Provisions – Ind AS 37

What is a Provision?

  • Provision is a liability of uncertain timing or amount
  • The word “uncertain” is very important here, because if timing and amount are certain or almost certain, then you don’t deal with the provision but with a payable or an accrual
  • To understand provisions better, let’s break down the definition of a liability in Ind AS 37
  • liability is a present obligation arising from past event that is expected to be settled by an outflow of economic benefits from an entity
  • In other words, if there is no past event, then there is no liability and no provision should be recognized.

Past event can create two types of obligation:

  • Legal obligation that arises from legislation, a contract or other legal act; or
  • Constructive obligation that arises from some business practice or customs and created an expectation in other parties to fulfill the obligation (in other words, people simply expect some company to fulfill the obligation even if it’s not in the law or any contract)
  • It does not really matter what type of obligation you deal with – whichever it is, it leads to a provision
  • However, if you identify the obligation, it can help you to decide whether recognize a provision or not

Example 2:

PQR Co has a published environmental policy. In this, PQR Co explains that they always replant trees to counterbalance the environmental damage created by their operations. PQR Co has a consistent history of honoring this policy. During 2020, PQR Co opened a new factory, leading to some environmental damage. PQR Co estimate that the damage will cost Rs. 400 lacs to restore.

Even if the country has no legal regulations forcing PQR Co to replant trees, PQR Co will have a constructive obligation because it has created an expectation from its publications, practice and history.

Question:

An entity is a telecom operator. Laying of cables across the world is a requirement to enable the entity to run its business. Cables are also laid under the sea and contracts are entered into for the same. By virtue of laws of the countries through which the cable passes, the entity is required to restore the seabed at the end of the contract period. What is the nature of

obligation that the entity has in such a case. Constructive or legal?

Answer:

Legal: Correct provision should be recognized as soon as the obligating event takes place because the entity is under legal obligation to restore the seabed, provided the other recognition criteria are met. Moreover, the amount of the provision would depend on the extent of the obligation arising from the obligating event. In the instant case, an obligating event is the laying of cables under the sea. To the extent the cables have been laid down under the sea, a legal obligation has arisen and to that extent provision for restoration of seabed should be recognized.

When to recognize a Provision

  • The Standard defines a provision as a liability of uncertain timing and amount and prescribes conditions that have to be satisfied for recognition of a provision
  • A provision shall be recognized when
  • There must be a present obligation as a result of a past event
  • The outflow of economic benefits to satisfy the obligation must be probable (i.e. more than 50% probable)
  • The amount of economic benefits required to satisfy the obligation must be reliably estimated
  • If all 3 criteria are met, then you should recognize a provision
  • If just one of them is not met, then you should either
  • Disclose a contingent liability, or
  • Do nothing if the outflow of economic benefits is remote
  • If you are unsure whether to recognize a provision in a particular situation or not, just ask yourself a simple question:

Can the obligation be avoided by some future actions?

  • If yes, then you should NOT book a provision
  • For example, if a government introduced new tax legislation, does the tax consulting company need to spend a cash for training of its employees and thus recognize a provision for that training?
  • No, it does not have to. Tax consulting company can avoid the training and decide to stop its activities
  • If you cannot avoid the obligation by some future action, then you have to recognize a provision.

Example 3: when you promised a free warranty service for defective products at the point of sale, then you have a present obligation. If your past statistics show that you needed to spend some cash for warranty repairs, then you need to make a provision.

To get better understanding and guidance on provisions and contingencies, Ind AS 37 presents a decision tree, too

Decision Tree

Question

A provision should be recognized if the liability is not uncertain with respect to either timing or amount.  Is the statement True or False?

Answer

False: Correct.The Provisions can be recognized only when the liabilities are uncertain with respect to either the timing or the amount. If liability is not uncertain w.r.t. timing or amount, an actual liability instead of provision should be recognized.

Question:

An entity estimates based on the past years’ experiences that its customers don’t pay money out of its sales made to customers @ approximately 2% of its Accounts receivables (AR) as at the respective year end. How would it record for the same in the books of accounts out of the following?

  1. Accruals
  2. Provision.

Answer:

  1. Accounting for doubtful debts is of the nature of provision as it fully satisfies the recognition criteria of provision.

Question:

The entity is an automobile component manufacturer. The automobile manufacturer has specified a delivery schedule, non-adherence to which will entail a penalty. As on March 31, 2020, the reporting date, the manufacturer has a delivery scheduled for June 2020. However, the manufacturer is aware that he will not be able to meet the delivery schedule in June 2020.

Determine whether the entity has a present obligation or not as at March 31, 2020, requiring recognition of provision.? Yes / No?

Answer

  1. No. In this case, there is no present obligation arising out of a past event as the goods are scheduled for delivery in June 2020 and there is no delay as at March 31, 2020. Hence, there is no present obligation to pay the penalty in the current year. Therefore, no provision can be recognized in the instant case.

In most cases, you should recognize a provision in profit or loss. Sometimes, a provision is recognized in the cost of another asset, for example, provision for removing the asset and restoring the site after its use. Don’t forget to split the provision in the current and non-current part for the presentation purposes in your statement of financial position

Provision: Present Obligation

  • In rare cases, it is not clear whether there is a present obligation
  • In these cases, a past event is deemed to give rise to a present obligation if, taking account of all available evidence, it is more likely than not that a present obligation exists at the end of the reporting period
  • Present Obligation is a key to recognition of Provisions, So, Broadly, there are two criteria to identify whether a present obligation exists or not and accordingly, treatment would depend as follows
Present Obligation

Provision: Past Event

  • A past event that leads to a present obligation is called an obligating event
  • For an event to be an obligating event, it is necessary that the entity has no realistic alternative to settling the obligation created by the event
  • This is the case only:
  • where the settlement of the obligation can be enforced by law

or

  • in the case of a constructive obligation, where the event (which may be an action of the entity) creates valid expectations in other parties that the entity will discharge the obligation
  • An obligating event is an event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation
  • Generally, Financial statements of an entity deals with the financial position at the end of the reporting period and not its possible position in the future
  • Therefore, no provision is recognised for costs to be incurred to operate in the future
  • Also, the liabilities as reflected in the balance sheet are only those which exist as at the end of the reporting period

Example 4:

QWE Co would have to provide for a potential legal case in 2020 arising from an employee who was injured at work in 2019 due to faulty equipment. This is because the event arose in 2019 which could lead to an obligation.

QWE Co could not provide for any possible claims which may arise from injuries in the future. That is because there is no past event which has created the obligation. Similarly, if QWE Co has to pay to install new safety equipment in the factory in 2021, there is no present obligation to do this in 2020, so no provision is required. QWE Co could delay the work until 2021 or sell the building.

Provision: – Probable outflow of resources embodying economic benefits

  • For a liability to qualify for recognition there must be not only a present obligation but also the probability of an outflow of resources embodying economic benefits to settle that obligation
  • For the purpose of this Standard, an outflow of resources or other event is regarded as probable if the event is more likely than not to occur, i.e. the probability that the event will occur is greater than the probability that it will not
  • Where it is not probable that a present obligation exists, an entity discloses a contingent liability, unless the possibility of an outflow of resources embodying economic benefits is remote

Provision: – Reliable estimate of the obligation

  • The use of estimates is an essential part of the preparation of financial statements and does not undermine their reliability
  • This is very true in the case of provisions, which by their nature are more uncertain than most other items in the balance sheet
  • In the extremely rare case where no reliable estimate can be made, a liability exists that cannot be recognised as a provision. That liability is disclosed as a contingent liability

Example 5: Reliable estimate

BNM Co has received legal advice that the most likely outcome of the court case from the employee is that they will lose the case and have to pay $10m. The legal team thinks there is an 80% chance of this. They believe there is a 10% chance of having to pay $12m, and a 10% chance of paying nothing

In this case, BNM Co would provide $10m, being the most likely outcome. It will not be uncommon to take the $12m, thinking that the worst-case scenario should be provided for. Some may calculate an expected value based on the various probabilities which may also come near to the most likely outcome [(0.80*10) + (0.10*12) = 9.2]

Relationship of “Provisions” and “Other liabilities”

  • Provisions can be separated / distinguished from “other liabilities” such as
  • trade payables and
  • accruals

because there is an uncertainty about the timing or amount of the future expenditure required in settlement connected with Provisions

  • Whereas
  • trade payables are liabilities to pay for goods or services that have been received or supplied and have been invoiced or formally agreed with the supplier; and
  • accruals are liabilities to pay for goods or services that have been received or supplied but have not been paid, invoiced or formally agreed with the supplier, including amounts due to employees (for example, amounts relating to accrued vacation pay)
  • Although it is sometimes necessary to estimate the amount or timing of accruals, the uncertainty is generally much less than for provisions
  • Accruals are often reported as part of trade and other payables, whereas provisions are reported separately in Financial statements

Question:

If the Cash credit (working capital facility) services from Bank has been availed / received and utilized by an organization for the month of March 2020, How would the organization account for the Interest expense on said Cash credit facility for March  2020 month  (which would be normally due for payment by 5th of next month) out of the following?

  1. Accruals
  2. Provision

Answer

Accruals are liabilities to pay for goods or services that have been received or supplied but have not been paid, invoiced or formally agreed with the supplier. Accruals involve recording of expenses that have been incurred but payment for which is yet to be made by the transacting entity. Here, cash credit services have been received by the organization but has not been paid by the organization which is due next month. Therefore, Accruals would be recorded for the interest expense.

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