The organisation I work for make a provision for a future cost that may be incurred as the result of cases being reviewed by an external body. The need for the provision is not in doubt (fulfills criteria of Ias 37) but what intrigues me is the way in which the provision is calculated. I have trawled the internet and books to find an answer to this but have got no where so hope somone can help!
Each case is reviewed by an indipendant panel. A fee is determined before the review. If the panel grant the payment the payment must be made in full at the predetermined amount, if not no fee is paid.
Before each review a case worker asses the likelyhood of the payment being granted (as apercentage) and this is used to determine whether a provision should be made or not. Currently if the percentage is over 50% my organisation takes this percentage and times it by the predetermined fee and makes a provision to this affect. Example below,
Example 1
75% chance of paying, pre determined fee 100k, Provision 75K
My argument is that the percentage likelyhood of payment has no correlation to the the fee as this is predetermined. Therefore it does not matter if the percentage likelyhood is anything from 50-99% when the provision is calculated it should be the full predetermined amount. Example below,
Example 2
55% chance of paying (therefore a provision must be made), pre determined fee 100k, provision 100k
Which method is the correct way to calculate the provision?
Many thanks
Dale
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Replies (6)
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FRS12
Have you read FRS12 which is the UK bible on the subject? In my opinion £75k and £55k are the correct amounts to provide for.
I used to account for some very large nuclear provisions, but my role changed just as FRS12 came in. It is understood with nuclear decommissioning and waste treatment that there are a very wide range of possible values, in some cases unfortunately the cash flows are 200 years or more in the future.
But one central number goes on to the balance sheet. And yes, it is in essence the most likely scenario.
"The amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date."
FRS12 came into being precisely to prevent the approach you are potentially suggesting, where you simply aggregate the worst case scenarios and end up with a total number which is likely to be much greater than the total payment actually needed. Hence for the - typically - PLCs which were doing this, they could drip feed the surplus back into the P&L and flatter their operating results for 2 to 3 years.
Not so sure
I'm not so sure that FRS 12 is so prescriptive on the way to calculate the correct provision. That tends to be the nature of accounting standards, that they act more as guidance rather than as a specific formula. But I'm happy to be corrected by others more knowledgeable.
I have seen provisions under IAS calculated exactly as you describe. If you think about it, the two methods you describe aren't that different:
Option A: Provide for each case at the percentage likelihood that it will be payable, e.g. 60% of £8,000 + 40% of £12,000 = £9,600.
Option B: Provide in full but only for cases that are more that are more than 50% likely to be paid, e.g. 100% of £8,000 + 0% of £12,000 = £8,000.
The more cases you have, the more likely Option A and Option B are likely to come out to a similar number. As long as the method is applied consistently, I wouldn't have a problem with either method.
I agree with thisistibi
The OP has indicated that his organisation is reporting under IFRS, and so the relevant standard is IAS 37 as was referred to in his query. It is though broadly consistent with FRS 12.
In line with thisistibi's comments above, your methodology does seem consistent with paragraph 39 of IAS 37:
"Uncertainties surrounding the amount to be recognised as a provision are dealt with by various means according to the circumstances. Where the provision being measured involves a large population of items, the obligation is estimated by weighting all possible outcomes by their associated probabilities. The name for this statistical method of estimation is ‘expected value’. The provision will therefore be different depending on whether the probability of a loss of a given amount is, for example, 60 per cent or 90 per cent. Where there is a continuous range of possible outcomes, and each point in that range is as likely as any other, the mid-point of the range is used."
Logically….
“Currently if the percentage is over 50% my organisation takes this percentage and times it by the predetermined fee and makes a provision to this affect.”
On basic stats, this will always give a result that is too low as some of the cases reviewed as having under a 50% chance of losing will be lost. So if the “chance of losing” is used to work out the likely cost of a case, it should not also be used to decide the cases to include.
Thankyou all for your comments It seems this is an area with little direct instruction. I personally take the view highlighted by ringi above.
Be careful, I am not an accountant...
Thankyou all for your comments It seems this is an area with little direct instruction. I personally take the view highlighted by ringi above.
Dale,
Be careful, I am not an accountant; I am a computer programmer that works on software with high stats contents. So my answer was based on logic not accounting standards!