Provisions and contingencies: Part 2
This is the second of a two-part article on provisions and contingencies. Part 1 dealt with provisions and their recognition and how a legal and constructive obligation may be created. This article will examine contingent liabilities and contingent assets.
To recap, provisions and contingencies are dealt with in FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland in Section 21 Provisions and Contingencies. FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime deals with provisions and contingencies in Section 16 Provisions and Contingencies.
Contingent liabilities
A ‘contingent liability’ is defined as follows:
| A contingent liability is either:
a) a possible obligation 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 within the control of the entity; or b) a present obligation that arises from past events but is not recognised because: I. it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or II. the amount of the obligation cannot be measured with sufficient reliability. |
Contingent liabilities are not recognised in the financial statements because they fail to meet the recognition criteria for a provision. There is, however, one exception to this recognition rule which applies to contingent liabilities that have been assumed by the acquirer of an acquiree in a business combination provided its fair value can be measured reliably and for which FRS 102, paras 19.20 and 19.21 apply (FRS 102, Section 19 deals with business combinations and goodwill).
Contingent liabilities are disclosed in the notes to the financial statements if they are material unless the possibility of an outflow of economic benefit resources is remote. The term ‘remote’ is not defined in FRS 102 but should be taken to mean the event is not expected to occur even though it cannot be ruled out completely.
| Example – Contingent liability |
| Breary Ltd has made a provision for damages amounting to £150,000 in its financial statements for the year ended 30 September 2021 in respect of a legal claim brought against the company by one of its customers for non-compliance with contractual terms of a service contract.
The legal advisers have advised the company that at the reporting date, they are uncertain as to the potential outcome of the case because the wording of the contract has been poorly drafted. The case is material to the company. Breary Ltd should not recognise a provision for damages because it is not ‘probable’ (defined in FRS 102 as ‘more likely than not’) that an outflow of resources will be required to settle the case. The legal advisers are unsure as to the outcome of the case. In such situations, disclosure of a contingent liability in the notes to the financial statements must be made because the case is considered material to the company. |
Contingent assets
A ‘contingent asset’ is defined as:
| 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 within the control of the entity. |
A contingent asset is not reflected in the financial statements of the reporting entity. A contingent asset will only become a recognised asset in the financial statements if its receipt is ‘virtually certain’ (for example, an insurance company agreeing to pay out a claim to the company). This essentially means that the company must have been told they will receive the reimbursement which can be confirmed by way of written correspondence or through tracing to an after-date cash receipt.
Keep in mind that the recognition criterion for a reimbursement asset (i.e. the virtually certain test) is stricter than that of a provision for a liability (which only has to be ‘probable’) because of the underpinning principle in financial reporting that assets cannot be stated in an entity’s balance sheet in excess of recoverable amount.
Offsetting provisions for liabilities and reimbursement assets
FRS 102, para 2.52 states:
| An entity shall not offset assets and liabilities, or income and expenses, unless required or permitted by an FRS.
a) Measuring assets net of valuation allowances (for example, allowances for inventory obsolescence and allowances for uncollectible receivables) is not offsetting. b) If an entity’s normal operating activities do not include buying and selling fixed assets, including investments and operating assets, then the entity reports gains and losses on disposal of such assets by deducting from the proceeds on disposal the carrying amount of the asset and relating selling expenses. |
There may be occasions when a company must recognise a provision for liabilities in its financial statements as the recognition criteria have been met, but that liability will be reimbursed by a third party (such as an insurance company).
In these cases, it is important that the entity recognises the asset and the liability separately; they must not be offset in the balance sheet because this would mean assets and liabilities are both understated; thus, presenting a misleading financial position.
FRS 102, para 2.52 states ‘… unless required or permitted by an FRS.’ FRS 102, para 21.9 does allow the expense relating to the provision in the profit and loss account to be offset, thus presenting the expense net of the reimbursement in the profit and loss account rather than showing the related expense gross with a related component of income.
Prejudicial disclosures
The disclosure requirements in respect of provisions and contingencies are found in FRS 102, paras 21.14 to 21.17A. There are detailed disclosures required to be made in the financial statements where provisions and contingencies are concerned. Understandably, some reporting entities may be reluctant to make certain disclosures, particularly where the provision or contingency is the subject of a legal case. This is where the prejudicial disclosures paragraph in FRS 102, para 21.17 may be applied, but it must only be applied in limited situations.
It may be the case that providing the disclosures required by FRS 102, 21.14 to 21.16 could be expected to seriously prejudice the position of the entity involved in a dispute with other parties on the subject matter of the provision, contingent liability, or contingent asset. In some cases, lawyers may advise against making the full disclosure requirements of FRS 102, Section 21.
FRS 102, para 21.17 states:
| In extremely rare cases, disclosure of some or all of the information required by paragraphs 21.14 to 21.16 can be expected to prejudice seriously the position of the entity in a dispute with other parties on the subject matter of the provision, contingent liability or contingent asset. In such cases, an entity need not disclose all of the information required by those paragraphs insofar as it relates to the dispute but shall disclose at least the following. |
The paragraph then sets out the disclosure requirements which are set out below.
It is worth noting that FRS 102, para 21.17 is heavily restrictive in that it says, ‘In extremely rare cases …’. The term ‘extremely rare cases’ is not defined in FRS 102 and in real life, there are a wide range of circumstances where entities may be in negotiation with third parties in respect of a provision, contingent liability or contingent asset.
The key point to emphasise is that paragraph 21.17 concerns disclosure requirements only. It follows, therefore, that paragraph 21.17 does not exempt a reporting entity from recognising a provision for a liability in the financial statements. It might also be the case that a provision for liability is reimbursed from a third party (such as an insurance company) and where this is the case and a reimbursement asset has been recognised on the grounds that its receipt is virtually certain, the prejudicial disclosure exemption may extend to the reimbursement asset.
The prejudicial disclosure exemption will not be available in respect of the provision, contingent liability, or contingent asset once the dispute has been resolved.
Prejudicial disclosures: provisions
FRS 102 requires at least the following where provisions are covered by the prejudicial disclosure exemption:
| a) a table showing the reconciliation required by paragraph 21.14(a) in aggregate, including the source and application of any amounts transferred to or from provisions during the reporting period;
b) particulars of each provision in any case where the amount of each provision is material; and c) the fact that, and reason why, the information required by paragraph 21.14 has not been disclosed. |
Prejudicial disclosures: contingent liabilities
FRS 102 requires at least the following where contingent liabilities are covered by the prejudicial disclosure exemption:
| a) particulars and total amount of any contingent liabilities (excluding those which arise out of insurance contracts) that are not included in the statement of financial position;
b) the total amount of contingent liabilities which are undertaken on behalf of or for the benefit of: I. any parent or fellow subsidiary of the entity; II. any subsidiary of the entity; or III. any entity in which the reporting entity has a participating interest, shall be stated separately; and c) the fact that, and reason why, the information required by paragraph 21.15 has not been disclosed. |
Prejudicial disclosures: contingent assets
FRS 102, para 21.17 requires an entity to disclose the general nature of the dispute, together with the fact that, and the reason why, the information required by paragraph 21.16 has not been disclosed.
Conclusion
The issues surrounding provisions and contingencies can be complex and it important that professional judgement is correctly applied when dealing with such issues to ensure that a provision is appropriately recognised or that a contingency is adequately disclosed.
Category: Accounting and standards, Audit
