PwC

Provisions, Contingent Liabilities and Contingent Assets

http://www.cc.cec/budg/

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

1. Scope of application

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
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Provisions, Contingent Liabilities and Contingent Assets

2. Key concepts

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 entitys 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.
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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

PwC

Provisions
Provisions

Write-downs
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

On the liabilities side

Present obligations resulting from past events

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.
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Contingent liabilities and contingent assets

Contingent liabilities =
Possible obligations that arise from past events and whose existence will be confirmed only by the occurrence or nonoccurrence 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
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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

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Provisions, Contingent Liabilities and Contingent Assets

3. Recognition

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.
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Provisions - Recognition
Start

Present obligation as a result of an obligating event?

no

Possible obligation?

no

yes
Probable Outflow?

yes no
Remote?

yes

Decision Tree

yes
Reliable estimate?

no no

yes
Provide Disclose contingent liability Do nothing

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Examples
Item 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 True/False

benefits
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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

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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.

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Provisions, Contingent Liabilities and Contingent Assets

4. Measurement

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
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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.

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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 5
5% x 100,000 x 25 Estimated warranty expense

125,000
125,000 250,000

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.

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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

Discount factor at 4.5% At inception 0.9157 NPV 1,099 Cash flows -

Balance sheet

Additional costs

Year 1

0.9569

1,148

49

Year 2

1.0000

1,200

1,200

52

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Other issues
Reimbursement:
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.
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Provisions, Contingent Liabilities and Contingent Assets

5. Disclosures

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

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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

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Provisions, Contingent Liabilities and Contingent Assets

6. Specific implications / Next steps

Ensuring compliance with the new rules

Caption Dismantlement of nuclear installations Pensions + employee benefits Food-and-mouth disease Provision under IPSAS 19? Yes Comments Annual estimates Current treatment Yes

Yes

Yes

Yes

Minimum in the range of possible outcomes Maximum possible outcome disclosed On a case by case basis

Yes

Legal disputes

Yes

Yes

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Provisions, Contingent Assets and Contingent Liabilities

7. Questions
http://www.cc.cec/budg/