Is recognition of the provision mandatory?
According to IAS 37 Provisions, Contingent Liabilities and Contingent Assets standard, the following three key terms are defined separately,
Provision
A liability of uncertain timing or amount. There is a possible argument on how much will be paid and when it will be paid. Before introducing IAS 37, the entities have misused the concept of uncertainty in order to achieve stakeholder’s expectations.
For example, consider a hypothetical entity called Buffer Ltd having a profit target of 20 million for the year 2022/23. The financial control (FC) of the entity has realized that Buffer will reach a profit of 22 million for the year. And also, the FC knows that there will be no additional bonus for directors over 20 million profit and then next year’s profit target will be more than the current period. Accordingly, FC can identify a potential future expense of 2 million as a provision in the current year and reverse it in the following year in order to maintain profit at 20 million. This representation will not be a true and fair view to the user of the financial statements (FS). IAS 37 introduced three criteria to be met before recognizing provision in the FS to avoid the misclassification and misinterpretation.
Recognition of the provision
The entity must recognize the provision only if the following three criteria are met
· A present obligation (legal or constructive) has arisen as a result of a past event
The obligation could be either a legal one arising from a court case or a constructive obligation and it is a present obligation as a result of an event occurred in the past period. The constructive obligation can create an expectation from its publications, practice and history.
Payment is probable
The criteria called probable has not perfectly defined with the percentage of outcome. But it certainly specified that the entity has more likelihood of resource outflow than not pay any money from the entity. With this criteria, there are few other levels that can be identified; Remote, Possible, Probable and Virtually certain. If the likelihood is;
ü Remote – Do nothing in cash inflow and outflow cases
ü Possible – Identify contingent liability in cash outflow cases but do nothing in cash inflow cases
ü Probable – Provision is required in cash outflow cases and the contingent asset will be disclosed in cash inflow cases
ü Virtually certain - Provision is required in cash outflow cases and asset must be recognized in cash inflow cases
The amount can be estimated reliably
This is based on professional judgment and the best estimate will be the most likely outcome.
For example, one of the employees in the Buffer factory got injured in July 2022 and a court hearing is continuing as at 31st March 2023. The lawyer has advised the management of Buffer Ltd, there is 80% chance of paying 1 million to the injured employee, 20% chance of paying 1.5 million and 10% chance of paying nothing. In this case, Buffer has to provide 1 million as a provision which is the most likely outcome.
Contingent Liability
Contingent liability can be defined as a possible obligation as a result of a past event but the resource outflow is not probable or cannot be reliably measured at the reporting date. The contingent liability cannot be recognized in the FS but proper disclosure is required to represent fair presentation to the user of FS unless the likelihood is remote.
Contingent Asset
Contingent asset is a possible asset that arises from past events and its existence will be confirmed by the occurrence or non-occurrence of uncertain future events that are not wholly within the control of the entity. A contingent asset is not recognized in FS unless the likelihood is virtually certain but proper disclosure is required.
Subsequent measurement
The entity must subsequently measure at each reporting period to ensure the provision is required or reversed back in the subsequent period.
This article will not cover other issues of restructuring, Onerous contracts and future operating loss.
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