Sunday, June 23, 2013

Legal meets Accounting – Provisions, contingent liabilities, and contingent assets under IFRS


How to account for litigation? I have touched upon this topic from different angles. When I was an attorney, clients asked to evaluate the risk of litigation and to put a total amount on such risk. When negotiating financing contracts, I often faced representations and warranties about litigation risk. The most important angle, the accountant perspective, is still missing in my career. It’s not very likely that I will ever be an accountant, but you never know...

Anyway, knowing the IFRS rules about this topic helps for any of the above perspective.


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“Perhaps you’re a scholar,” said the prize-fighter, after a moment’s reflection.
“I have been at school; but I didn’t learn much there,” replied the youth. “I think I could bookkeep by double entry, “he added, glancing at the card.
Double entry! What’s that?”
“It’s the way merchants’ books are kept. It is called so because everything is entered twice over.”
“Ah!” said Skene, unfavorably impressed by the system; “once is enough for me.”
(George Bernard Shaw, Cashel Byron’s Profession)
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Provisions

A provision, in IFRS accounting jargon, is a liability of uncertain timing or amount. If you would like recognize a provision, three cumulative conditions must be met:

  • A present obligation results from a past event. To make it more pompous, IAS names this past event an “obligating event”.
  • An outflow of resources is probable.
  • You can estimate the amount of the obligation reliably.

Four principles guide you when measuring the provision: You should

  • take risks and uncertainties into account;
  • discount the provisions if the time value of money is relevant;
  • take future events, especially of legal and technological nature, into account;
  • not take gains from the expected disposal of assets into account.

The final amount is then a “best estimate”, based on management judgment, experience of similar transactions, and reports from independent experts. In addition, where many outcomes are possible, a weighted average shall be determined (“expected value”).

Provisions shall be reviewed and readjusted at the end of each financial year.

Specific examples of provisions include future operating losses, onerous contracts (= the contract’s costs exceed its benefits), and restructurings.


Contingent liabilities

A contingent liability is

  • a possible obligation that arises from past events but depends on uncertain future events not wholly controlled by the company, or
  • a present obligation where it is not probable that such obligation requires economic resources for its settlement or where the amount of the obligation cannot be measured reliably.

Contingent liabilities are not recognized on the firm’s balance sheet. By contrast, they are disclosed as a contingent liability, unless the outflow of economic resources is remote.


Contingent assets

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 owned within the control of the entity.

Firms shall not recognize a contingent asset on its balance sheet. However, when an inflow of economic benefits is probable, the contingent asset shall be disclosed.


Disclosure

In its financial statements, the company must disclose some basic information about its provisions, contingent liabilities, and contingent assets as follows:



Disclosure under IAS 37



Resource:

  • IAS 37 – Provisions, Contingent Liabilities, and Contingent Assets