Liabilities, Provisions and Contingencies
What you must know
Distinguish liabilities (present obligation from past events) from provisions (liabilities of uncertain timing or amount). Recognise a provision when there is a present obligation from a past event, an outflow is probable, and the amount can be reliably estimated. Measure at the best estimate of the expenditure required, discounted where the time value of money is material. Know the treatment of onerous contracts, restructuring (recognise only when a detailed plan exists and a valid expectation has been raised), and decommissioning costs. Contingent liabilities are disclosed unless the outflow is remote; contingent assets are disclosed only when an inflow is probable and recognised only when virtually certain. Distinguish financial liabilities measured at amortised cost from those at fair value through profit or loss.
Traps candidates fall into
- Recognising a provision for future operating losses; these are not present obligations.
- Recognising a restructuring provision without a detailed plan and valid expectation.
- Forgetting to discount a long-term provision and to unwind the discount as a finance cost.
- Recognising a contingent asset before it is virtually certain.
- Treating a guarantee as a provision when it should be measured as a financial liability at fair value initially.
- Ignoring the reimbursement asset, which is recognised separately only when virtually certain.
Rule of thumb
Apply three tests: present obligation, probable outflow, reliable estimate. If any fails, disclose (unless remote) rather than recognise. For long-term provisions, discount and accrete the liability each period.
Worked example
A decommissioning obligation of 1,000,000 is due in 10 years; discount rate 8%. Present value = 1,000,000 / 1.08^10 ≈ 463,000. Recognise a provision of 463,000 and add the same amount to the cost of the asset. Each year, unwind the discount through finance cost, increasing the provision.