Stage 2 – Measuring recoverable amount

Chapter 14 – Provisions and Contingencies Page 173  a reliable estimate can be made of the amount. If one or more of these criteria are not met, a contingent liability may exist, but no provision should be recognised. IAS 37 describes a “past event” as an obligating event. It is the original action causing a liability to arise. As an example, if an entity is required to operate within certain emission levels and these were breached at some point in time, the past event is when the emission levels were breached rather than when the breach was discovered. It is important to realise that an obligating event involves another party, to whom the obligation is owed. In the above example, a penalty may be payable to, say, a regulatory body.

4.1.1 Future operating losses

A provision should not be recognised in respect of future operating losses since there is no present obligation arising from a past event. However, an expectation that the entity will incur future operating losses may indicate that there has been an impairment a reduction in value of assets, and an impairment review should be carried out in accordance with IAS 36 Impairment of assets. [IAS 37.63]

4.1.2 Onerous contracts

If the future benefits under a contract are expected to be less than the unavoidable costs under it, then the contract is described as onerous. The excess unavoidable costs should be provided for at the time the contract becomes onerous. The entity has an obligation to meet these future costs as a result of signing the original contract, it will be required to pay them and they can be measured reliably. Where an onerous contract has been identified, an impairment review should be carried out before a provision is recognised. [IAS 37.66] When making a best estimate of the provision for an onerous contract the entity should take into account an estimate of any likely income that will be received under the contract. Illustration 1 An entity entered into a 10 year lease of a building. The annual rent under the lease agreement is CU36,000. The entity has decided to relocate its head office with 5 years still to run on the original lease. The entity is permitted to sublet the building and believes that, although market rentals have decreased, it should be able to sublet the building for the full 5 years. The expected rental is CU24,000 per annum. A provision should be recognised for the excess costs under the lease contract above the expected benefits to be received. The obligating event was the signing of the lease agreement and CU36,000 is required to be paid in each of the remaining 5 years. A provision for the following amount should be recognised: Annual outflow CU36,000 Annual expected inflow CU24,000 Excess annual outflow expected CU12,000 A provision of CU60,000 CU12,000 x 5 years should be recognised. Note: all other costs and the time value of money have been ignored. Chapter 14 – Provisions and Contingencies Page 174

4.1.3 Restructuring

A provision should only be recognised in respect of restructuring costs, for example closing a division or reducing the number of employees, where specific criteria have been met, as detailed below. A constructive obligation to restructure an entity only arises when: [IAS 37.72]  a detailed formal plan has been made. This should include identifying the area of the business and location that is going to be restructured, an estimate of the number of employees that will be affected, the likely cost of the restructuring and the estimated time scales involved; and  an announcement about the restructuring plan has been made to those who will be affected. Time scales should be mentioned as part of this announcement, or the entity should have started to carry out the restructuring. Evidence that a restructuring plan has commenced might be the removal or dismantling of assets at the affected location. If an announcement has been made then commencement of the plan should be within a short period of time to reduce the likelihood of significant changes being made. A restructuring provision should only include direct expenditure arising from the restructuring. Costs which relate to the future activities of the entity should not be provided for as part of the restructuring, for example relocating or retraining staff. [IAS 37.80]

4.2 Contingent liabilities and contingent assets

A contingent liability or asset should be disclosed in the financial statements rather than being recognised in the statement of financial position. [IAS 37.27, 37.31] A contingent liability should be disclosed unless the possible outflow of resources to meet the liability is remote. If the outflow is thought to be remote, no disclosure is required. A contingent asset should be disclosed when the expected inflow of economic benefits is probable. An example of a contingent asset is a legal claim that the entity is pursuing, where the outcome is uncertain although it is probable that the entity will gain some financial benefit from it. Where the outflow of resources is probable, a provision should be recognised rather than a contingent liability disclosed. However, in relation to assets a ‘probable’ inflow of economic benefits only results in the disclosure of a contingent asset; for an asset to be recognised, the inflow of benefits should be ‘virtually certain’.