By Alok Jain, Contributor
THE INSTITUTE of Chartered Accountants of Jamaica (ICAJ) has adopted International Accounting Standards (IAS), now termed International Financial Reporting Standards (IFRS), as Jamaica's national accounting standards for accounting periods beginning on or after July 1, 2002. Continuing the series on IAS, this article examines the main aspects of IAS 37, Provisions, Contingent Liabilities and Contingent Assets.
IAS 37 is one of the standards likely to have a significant impact on Jamaican companies as there was no comparable standard under Jamaican Accounting Standards.
IAS 37 sets out strict criteria for the recognition and measurement of provisions. The key principle is that a provision should be recognised in the financial statements only when there is a liability i.e. a present obligation resulting from past events. Mere plans to incur expenditure in the future are excluded from recognition, even where authorised by the board of directors. Definitions and Scope
The standard defines a provision as "a liability of uncertain timing or amount". Many asset adjustments such as bad debts, depreciation and impairment of assets are often loosely described as 'provisions'. These are not provisions for the purposes of this standard.
A contingent liability is:
a possible obligation whose existence will be confirmed only by one or more uncertain future events; or
a present obligation that is not recognised because payment is not probable or the amount cannot be measured with sufficient reliability. A contingent asset is a possible asset that arises from past events whose existence will be confirmed only by one or more uncertain future events not wholly within the control of the enterprise.
The standard applies to all provisions, contingent liabilities and contingent assets excluding:
those resulting from financial instruments that are carried at fair value;
those resulting from executory contracts, except where the contract is onerous;
those arising in insurance enterprises from contracts with policyholders; and
those covered by another IAS (for example, construction contracts, income taxes, leases and employee benefits).
RECOGNITION CRITERIA
IAS 37 sets out three criteria that must be met before a provision can be recognised. A provision should be recognised when, and only when:
the entity has a present obligation (legal or constructive) as a result of a past event;
it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
a reliable estimate can be made of the amount of the obligation. The past event that leads to a present obligation is called an 'obligating event'. An obligating event must create a legal or constructive obligation, leaving the entity with no realistic alternative but to settle the obligation. A legal obligation is an obligation that derives from a contract, legislation or other operation of law. A constructive obligation derives from an entity's actions where, by an established pattern of past practice or a sufficiently specific current statement, the entity indicates to other parties that it will accept certain responsibilities and, as a result, creates a valid expectation on their part that it will discharge those responsibilities.
IAS 37 emphasises that if there is an obligation on the part of the entity, there must be a corresponding entitlement of another party. Those other parties need not, however, be specifically identified; they might be a class of individuals or enterprises sharing certain characteristics. It follows, therefore, that those qualifying characteristics must be sufficiently specific and publicly communicated so that potentially qualifying parties are aware of that fact as at the balance sheet date. Without such communication, management's intention, or even a decision of the board of directors, is not sufficient to give rise to a constructive obligation.
An outflow of resources is regarded as probable if it is 'more likely than not' to occur. This is normally interpreted to mean that anything above a 50 per cent probability qualifies for recognition. Judgement and prudence will clearly come into play, particularly in close calls around the 50 per cent mark.
MEASUREMENT
The standard requires that the provision recognised should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date. In arriving at this estimate, the surrounding risks and uncertainties should be taken into account.
Provisions for one-off events (e.g. settlement of a law suit, environmental clean-up) should be measured at the most likely amount while provisions for large populations of items (e.g. warranties) should be measured by weighting all possible amounts by their associated probabilities (expected value).
Provisions should be determined on a discounted cash flow basis, where the effect is material. The discount rate used should be a pre-tax rate reflecting current market assessments of the time value of money and the risks specific to the liability.
Where discounting is used, the carrying amount of a provision will increase in each period to reflect the passage of time. This 'unwinding of the discount' has the effect of converting provisions into interest-bearing liabilities.
Where some or all of the expenditure required to settle a provision is expected to be recovered from a third party, typically an insurance company, IAS 37 is clear that reimbursements should not be taken into account unless they are virtually certain.
If they are virtually certain, an asset should be separately recognised and not deducted from the provision, unless a legal right of set-off exists.
Provisions should be reviewed at each balance sheet date and adjusted to reflect the current best estimate. If an outflow of resources is no longer probable, the provision should be reversed.
RESTRUCTURING PROVISIONS
A restructuring as a programme that is planned and controlled by management that materially changes either the scope of a business or the manner in which the business is conducted.
A provision for restructuring costs is recognised only when the three general recognition criteria for provisions set out above have been met. IAS 37 provides guidance on applying these criteria to restructurings. A constructive obligation to restructure arises only when an entity:
has a detailed formal plan for the restructuring; and
has raised a valid expectation in those affected that it will carry out the restructuring by starting to implement that plan or announcing its main features to those affected by it.
The detailed formal plan must, at a minimum, identify the business or part of a business concerned, the location, function, and approximate number of employees who will be compensated for terminating their services, the expenditures that will be undertaken, and when the plan will be implemented.
Although the standard does not specify the maximum period that may elapse either prior to the implementation or completion of the plan, as the time-frames lengthen, it becomes more difficult to meet the test because the time-frame allows opportunities for the entity to change its plans.
The key issue here is whether there is a valid obligation at the balance sheet date from which the entity cannot realistically withdraw. If the time-frame for the plan's implementation is lengthy, it is unlikely that the plan can initially be specific enough to make a provision for the proposed restructuring.
A restructuring provision should include only the direct expenditures arising from the restructuring i.e. those necessarily entailed by the restructuring and not associated with the ongoing activities of the entity.
CONTINGENCIES
Contingent liabilities and contingent assets should not be recognised. Contingent liabilities should be disclosed unless the possibility of an outflow of resources is remote. Contingent assets should be disclosed where an inflow of economic benefits is probable.
DISCLOSURE
The main disclosures required are as follows:
Reconciliation of opening balance and closing balance for the year, for each major class of provision. A comparative prior year reconciliation is not required.
For each class of provision, a brief description of the nature, expected timing, major uncertainties and assumptions, expected reimbursements including any asset recognised.
For each class of contingent liability or contingent asset, a brief description of the nature and estimate of financial effect.
Alok Jain is a partner at PricewaterhouseCoopers (PwC) in Kingston, Jamaica. He is a Chartered Accountant and a US Certified Public Accountant. This article contains general information only; it is not a substitute for consultation with a professional. For further information, questions, or comments, e-mail: alok.jain@jm.pwcglobal.com. For reprints of this article visit PwC Jamaica's IAS Resource Centre at www.pwcglobal.com/jamaica
