In order to recognize a provision [and record it on the books as opposed to only disclosing it in footnotes], certain conditions [as discussed on my previous post: Recognition and Measurement of Provision] need to be satisfied. However, when one of the prescribed conditions is not satisfied, then a provision cannot be recognized. It is then a contingent liability and needs to be disclosed in footnotes, unless the probability of the outflow embodying economic benefits is remote [in which case it does not even have to be disclosed]. I have talked about recognition and measurement of provision [IAS 37] on my previous post. I ought to discuss the contingent liabilities and assets as well. I hope it enriches your knowledge and brings a complete understanding to the IAS 37.

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Contingent liability is a possible obligation arising from past events, the outcome of which will be confirmed only on the occurrence or nonoccurrence of one or more uncertain future events. A contingent liability is also a present obligation that is not recognized, either because it is not probable that an outflow of resources will be required to settle an obligation or the amount of the obligation cannot be measured with sufficient reliability.

Once recognized as a contingent liability, an entity should continually assess the probability of the outflow of the future economic benefits relating to that contingent liability. If the probability of the outflow of the future economic benefits changes to more likely than not, then the contingent liability may develop into an actual liability and would need to be recognized as a provision.

 

 

Disclosures Of Contingent Liabilities

Unless the possibility of any outflow is remote, for each class of contingent liability an entity should disclose at the balance sheet date a brief description of the nature of the contingent liability and, where practicable:

  • An estimate of its financial effect;
  • An indication of the uncertainties relating to the amount or timing of any outflow; and
  • The possibility of any reimbursement.

 
Where any of the information required above is not disclosed because it is not practicable to do so, the fact should be disclosed.

In extremely rare circumstances, when disclosure of any or all the above information is considered to be seriously prejudicial to the position of the entity in a dispute with other parties on the subject matter of the contingent liability, an entity need not disclose the information but should disclose the general nature of the dispute, together with the fact that, and reason why, the information has not been disclosed.

 

Case Example:

Amazon Inc. has been sued for following three alleged infringements of law:

[1] Unauthorized use of a trademark; the claim is for $100 million

[2] Nonpayment of end-of-service severance pay and gratuity to 5,000 employees who were terminated without Amazon Inc. giving any reason; the class action lawsuit is claiming $3 million

[3] Unlawful environmental damage for dumping waste in the river near its factory; environmentalists are claiming unspecified damages as cleanup costs Legal counsel is of the opinion that not all the legal cases are tenable in law and has communicated to Amazon Inc. This assessment of the three lawsuits:

Lawsuit 1: The chances of this lawsuit are remote.

Lawsuit 2: It is probable that Amazon Inc. would have to pay the displaced employees, but the best estimate of the amount that would be payable if the plaintiff succeeds against the entity is $2 million.

Lawsuit 3: There is no current law that would compel the entity to pay for such damages. There may be a case for constructive obligation, but the amount of damages cannot be estimated with any reliability.

The question is: What should be the provision that Amazon Inc. should recognize or the contingent liability that it should disclose in each of the lawsuits, based on the assessments of its legal counsel?

 

Here are the answers:

  • Lawsuit 1: Because the probability of an outflow of economic benefits is remote, no provision or disclosure is required.
  • Lawsuit 2: Because it is probable [“more likely than not”] that Amazon Inc. would ultimately have to pay the dues to the displaced employees and the best estimate of the settlement is $2 million [as against the claim of $3 million], Amazon Inc. would have to make a provision for $2 million.
  • Lawsuit 3: There is no legal obligation, but there is a constructive obligation. However, an estimate of the obligation with reasonable reliability is not possible. Hence this qualifies for disclosure as a contingent liability because it cannot be recognized as a provision [as it does not meet all the prescribed conditions for recognition of a provision].

 

 

Contingent Assets [Possible Assets]

Contingent assets are possible assets that arise from a past event and whose existence is confirmed only by the occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of the entity.

 

Interpretation Of IAS 37 [IFRIC]

IFRIC Interpretation 1IFRIC 1 is titled Changes in Existing Decommissioning, Restoration and Similar Liabilities. IAS 37 contains requirements on how to measure decommissioning, restoration, and similar liabilities. IFRIC 1 provides guidance on how to account for the effect of changes in the measurement of existing decommissioning, restoration, and similar liabilities. This IFRIC interpretation addresses the issue of how the effect of a change in the current market-based discount rate [as defined in IAS 37] should be accounted for. According to the “consensus,” the periodic unwinding of the discount shall be recognized in profit or loss as a finance cost as it occurs. [The allowed alternative treatment of capitalization of borrowing costs under IAS 23 is not permitted].

 

IFRIC Interpretation 5This interpretation applies to accounting in the financial statements of a contributor for interests arising from decommissioning funds. As per the “consensus,” the contributor shall recognize its obligation to pay decommissioning costs as a liability and recognize its interest in the fund separately unless the contributor is not liable to pay decommissioning costs even if the fund fails to pay. Further, if the contributor does not have control, joint control, or significant influence over the fund, the contributor shall recognize the right to receive reimbursement from the fund as a reimbursement in accordance with IAS 37. This reimbursement should be measured at the lower of:

  • The amount of decommissioning obligation recognized; and
  • Contributor’s share of fair value of the net costs of the fund attributable to contributors.

 

In case a contributor has an obligation to make additional contributions [e.g., in the event of the bankruptcy of another contributor], this obligation is a contingent liability that is within the scope of IAS 37, which shall be disclosed as per disclosure requirements of IAS 37.

IFRIC Interpretation 6 – The European Union’s Directive on Waste Electrical and Electronic Equipment [WE & EE] has given rise to questions about when the liability for the decommissioning of “WE & EE” shall be recognized. This Interpretation provides guidance on the recognition of liabilities for waste management under this EU Directive.

IFRIC was asked to determine in the context of the decommissioning of “WE & EE” as to what constitutes the “obligating event” in accordance with IAS 37. Whether:

[a] it is “manufacture or sale of the historical household equipment”; or

[b] it is “the participation in the market during the measurement period”; or

[c] it is the “incurrence of costs in the performance of waste management activities”; and

as per the “consensus” [b] above triggers the “obligating event” under IAS 37 at which point a liability has to be recognized.

 

Disclosures Of Contingent Assets [Possible Assets]

Where inflow of economic benefits is probable, an entity should disclose a brief description of the nature of the contingent assets at the balance sheet date and, where practicable, an estimate of their financial estimate.

Where any of the information required above is not disclosed because it is not practicable to do so, the fact should be disclosed.

 

In extremely rare circumstances, when disclosure of any or all the above information is considered to be seriously prejudicial to the position of the entity in a dispute with other parties on the subject matter of the contingent asset, an entity need not disclose the information but should disclose the general nature of the dispute, together with the fact that, and reason why, the information has not been disclosed.

 

Case Example:

A Singapore-based shipping company lost an entire shipload of cargo valued at $5 million on a voyage to Australia. It is, however, covered by an insurance policy. According to the report of the surveyor the amount is collectible, subject to the deductible clause [i.e., 10% of the claim] in the insurance policy. Before year-end, the shipping company received a letter from the insurance company that a check was in the mail for 90% of the claim.

The international freight forwarding company that entrusted the shipping company with the delivery of the cargo overseas has filed a lawsuit for $5 million, claiming the value of the cargo that was lost on high seas, and also consequential damages of $2 million resulting from the delay. According to the legal counsel of the shipping company, it is probable that the shipping company would have to pay the $5 million, but it is a remote possibility that it would have to pay the additional $2 million claimed by the international freight forwarding company, since this loss was specifically excluded in the freight forwarding contract.

The question is: What provision or disclosure would the shipping company need to make at year-end?

 

The shipping company would need to recognize a contingent asset of $4.5 million [the amount that is virtually certain of collection]. Also it would need to make a provision for $5 million toward the claim of the international freight forwarding company. Because the probability of the claim of $2 million is remote, no provision or disclosure would be needed for that.