Provisions in the financial statements
In recent months there appears to have been an increase in firms’ clients receiving information from third parties claiming to be able to assist with claims to HMRC in respect of suspected breaches of GDPR. These third parties will assist clients in submitting claims to HMRC which can generate a refund of corporation tax in some cases.
Material that we have seen that promotes these schemes does (in some cases) correctly make reference to directors’ duties under company law to prepare financial statements that give a true and fair view. However, some of the material that we have seen contains very little reference to accounting standards that govern the recognition and measurement of provisions. In some material there is no reference at all to accounting standards.
Some material suggests that all companies should have some form of provision in place for potential breaches of legislation/regulation but in many cases this is likely to breach UK and Ireland accounting standards.
Some of the professional bodies are aware of these schemes and have issued guidance to members accordingly to advise clients to approach such schemes with caution to ensure that claims for provisions are appropriate in the client’s circumstances.
In two separate cases that were mentioned during recent lectures, HMRC had opened compliance checks on clients that had made retrospective claims for provisions for GDPR breaches (although at the time the checks were still ongoing by HMRC). Of course, there are associated costs involved in dealing with such investigations, which are likely to be borne by the client. Ultimately, HMRC will be keen to ensure that accounting standards have been correctly followed and it will be down to the client to demonstrate this is the case. Where HMRC are not satisfied that the accounting standards have been followed, they will disallow the claim. This can prove costly to a client and given the challenges that businesses have faced over the last couple of years due to the global pandemic, any large cash outflows which can be avoided should be.
In one case mentioned by a delegate, the provision for a suspected GDPR breach was excessive and had a detrimental impact on the level of distributable profit which was available to the shareholders because of the debit to the profit and loss account that arose due to the calculation of the provision for a suspected breach of GDPR (the provision wiped out distributable profit). Once the accountant acting for the client had been told the facts of the case, it was concluded that no provision should have been made in the financial statements because the recognition criteria for a provision in FRS 102 was not met.
Recognition of a provision in the financial statements
Both FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland and FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime contain consistent recognition and measurement requirements for a provision. The Glossary to FRS 102 defines a ‘provision’ as:
| A liability of uncertain timing or amount. |
Essentially, FRS 102, para 21.4 states that an entity must recognise a provision only when:
| a) the entity has an obligation at the reporting date as a result of a past event;
b) it is probable (ie more likely than not) that the entity will be required to transfer economic benefits in settlement; and c) the amount of the obligation can be estimated reliably. |
For entities preparing financial statements under UK-adopted IFRS, IAS 37 Provisions, Contingent Liabilities and Contingent Assets contains the same recognition requirements.
All three criteria must be met at the balance sheet date in order to correctly recognise a provision. The wording in FRS 102, para 21.6 is also particularly important in the context of provisions because it confirms that the condition in FRS 102, para 21.4(a) (see above) means the entity has no realistic alternative to settling the obligation. For completeness, FRS 102, para 21.6 states:
| The condition in paragraph 21.4(a) means that the entity has no realistic alternative to settling the obligation. This can happen when the entity has a legal obligation that can be enforced by law or when the entity has a constructive obligation because the past event (which may be an action of the entity) has created valid expectations in other parties that the entity will discharge the obligation. Obligations that will arise from the entity’s future actions (ie the future conduct of its business) do not satisfy the condition in paragraph 21.4(a), no matter how likely they are to occur and even if they are contractual. To illustrate, because of commercial pressures or legal requirements, an entity may intend or need to carry out expenditure to operate in a particular way in the future (for example, by fitting smoke filters in a particular type of factory). Because the entity can avoid the future expenditure by its future actions, for example by changing its method of operation or selling the factory, it has no present obligation for that future expenditure and no provision is recognised. |
Provisions cannot simply be recognised because the directors ‘think’ there may be a possibility that the company will incur an outflow of cash at some stage in the future in respect of a claim against it; there has to be an obligation at the balance sheet date. Such an obligation arises either through a legal obligation or a constructive obligation.
Probability criterion
FRS 102, para 21.4(b) requires that it is ‘probable’ that the entity will be required to transfer economic benefits in settlement. The term ‘probable’ is defined as ‘more likely than not’. This means that there is more than a 50% chance that the entity will incur a cash outflow at the balance sheet date in respect of the matter giving rise to the potential provision. If it is more likely than not that there will not be a cash outflow, no provision is recognised and a contingent liability may need to be disclosed (see below).
Prudence
One of the qualitative characteristics of financial statements according to FRS 102, Section 2 Concepts and Pervasive Principles is the concept of prudence. FRS 102, para 2.9 states (among other things) that:
| Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated. However, the exercise of prudence does not allow the deliberate understatement of assets or income, or the deliberate overstatement of liabilities or expenses. In short, prudence does not permit bias. |
In terms of a provision for a liability, the entity must consider whether a liability actually exists. The entity may ‘think’ there could be a future cash outflow, but this is insufficient to justify a provision in the financial statements unless a liability exists at the balance sheet date.
Contingent liabilities
In respect of contingent liabilities, FRS 102, para 21.12 states:
| A contingent liability is either a possible but uncertain obligation or a present obligation that is not recognised because it fails to meet one or both of the conditions (b) and (c) in paragraph 21.4. An entity shall not recognise a contingent liability as a liability, except for provisions for contingent liabilities of an acquiree in a business combination (see paragraphs 19.20 and 19.21). Disclosure of a contingent liability is required by paragraph 21.15 unless the possibility of an outflow of resources is remote. When an entity is jointly and severally liable for an obligation, the part of the obligation that is expected to be met by other parties is treated as a contingent liability. |
Hence, where the recognition criteria for a provision cannot be met, the entity may need to disclose a contingent liability, but only if that contingent liability is material and the condition in FRS 102, para 21.4(a) is met (i.e. the entity has a present obligation at the reporting date as a result of a past event). When the possibility of an outflow of economic resources is remote, no disclosure is required. Note, FRS 102 does not define ‘remote’, but it should be taken to mean that something is not expected to happen, although it cannot be ruled out completely.
Conclusion
Where a provision has been inappropriately included in the financial statements, it will, of course, reverse at some point in time (usually in the next accounting period). Hence, the reversal will cause the tax that has been refunded to be ‘repaid’ in the year in which the reversal takes place. This reversal could also attract a higher rate of corporation tax where it is reversed post 1 April 2023.
Provisions must only be recognised in the financial statements when the recognition criteria in FRS 102, Section 21 (paragraph 21.4) or FRS 105, Section 16 (paragraph 16.5) have been met. Retrospective claims may result in a compliance check by HMRC, who could disallow the claim and charge penalties and/or interest, especially where they are not satisfied that the requirements of UK GAAP have been followed correctly. Clients should be advised to consult with their advisers before entering into such schemes to ensure that any provision can be justified because while there is a chance that any claims may not be reviewed by HMRC, there is always a possibility they could.
Category: Accounting and standards, Audit
