Sarah Ardiles and Tom Clendon have a head to head on a subject that often causes confusion among students.
Sarah sets the scene
I was helping a student the other day regarding accounting for provisions. They had been looking at the relevant standard IAS 37 Accounting for Provisions, Contingent Liabilities and Contingent Assets and they were confused.
First of all, I had to clear up that the standard was not about providing for depreciation nor providing for bad debts; rather the standard was giving guidance on when, and how to provide for a liability. In this context a provision is defined as a liability of uncertain timing or amount. A good example where a provision might be recognised is where the business is being sued for damages following a breach of contract.
Tom chips in
The standard sets out there are three conditions that all have to be met before a provision for a liability can be recognised. An entity must recognise a provision if, and only if:
- a present obligation (legal or constructive) has arisen as a result of a past event (the obligating event),
- payment is probable, and
- the amount can be estimated reliably.
Now as you well know Sarah, students can sometimes rote learn these conditions without really understanding their meaning. How do you go about explaining what is really meant by the term “constructive obligation”?
Sarah explains constructive obligation
A constructive obligation is a little bit like a very serious promise! Legally you do not have to go through with it but if you don’t then there is a loss of face and credibility.
Let’s consider the example of a board of directors who decided to reorganise the business and as a result, will incur costs of $10 million. Under what circumstances can these costs be provided for?
In order for there to be a constructive obligation, prior to the year-end there needs to be a valid expectation that the company will go through with this reorganisation and incur these costs. This expectation could be created by a detailed public announcement explaining that the reorganisation will take place. It is this public announcement, the past obligating event, that creates the valid expectation that the reorganisation costs will be incurred. By making public their plans to restructure, the directors have a constructed an obligation which must be provided for at the reporting date in the form of a liability (a provision).
But I also find Tom, that some students can struggle with the idea that for a provision to be recognised, the likelihood of payment must be considered ‘probable’.
Tom explains probable
Probable simply means that it is more likely than not; that there is a greater than 50% chance that it will happen. This can require judgment. For example, I think that it is probable that come the end of the football season Manchester City will be crowned premiership football champions again! Thus, if a Manchester City player was contracted to receive a bonus in that event, then a liability should be recognised. However, if it were judged that it was only possible that such a payment would be made then no liability would be provided for and instead there would be a disclosure in the notes of this contingent liability.
Sarah follows up
The standard takes an “all or nothing approach” to recognising provisions – and I think that can potentially confuse students too.
Yes, it can do Sarah. I explain that either there is a liability to be recognised, in which case it is recognised in full, or there is not a liability – in which case nothing is recognised. I suppose it is a bit like being pregnant – you are, or you are not!
Thus, if the company is being sued for $20 million and is advised that there is an 80% chance that the monies will have to be paid, then the probability criteria is met and a provision of $20 million is recognised. We don’t provide for $16 million (80% x $20 million). After all, the obligation will not be settled at $16 million.
This all or nothing approach though is at odds with the fair value approach as to how liabilities are measured on the acquisition of a subsidiary (IFRS 3 Business Combinations) or how financial instruments are measured (IFRS 9 Financial Instruments) – but I think that is for another day.
Indeed. This is an article so let’s keep it simple.
Tom Clendon is an ACCA SBR online lecturer and podcaster www.tomclendon.co.uk
Sarah Ardiles is an ACCA FR online lecturer – See courses here