. 1-9): AASB137 excludes obligations
and contingencies arising
from:
Financial instruments Non-onerous executory contracts
Insurance contracts
Items covered by:
AASB111 Construction Contracts AASB 112 Income Taxes
AASB 117 Leases
AASB 139 Employee Benefits
LO: Outline the concept of a provision
Liabilities:
- Present obligation as a result of past events
- Settlement is expected to result in an outflow of resources
(payment)
Provisions:
- Liabilities of uncertain timing or amount.

 Contingent Liabilities:
- A possible obligation depending on whether some
uncertain future event occurs, or
- A present obligation but payment is not probable or the amount
cannot be measured reliably.
AASB 137 para 10 and the Framework
Present obligation
duty or responsibility to act/perform in a certain way towards an
external party
- not necessary to know who the external party is most obligations
are legally enforceable (arise from
contracts)
- may also be a constructive obligation (inferred from the
facts/circumstances)
mere intention to sacrifice economic benefits is not sufficient
Outflow (sacrifice) of economic benefits
little, if any, discretion to avoid future sacrifice of economic
benefits
- i.e., failure to honor obligations will result in legal, social, political
or economic consequences
future sacrifice may take various forms
- e.g., cash, goods, using up resources to provide
services
settlement may be on demand, on a specified date, or when an
event occurs
Past events
event must leave the entity with no realistic alternative but to
settle the obligation
only obligations arising from past events that exist independently
of future actions should be recognised

Recognition criteria - (see the Framework paras 83 & 91)

Probable
Reliable measurement
- Note: where the obligation is mature or unconditional and
settlement is certain then recognition criteria are more likely to be
satisfied
- A liability that fails the recognition criteria may require disclosure
as a contingent liability

LO: Discuss how to distinguish provisions from other liabilities

Provisions can be distinguished from other liabilities such as trade
payables and accruals because there is uncertainty about the timing
or amount of the future expenditure required in settlement.
Examples:
- Trade Payables - Accruals

LO: Outline the concept of a contingent liability

Definition: see AASB137.10
A contingent liability does not meet the recognition
criteria
AASB137.12:
the term contingent is used for liabilities and assets that are not
recognised because their 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.

LO: Describe how to distinguish a provision from a contingent

liability
Contingent liabilities which are not recognised as liabilities
because they are either:

 (a) possible obligations, as it has yet to be confirmed whether the

entity has a present obligation that could lead to an outflow of
resources embodying economic benefits; or
(b) present obligations that do not meet the recognition criteria in
this Standard (because either it is not probable that an outflow of
resources embodying economic benefits will be required to settle
the obligation, or a sufficiently reliable estimate of the amount of
the obligation cannot be made).

Definition see AASB 137 para 10

Notice: the term contingent liability is used for liabilities which do
not meet the recognition criteria (AASB 137 para 12)
Recognition criteria see AASB 137 para 27
Contingent liability is not recognised in financial statements
Note disclosures are required where the probability of a sacrifice of
future economic benefits is higher than remote (AASB 137 para 28)

 When Endeavour Limited provides a guarantee to a bank in

relation to a bank loan provided to Tower Limited:
- If Tower Limited is solvent and able to repay the loan without
breaching any debt covenants
- If Tower Limited has breached the debt covenants and it is
probable that Endeavour Limited will be called upon as guarantor of
the loan by the bank
LO: Explain when a provision should be recognised
A provision shall be recognised when:

- (a) an entity has a present obligation (legal or constructive)

as a result of a 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.

If these conditions are not met, no provision shall be

recognised.
Definition see AASB 137 para 10 Recognition criteria see
AASB 137 para 14
In rare cases where it is not clear whether there is a present
obligation, a past event is deemed to give rise to a present
obligation if, taking account of all available evidence, it is more
likely than not that a present obligation exists at the reporting date
(AASB 137 para 15)
Many types of items meet the definition and recognition criteria of
liabilities
- e.g., provisions for warranties, refunds, restoration Where no
present obligation exists to an external
party a liability does not exist
- e.g., setting aside a reserve for a future event
LO: Explain how a provision, once recognised, should be measured
Amount to be recognised see AASB 137 para 36
Need to consider risks and uncertainties
Recognition based on best estimate of the present value of the
obligation (where effect of time value of money is material)
Jet Ltd provides a 2 year warranty on the engines it manufactures
and sells.
In 2012 Jet sells 1,000 engines.
Past experience indicates that approximately 10% of engines sold
will require repairs and the average repair cost will be $150 per
engine.
Actual repair costs in 2013 amount to $14,200.
Discounting will be ignored for the purposes of simplicity in this
example.
Recognise provision in 2012:
Record actual repairs in 2013:
What about excess of $800?

 Either reverse back to expense

- OR
Recognise lower expense when accounting for the provision arising
from 2013 sales
LO: Apply the definitions, recognition and measurement criteria for
provisions and contingent liabilities to
practical situations

A manufacturer gives warranties at the time of sale to

purchasers of its product. Under the terms of the contract for
sale the manufacturer undertakes to make good, by repair or
replacement, manufacturing defects that become apparent
within 3 years from the date of sale. On past experience, it is
probable (that is, more likely than not) that there will be some
claims under the warranties.

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.

An entity in the oil industry causes contamination but cleans

up only when required to do so under the laws of the
particular country in which it operates. One country in which it
operates has had no legislation requiring cleaning up, and the
entity has been contaminating land in that country for several
years. At 31 December 2013, it is virtually certain that a draft
law requiring a clean up of land already contaminated will be
enacted shortly after the year end.

An entity in the oil industry causes contamination and

operates in a country where there is no environmental
legislation. However, the entity has a widely published
environmental policy in which it undertakes to clean up all
contamination that it causes. The entity has a record of
honouring this published policy.

LO: Describe the disclosure requirements for provisions, contingent

liabilities

Provisions:

- Nature of the obligation & expected timing, indication of

related uncertainties & any expected reimbursement

- the carrying amount at the beginning and end of the period;

additional provisions made; amounts used; unused amounts
reversed during the period; and effects of time value of money
(AASB137.84-85)

- Accuals are reported as part of trade & other payables

whereas provisions are reported seperately

Contingent Liabilities:

- Not recognised but disclosed if not remote, otherwise no

disclosure required at reporting date.

- For each class of contingent liability, when not remote, a

brief description of the nature and where applicable:
- an estimate of its financial effect; indication of related
uncertainties; possibility of any reimbursement
(AASB137.86)a