Audit and Technical Partner Leavitt Walmsley Associates Ltd
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Provisions and contingencies: Get the details right, part 1

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Provisions and contingencies have moved up the ranks of importance recently. In the first of a two-part article examining provisions, Steve Collings explores the requirements for provisions and contingencies outlined in FRS 102 and FRS 105.

2nd Nov 2021
Audit and Technical Partner Leavitt Walmsley Associates Ltd
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In practice, provisions and contingencies lend themselves to some common pitfalls. In addition, the Financial Reporting Council recently issued a Thematic Review of IAS 37 Provisions, Contingent Liabilities and Contingent Assets which highlights some areas that have caused issued for IFRS reporters. The feedback in this Thematic Review can be taken on board by UK GAAP reporters.

FRS 102 defines a ‘provision’ as:

A liability of uncertain timing or amount.

The fact that there is uncertainty in respect of the timing and amount of the liability is what distinguishes a provision from a normal liability. If the provision subsequently becomes certain in terms of its timing and amount, it is reclassified as a liability (such as a trade creditor or sundry creditor).

Recognition criteria

There are three criteria which must be met before a provision can be recognised in the financial statements:

  1. The entity must have a present obligation that has arisen because of something that has occurred in the past.
  2. It is more likely than not that the entity will have to transfer some economic benefit (eg cash or another form of asset) to settle the obligation.
  3. The amount of the obligation can be measured with some degree of reliability (ie a reliable estimate can be made).

Where any of the above criteria cannot be met, a provision is not recognised in the financial statements. Instead, a contingent liability will be disclosed (if material). 

Creation of an ‘obligation’

Not all obligations will give rise to a provision being recognised in the financial statements. Only those obligations which exist at the balance sheet date that have arisen because of a past event and can be reliably measured will give rise to a provision.

This means that the reporting entity has no realistic alternative to settling the obligation which can be created in one of two ways:

  • by way of a legal obligation; or
  • by way of a constructive obligation.

Legal obligation

A legal obligation is one which can be enforced by law. It will usually be obvious when a company has a legal obligation; for example, by way of an agreement or a court order.

Provisions can also be made for normal day-to-day transactions, such as a provision for goods and/or services received by the period/year end but not yet invoiced, such as an accrual.

A business cannot base a provision on its future actions. FRS 102, para 21.6 is strict on its approach to an entity’s future actions because such actions do not meet the definition of a provision.

The entity has not got an obligation at the balance sheet date for its future actions, regardless of how likely or unlikely they are to occur. An obligation arises because of an obligating event and hence it follows that the obligating event must have occurred at, or by, the balance sheet date to give rise to a provision.

Constructive obligation

Constructive obligations are less straightforward. A constructive obligation arises when an entity creates an expectation in the mind-sets of others that it will discharge its obligations.  This usually arises because of the entity’s past practices, published policies or by way of a specific statement.

Example – Constructive obligation

Sunnie Ltd operates a chain of hotels that has been severely impacted by the pandemic and is struggling to recover. Its year end is 31 October 2021.

Due to increasing cashflow difficulties, management took the decision on 10 October 2021 to make 20% of its workforce redundant in November 2021. It made the announcement to the staff concerned on 20 October 2021 and the payroll provider calculated the costs of terminating the relevant staff members’ employment.

Sunnie Ltd has a constructive obligation as it has announced to those staff affected that it will be making them redundant and hence the staff will expect the company to discharge its obligations (ie pay them the costs of terminating their employment).

The redundancies will result in an outflow of economic benefits in the form of redundancy payments and the payroll department is able to reliably estimate the amount of the obligation. In this example, Sunnie Ltd must recognise a provision in the 31 October 2021 financial statements as it has a constructive obligation.

Steve Collings will be speaking about financial reporting at AccountingWEB Live Expo. Register now to get the latest on FRS 102 and FRS 105

Onerous contracts

An ‘onerous contract’ is defined in the glossary to FRS 102 as:

A contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.

The unavoidable costs under a contract reflect the least net cost of exiting from the contract. This is the lower of the cost of fulfilling the contract and any compensation or penalties arising from a failure to fulfil it.

Example – Onerous contract in the Covid-19 pandemic

Morley Ltd is in the manufacturing industry. It has a contract with a major customer to sell certain products at a fixed price. Due to the impact of Covid-19, it had to close its manufacturing division and could not deliver the goods itself without purchasing them from another supplier at a significantly higher cost.

In this example, the provision for the onerous contract will reflect the lower of the penalty for terminating the contract or the present value of the cost of fulfilling the contract. This is the excess of the cost to purchase the goods over the consideration to be received. 

If, on the other hand, the contract could be cancelled due to the pandemic without paying any compensation to the other party, the contract does not become onerous and there is no obligation.

Restructuring provisions

A ‘restructuring’ is defined in FRS 102 as follows:

A restructuring is a programme that is planned and controlled by management and materially changes either:
  1. the scope of a business undertaken by an entity; or
  2. the manner in which that business is conducted.

A restructuring gives rise to a constructive obligation only when the entity:

  • has a detailed formal plan for the restructuring which identifies at least:
    • the business (or part thereof) concerned;
    • the principal locations affected;
    • the location, function and approximate number of employees who will be compensated for terminating their services;
    • the expenditure that will be undertaken; and
    • when the plan will commence; and
  • has raised a valid expectation in those affected that the entity will carry out the restructuring by starting to implement it or by announcing its main features.

Example – Creation of a constructive obligation in a restructuring plan

Dexter Ltd has five branches spread across the UK and the company has an accounting reference date of 30 September. Over the last two years the depots in Stratford and Warrington have been sustaining heavy losses and were closed during the height of the pandemic. Since reopening both depots have sustained month-on-month losses and the directors have taken the decision to transfer operations to its head office located in Edinburgh. This decision was taken by the board on 16 September 2021.

The restructuring plan was communicated to all staff in the Stratford and Warrington depots on 17 September 2021 and staff were given redundancy notices. Both depots will close on 1 November 2021 and the payroll department has been able to calculate the value of the termination payments that will be paid to those staff who will be made redundant.

In addition, the depot in Warrington is rented via an operating lease and the agreement is due to end on 31 October 2023. The landlord of the premises has agreed that Dexter Ltd can terminate the lease on 1 November 2021 provided they pay an early termination fee of £35,000 to which the directors have agreed.

A provision for restructuring should be made in the 30 September 2021 financial statements for the total amount of the termination costs which the company will incur in closing both depots.

In addition, the company should also make a provision for the £35,000 early termination fee which is to be paid to the landlord of the Warrington branch as this represents the minimum expected obligation and arises as a direct result of the restructuring. This is because a valid expectation has been created in the mind-sets of those affected (the employees and the landlord) that the company will discharge its obligations.

Recognition of a provision in the financial statements

FRS 102 says that where a provision meets the recognition criteria, it must be recognised at the best estimate of the amount that will be required to settle the obligation. FRS 102, para 21.7 clarifies that the ‘best estimate’ is the amount an entity would rationally pay to settle the obligation at the balance sheet date, or to transfer it to a third party at that time.

As a provision is an estimate of the amount that an entity would rationally pay to settle or transfer the obligation, it does not have to be recognised in respect of actual cash outflows. Instead, the provision is recognised at the amount that could be settled in respect of liabilities arising at the balance sheet date.

When a provision involves a large population of items, the estimate must reflect the weighting of all possible outcomes by their associated probabilities.

Example – Provision for defective goods

Bolton Ltd is a well-established company selling electrical products such as dishwashers, washing machines, TV, and audio equipment. It sells its products to the public with a warranty which covers customers for the costs of repair that occur during the first six months from the date of purchase. 

The company is preparing its financial statements for the year ended 30 September 2021 and calculations carried out by the financial controller suggest that if all the products sold contained minor defects, the costs of repair would be £1m. If major defects occurred in all the products, the costs of repair would be £4m.

Management have concluded that past experience, and future expectations, suggest that for the coming year 75% of the goods sold will contain no defects; 20% will contain minor defects and 5% will have major defects. 

Example – Provision for defective goods

Bolton Ltd is a well-established company selling electrical products such as dishwashers, washing machines, TV, and audio equipment. It sells its products to the public with a warranty which covers customers for the costs of repair that occur during the first six months from the date of purchase. 

The company is preparing its financial statements for the year ended 30 September 2021 and calculations carried out by the financial controller suggest that if all the products sold contained minor defects, the costs of repair would be £1m. If major defects occurred in all the products, the costs of repair would be £4m.

Management have concluded that past experience, and future expectations, suggest that for the coming year 75% of the goods sold will contain no defects; 20% will contain minor defects and 5% will have major defects. 

The provision for the year is calculated as follows:                                                             £

75% x nil                                            nil

20% x £1 million                          200,000

5% x £4 million                            200,000

Total provision                            400,000

Assuming the provision brought forward was £350,000, the entries to record the movement are:

  • Dr Profit and loss                £50,000
  • Cr Provisions for liabilities £50,000

Example – Single obligation

Wanderers Ltd is preparing its financial statements for the year ended 30 September 2021. A customer has made a claim for losses against Wanderers Ltd. The legal advisers acting for Wanderers have said there is 40% chance of successfully defending the claim with no costs or damages to pay, but there is a 60% chance that Wanderers will have to pay costs of £500,000 due to the wording of the contract.

Wanderers would not be able to use an expected value in this example, ie £300,000 (£500,000 x 60%) because the legal advisers have stated that they will either successfully defend the claim with no costs to pay or be found liable and have costs to pay of £500,000. Hence the results are either £nil or £500,000.

As it is more likely than not that Wanderers will have to pay costs of £500,000, this should be the value of the provision in the financial statements as at 30 September 2021.

Conclusion

This article has considered some of the more notable aspects of dealing with provisions. Importantly, the three recognition criteria must be met before a provision is recognised and if these criteria cannot be met, no provision is included in the financial statements. The next article in this series will examine contingent assets and contingent liabilities.

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Steve Collings looks back at the highlights of financial reporting in 2021 plus previews 2022 at AccountingWEB Live Expo.

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