If the global pandemic (or perhaps more recently, your NCAA basketball bracket) has taught us all one thing, it is that there is a lot of uncertainty in this world, and no one can truly predict the future. But does that mean we can’t be prepared for it? Does it mean that, as accountants, we shouldn’t prepare the users of our financial statement for the outcomes of contingent liabilities or contingent gains? Of course not! In fact, accounting for contingences was one of the top accounting issues we noted as a result of the COVID-19 pandemic. And we weren’t alone. But what are contingent liabilities and contingent gains? And how do we account for them under either IAS 37 for IFRS financial statements? Read on to find out!
As stated on the IFRS’s website, IAS 37 defines and specifies the accounting and disclosures for:
- Contingent liabilities; and
- Contingent assets
Let’s look at each of these, in turn.
A provision is defined by IAS 37 as a liability of uncertain timing or amount. That begs the follow-up question: What is a liability? A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Let’s translate that. A liability is a current obligation, arising from something that already happened, and we’re probably going to have to pay some cash to settle it (or some other asset).
Okay, so let’s put it all together then. A provision is a current obligation, arising from something that already happened, and it’s probably going to be settled in cash, but we don’t know how much yet. Some examples of provisions could include things like:
- Warrant obligations
- Obligations for retailers to provide refunds to customers
- Environmental remediation obligations
Provisions are recognized when it is probable (or expected) that the obligation will be settled in cash (or by some other asset). Remember, IFRS defines “probable” as more likely than not…or a likelihood of 51% or more. What happens if it is not probable? We’ll treat it as a contingent liability, but more on that in a moment…
Okay, so we’ve got a provision, and it is probable that it will be settled in cash. How do we measure that obligation? It’ll be measured at the amount that the entity would rationally pay to settle the obligation at the end of the reporting period (or to transfer it to a third party). This estimate includes considering risks and uncertainties related to the timing and amount of payment as well as the time value of money. The amount should be discounted if the effect is material. Not only that, but the estimate should be updated each and every reporting period to reflect the current best estimate.
What if one single amount cannot be estimated? If the entity can estimate a range, and no single amount within that range represents the best estimate (in other words, each amount is equally likely to occur), the midpoint of that range should be accrued.
In the very RARE circumstance that no estimate can be made, the provision should be disclosed only.
Also, please be aware that IAS 37 lays out specific guidance for certain types of provisions, including onerous contracts and restructuring costs.
Let’s look at the next item addressed by IAS 37: Contingent liabilities. Contingent liabilities are defined in IAS 37 as possible obligations whose existence will be confirmed by uncertain future events that are not wholly within the control of the entity. In other words, it doesn’t quite arise to the level of a provision yet, because the entity does not think it is probable (at least not at this date) that it will be settled in cash (or some other asset). The most common example of a contingent liability would be litigation. Yes, the entity might have to pay a settlement depending on the decision of the court, but it also might NOT. And at this point in time (aka the reporting date), the reporting entity doesn’t know which of those two outcomes is probable. Remember, provisions for which the entity determined settlement was not probable are also treated as contingent liabilities.
Because the entity cannot estimate the amount of settlement (because settlement itself is uncertain), contingent liabilities are not recognized in the balance sheet, but instead included in the entity’s financial statement disclosures. The only time that a contingent liability is not disclosed is when the possibility of settlement is remote.
Finally, the last category of items discussed in IAS 37 are contingent assets. Contingent assets are possible assets whose existence will be confirmed by the occurrence or non-occurrence of uncertain future events that are not wholly within the control of the entity. A common example of a contingent asset could be a lawsuit where the entity could be entitled to receive the proceeds of a settlement.
Sweet! So, if it is probable the settlement of the contingency will result in a gain, the entity should probably go ahead and record that gain on the income statement, right? WRONG! Contingent assets are not recognized, but they are disclosed when it is more likely than not that an inflow of benefits will occur. The only time a contingent asset can be recognized in the statement of financial position is when it is VIRTUALLY CERTAIN that the inflow of benefits will happen. At that point, the asset is no longer considered contingent.
This flow chart from our IAS 37 course is a helpful visual to follow the accounting rules!
What to learn more?
Make sure you check out one of our newest course offerings, Provisions and Contingencies: IAS 37. For group discounts or bulk purchases, make sure to contact us! Prepare your financial statements under U.S. GAAP? No worries, we’ve got that too!
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