Accounting for Provisions and Contingencies
Before the introduction of accounting standards governing the accounting requirements for provisions, companies were quite able to ‘massage’ the profits (or losses) and report figures which were ‘desired’ as opposed to ‘true and fair’.
This particular method of profit manipulation was coined ‘big bath accounting’ and was quite common before the introduction of SSAP 18 Accounting for Contingencies which was superseded by FRS 12 (IAS 37) Provisions, Contingent Liabilities and Contingent Assets. A typical scenario using ‘big bath accounting’ entailed a company calculating ‘actual’ profits and then deciding these were too high (usually because if profits were too high in year one, shareholders would expect a higher profit in year two). Management would then create a ‘provision’ for expenditure which had not actually been committed to at the balance sheet date and this would have the effect of reducing profits and (on the face of it) increasing liabilities. In year two when profits were not quite as high as the previous year some (or all) of the provision recognised in year one would be reversed and it was for this very reason that FRS 12 (IAS 37) was issued. While FRS 12 is a relatively simple standard to understand, occasionally it is not quite as apparent as to whether a provision should be recognised, or not.
In a nutshell, a company can only make a provision for a liability if an obligation exists at the balance sheet date. FRS 12 defines liabilities as ‘obligations of an entity to transfer economic benefits as a result of past transactions or events.’ Practical problems can be encountered with HMRC insofar as excessive provisions are concerned.
Figure 1
Gabriella Garments has an ongoing dispute with one of its suppliers, Lucas Lingerie. Gabriella has refused to pay several invoices issued by Lucas because of defective goods. Lucas has issued credit notes compensating Gabriella for the value of the defective goods, but Gabriella is still refusing to pay Lucas claiming that the defective goods resulted in many customers cancelling orders, but so far Gabriella has been unable to provide evidence that customers were lost as a result of the defective goods. The legal advisers have told Gabriella that the chances of them successfully defending the case are poor and that the overall settlement including legal fees has been calculated to be in the region of £100,000. Gabriella has made a provision in the year-end financial statements for £180,000 and has claimed corporation tax relief on this amount.
In this scenario, Gabriella has made a provision in excess of the actual anticipated amount and HMRC would undoubtedly have a problem with this excessive provision.
Satisfying the provisioning criteria
In the above example Gabriella had made a provision (albeit excessive) for settlement of the dispute and legal fees. It is worth mentioning at this point that a provision can only be recognised if three criteria within FRS 12 (IAS 37) are met:
- an entity has a present obligation (legal or constructive) as a result of a past event
- it is probable that a transfer of economic benefits will be required to settle the obligation
- a reliable estimate can be made of the amount of the obligation
The standard requires that the amount recognised as a provision should be the best estimate of the expenditure required to settle the obligation at the balance sheet date.
If any of the criteria above cannot be met then there is to be no provision, but disclosure of a contingent liability should be made in the notes to the financial statements if the contingent liability is of a material nature.
Figure 2
Smyth Sunbeds supplies sunbeds to beauty salons throughout the country. The company’s year-end is 31 October 2011 and on this date the management undertook a review of the aged debtors listing. Management determined that there were a number of very overdue debts which they considered to be impaired. In addition, Smyth Sunbeds has its own outlets and utilises its own developed brand, FastTan Tanning. Recent adverse press reports in respect of FastTan Tanning has resulted in a significant decline in demand for this brand and management have therefore estimated that the recoverable amount of the FastTan Tanning brand is below its carrying amount in the balance sheet. The question arises as to whether provisions for impairment of the financial and non-financial assets within the balance sheet fall under the scope of FRS 12?
The impairment loss on the trade debtors is not actually a provision insofar as FRS 12 is concerned. Smyth Sunbeds would actually recognise a reduction in the trade debtors (a financial asset) by way of a provision for bad debts (for FRS 26 reporters this is also consistent with paragraph 63).
In respect of the impairment of the brand, the impairment should be presented net of the impairment in the balance sheet in accordance with FRS 11 Impairment of Fixed Assets and Goodwill. An impairment charge is not a probable outflow of economic resources, but instead it is a reduction in the cash flows expected from the brand. As a result, an impairment charge does not fall within the scope of FRS 12.
Recognition of a provision
FRS 12 specifically prohibits provisions from being recognised in the financial statements in respect of future expenses and losses of which no obligation exists at the balance sheet date. As a consequence, FRS 12 had a significant impact on certain companies, specifically:
- Companies which are undertaking major restructuring programmes
- Companies which operate in the extractive and nuclear industries which often have decommissioning provisions
- Companies which have specific environmental obligations
- Companies with onerous contracts
- Companies that have outstanding legal cases at the balance sheet date
When a company fails to meet the three recognition criteria of a provision, it is required, instead, to disclose a contingent liability. FRS 12 requires a contingent liability to be disclosed when:
- There is a present obligation as a result of a past event which probably requires a transfer of economic benefits, but the obligation cannot be reliably measured
- That may, but will probably not, require a transfer of economic benefits
- There is a possible obligation that will probably not require a transfer of economic benefits
Figure 3
Company A Ltd operates in a jurisdiction which has just introduced legislation that now mandates the use of air filters for all companies in the Brick industry to be fitted to all buildings. The number of air filters to be fitted is determined on the size of each building. Company A has calculated that it will need 250 air filters to be fitted which costs £15,000 to fit. Legislation was passed on 1 October 2010 and as at 31 December 2010, the company had not fitted the air filters. The FD of Company A has made a provision in the balance sheet amounting to £15,000 on the basis that it is now a legal requirement and that the company will, inevitably, have to fit the air filters.
This provision should not be recognised because at the balance sheet date, no obligating event (the fitting of the air filters) had taken place.
On 31 December 2011, the company had still not fitted the air filters and the director said “the company cannot afford this amount of expenditure and until we are caught, I don’t think we should fit them”. The FD remained sceptical about this and the provision was again recognised.
Again, there is still no obligation because no obligating event has occurred (the fitting of the smoke filters). There could well be good reason 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).
Provisions versus liabilities
Many would argue that a provision is simply a liability. Indeed the effect a provision has on the balance sheet is the same as any other liability, such as trade creditors. However, if you look closely at the detail in FRS 12 it defines a provision as simply ‘a liability of uncertain timing or amount’. In contrast, a liability such as a trade creditor is not of ‘uncertain’ timing or amount. Trade creditors form a separate line item in the balance sheet formats set out in Companies Act 2006 and the only amounts which should be recognised as trade creditors are those liabilities which have been incurred by the company to pay for goods or services which have been supplied or received and for which an invoice has been received from the supplier.
One could also argue that provisions can be classed as accruals. However, Companies Act 2006 specifies two format positions for accruals:
- Accruals and deferred income shown as a separate line item within creditors split between those amounts falling due within one year and amounts falling due after more than one year
- As a separate line item after ‘provisions for liabilities’
Many of us in practice that prepare accounts for clients will make an accrual for things like electricity, telephone, accountancy fees and such like. Ordinarily these estimates are pretty easy to account for by reference to previous bills and making any relevant adjustments. These types of accruals are estimates and to some extent the timing of the payment of such might not be known exactly, but the difference with these types of accruals and provisions is the degree of uncertainty is much less with things like a telephone accrual, than (say) a provision for legal costs in an ongoing dispute.
Contingent assets
Just as contingent liabilities are not provided for, neither are contingent assets. Instead a company will disclose contingent assets in the notes to the financial statements, but only where an inflow of economic benefits is probable. In contrast, FRS 12 requires contingent liabilities to be disclosed but only if the outflow of economic benefits is remote. FRS 12 defines a contingent asset as:
‘A possible asset that arises from past events and whose existence will be confirmed only by the occurrence of one or more uncertain future events not wholly within the entity’s control.’
Figure 4
Charlotte’s Champagne Company is involved in a long-running legal dispute with one of its suppliers. The legal advisers have told Charlotte that she will not successfully defend the case and at the year-end 31 July 2011 Charlotte was in negotiations with her insurance company who have agreed, in principle, to reimburse the costs of the case if Charlotte does not win. Because the case is ongoing, there is no final monetary amount which will be reimbursed, but it is very likely that reimbursement by the insurance company will take place. The financial statements are going to be approved on 30 November 2011 and the legal advisers have told Charlotte that the court hearing will be heard before the financial statements are approved and the insurance company have also confirmed that reimbursement will take place before the financial statements are approved. The question is can Charlotte provide for an asset in respect of the insurance company’s reimbursement?
The answer is yes she can – but paragraph 56 to FRS 12 states that the asset can only be recognised if it is virtually certain at the balance sheet date that reimbursement will be received once Charlotte settles the obligation. FRS 21 Events After the Balance Sheet Date also cites an example involving the settlement of a court case confirming the entity had a present obligation at the balance sheet date, thus a provision for a liability is made. This can also work in the other direction where amounts reimbursed to the company become known after the balance sheet date, hence giving rise to an ‘adjusting event’.
Category: Accounting and standards, Audit
