1. Provisions, Contingent Liabilities and Contingent Assets

2. 6. Specific implications / Next steps
Overview of session
1. Scope of application
2. Key concepts
3. Recognition
4. Measurement
5. Disclosures
6. Specific implications / Next steps
7. Questions

3. Provisions, Contingent Liabilities and Contingent Assets
1. Scope of application

4. Scope
Covers accounting for all provisions and contingencies, excluding:
Social benefits provided by an entity for which it does not receive consideration that is approximately equal to the value of goods or services provided
Provisions resulting from financial instruments carried out at fair value
Provisions arising in relation to income taxes
Employee benefits (except those that arise as a result of a restructuring)
Provisions covered by another IPSAS

5. Provisions, Contingent Liabilities and Contingent Assets
2. Key concepts

6. Legal and constructive obligations
Legal obligation = an obligation that derives from:
A contract (through its explicit or implicit terms); or
Legislation; or
Other operation of law
Constructive obligation = an obligation that derives from an entity’s action where:
By an established pattern of past practice, published policies or sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and
As a result, the entity has created a valid expectation on the part of those other parties that it will discharge its responsibilities.

7. Liabilities and provisions
Liabilities = present obligations (legal or implicit) of the entity arising rom past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits or service potential
Provisions = a special category of liabilities = liabilities of uncertain timing and amount
There must be a clear present obligation from a past obligating event

8. Provisions Write-downs
On the liabilities side
Present obligations resulting from past events
Write-downs
To reduce the carrying value of assets
E.g. write-down of inventories to net realisable value; write-down of property, plant and equipment to recoverable amount
Provisions should not be recognised for future operating losses. An expectation of future operating losses is an indication that certain assets of the operation may be impaired. In this case, an enterprise tests these assets for impairment.

9. Contingent liabilities and contingent assets
Possible obligations that arise 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
Present obligations that arise from past events but are not recognised because:
It is not probable that an outflow of resources embodying economic benefits or service potential will be required to settle the obligation; or
The amount of the obligation cannot be measured with sufficient reliability

10. Contingent liabilities and contingent assets
Contingent assets = possible assets that arise 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
Guarantees = possible assets or liabilities that arise from past events and whose activation will be confirmed by the occurrence or non-occurrence of the object of the guarantee
Guarantees qualify as contingencies

11. Provisions, Contingent Liabilities and Contingent Assets
3. Recognition

12. Provisions - Recognition
A provision should be recognised as a liability in the balance sheet and as an expense in the economic outturn account when:
An entity has a present obligation (legal or constructive) as a result of a past event; and
A reliable estimate can be made of the amount of the obligation; and
It is probable that an economic outflow of economic resources embodying economic benefits or service potential will be required to settle the obligation.

13. Provisions - Recognition
Present
obligation as a result of an obligating event?
Probable
Outflow?
Reliable
estimate?
Possible obligation?
Remote?
Start
Provide
Disclose contingent liability
Do nothing no no
yes
yes no
yes
Decision Tree
yes no no
yes

14. Examples Item True/False
1. Warranties given where some claims are more likely than not
2. Board decision which has not been communicated to those affected
3. Future operating losses
4. Pollution that an entity is obliged to clean up
5. Staff retraining needed as a result of law changes
6. Court case where a loss seems more likely than not
7. Repairs and maintenance
8. Single guarantee for which there is no probable outflow of economic benefits

15. Specific application of recognition criteria
Restructuring provisions
Programme which materially changes scope of business
Following two conditions need to be met to be recorded as provision
Detailed plan identifying key features of programme and its implementation must exist at balance sheet date
Must be valid expectation that business will undergo restructuring
Can only include direct expenses associated with restructuring programme; cannot relate to ongoing operation of business
Example: Relocation of a Directorate or of an Agency

16. Specific application of recognition criteria
Onerous contracts
Unavoidable costs of meeting obligation greater than economic benefits expected to be received
Should include all indirect benefits that are derived from the contract
A provision should be made for the present obligation net of recoveries – the unavoidable costs reflect the least net cost of exiting from the contract, which is the lower of:
The cost of fulfilling it; and
Any compensation or penalties arising from failure to fulfil it.

17. Provisions, Contingent Liabilities and Contingent Assets
4. Measurement

18. Measurement
Best estimate at balance sheet date of amount needed to settle obligation
If range is predicted with all the same likelihood of occurrence, mid point must be selected
Large population of items – expected value measurement
Anticipated cash flows must be discounted at risk free rate where changing value of money over time is material:
Carrying value of liability increases by imputed interest in each period; recognised as interest expense in income statement

19. Measurement – Worked example
A government medical laboratory provides diagnostic scanners with a one-year guarantee for parts and labour.
Experience indicates that 70% of the diagnostic scanners will not be the subject of warranty claims, 25% will have minor defects and 5% will require replacement or major work. 100,000 units were provided in the current year. Major repair or replacing the unit costs approximately 25. Minor repairs cost 5 each.

20. Measurement - Worked example
The estimated warranty expense and the warranty provision should be determined by applying the probability of each outcome to the cost of each outcome as follows:
Expected Value
70% x nil nil
25% x 100,000 x ,000
5% x 100,000 x ,000
Estimated warranty expense 250,000
The warranty provision will be reduced to the extent of costs already incurred in respect of warranty claims on vacuum cleaners sold during the year.

21. Measurement - Worked example
The E.C. have litigation pending. Legal advice is that the E.C. will lose the case, and costs of € 1,200 in two years time are estimated. The appropriate discount rate is 4.5 %.
Economic outturn account
Balance sheet
Discount factor at 4.5%
NPV
Cash flows
Additional costs
At inception
0.9157
1,099 -
Year 1
0.9569
1,148 49
Year 2
1.0000
1,200 52

22. Other issues Reimbursement: Use of provision:
To be recognised when, and only when, it is virtually certain that reimbursement will be received if the entity settles the obligation
The reimbursement should be treated as a separate asset
In the economic outturn account, the expenses relating to a provision may be presented net of the amount recognised for the reimbursement
Use of provision:
A provision should be used only for expenditures for which the provision was originally recognised.

23. Provisions, Contingent Liabilities and Contingent Assets
5. Disclosures

24. Disclosures - Provisions
Key disclosures required:
Accounting policies for each major type of provision (for example, warranties)
Movements in provisions during the period
Descriptions of contingent liabilities and contingent assets

25. Disclosures - Guarantees
Guarantees for pre-financing received for procurement and for grants
Performance guarantees:
“Regular” performance guarantees: disclose
“Specific” guarantees related to performance guarantees: do not disclose but consider as they are automatically activated and are in essence a liability towards the contractor
Guarantees given or received by the DG ECFIN for borrowings and loans
Guarantees received by the DG BUDG when fines are disputed
« Specific » guarantees: 10% deduction from payments made to contractors

26. Provisions, Contingent Liabilities and Contingent Assets
6. Specific implications / Next steps

27. Ensuring compliance with the new rules
Caption
Provision under IPSAS 19?
Comments
Current treatment
Dismantlement of nuclear installations
Yes
Annual estimates
Pensions + employee benefits
Food-and-mouth disease
Minimum in the range of possible outcomes – Maximum possible outcome disclosed
Legal disputes
On a case by case basis

28. Provisions, Contingent Assets and Contingent Liabilities
7. Questions