Getting little deeper into the contingent liabilities and provisions, let's try to address the in-depth issues in their recognition.
To read about the definition and meaning of contingent Liabilities and Contingent Assets click here
To read about the difference between Contingent Liabilities and Provisions click here
RECOGNITION OF PROVISIONS:
A contingent liability becomes a provision when all the three criteria are satisfied
1) The entity has a present obligation as a result of a past event.
2) It is considered probable that the entity will have an outflow of economic resources.
3) The entity is able to make a reliable estimate of the outflow of economic resources.
Let us look into each of these criteria in detail
Criteria 1: Present Obligation as a result of past events: The obligation must relate to the current period.
Example: There was a Government Mandate that all factories must be equipped with industrial air filters before 30th October 2019, and failing to do so, will attract huge fines and penalties. Now, at the end of the year December 2018, the company Finger Foods Pvt Ltd has no present obligation arising out of some past events. The reason is that, firstly there were no past events and the obligation is not immediate. Hence it is not required to disclose the contingent liability. Secondly, the entity might very well decide to change its method of operation in future so that it will not be obligated to install those air filters.
However, at the end of the year 2019, if the company still continues to operate without air filters, it might be obligated to pay penalties for defaulting.
present obligation is paying the penalty and
past event is non-compliance with the mandate.
Hence, Finger Foods Pvt Ltd, will have to create a provision only to the extent of penalties estimated to be paid. It need not create a provision for the cost of installing an industrial air filter, because even now there is no obligation on the part of the company to install it arising out of past events.
Example 2: Meghna Oils Pvt Ltd was continuously contaminating the nearby lands and lakes for several years. End of the year, it becomes virtually certain that the Government will enact a law requiring companies that had contaminated the land and water to clean it up.
In the above case, there is a present obligation as a result of past action, which was polluting the nearby lands and waters. Even if the company changes it mode of operation in the future, the obligation to clean-up still remains as a result of its past actions/ events. Therefore, in this case, if the company is able to reliably estimate the cost involved for the clean-up operation (outflow of resources embodying economic benefits), it must create a provision at the end of the year in its balance sheet.
Criteria 2: It is considered probable that the entity will have an outflow of economic resources.
According to IAS 37 on Provisions, Contingent Liabilities and Contingent Assets: probability is anything with a chance of more than 50%. According to Ind AS, an outflow of resources or any other event is regarded as probable if the event is more likely than not to occur, which also roughly means, more than 50% probability, although Ind AS has not specified the percentage.
Criteria 3: The entity is able to make reliable estimate of the outflow of resources
A reliable estimate would mean the company should be able to make best possible estimate on the amount of outflow.
Let's look at an example:
Ram and Co has a case filed against them by its supplier who has sued Ram & Co for $ 1,00,000 and it has not been settled as of the year end when the accounts were approved by the Board of Directors. The legal counsel of Ram & Co estimated that the success rate is about 60% and if successful, the supplier should be paid $ 80,000 to $90,000. State whether in this situation, Ram & Co is required to disclose and create a provision or a contingent liability.
Possibility: There exist a possibility of liability of more than 60% for Ram & Co.
Probability: On top of the possibility stated above, there is also a probability that Ram & Co will have an outflow of economic resources.
Reliable estimate on the outflow of economic resources:
A reasonable estimate of the amount is also available, which is from $ 80,000 to $90,000.
Conclusion: Ram & Co should create a provision for the liability in its books of accounts.The amount shall be determined as follows:
($80,000) * 50% + ($90,000) * 50% = $85,000
Lawsuit Expense Dr. $85,000
Provision for Lawsuit Cr. $85,000
In the above case, the provision is finally created as the item has satisfied all the three criteria.
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