Accounting Standards

Liabilities, reserves and events after the reporting period

Why is it important?

• The classification of items as liabilities, reserves or nothing at all affects the figures used in several key ratios

• Items may requires the use of judgment about amounts or the probability of future events – this makes them more likely to be manipulated

Liability

• A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.

IASB framework

Liability

May be recognised as:• Current liability – can be determined with

reasonable accuracy and is payable within 1 year

• Non-current liability - can be determined with reasonable accuracy and is payable after 1 year

• Provision

ProvisionLiabilities of uncertain timing or amount IAS 37

A provision should be recognised when:• An entity has a present obligation (legal or constructive) as a

result of a past event;• It is probable that an outflow of resources embodying

economic benefits will be required to settle the obligation; and

• A reliable estimate can be made of the amount of the obligation.

• If these conditions are not met, no provision shall be recognised. IAS 37

Constructive obligation

An obligation that derives from an entity’s actions where:

• By an established pattern of past practice, published policies or a 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 those responsibilities.

IAS 37

Constructive obligation - example

• The company has announced to staff that it will match contributions made by staff to a natural disaster appeal.

• The events have taken place – the disaster and the promise to match the contributions

• Morally and to avoid bad publicity, the company must make the payments.

Importance of dates

• A company decides at a board meeting on 20th December 2006 that it is going to close down a part of its business at an estimated cost of £5m

• It makes no public announcement until 2nd January 2007

• There is no obligation in the accounts at 31st December as the company could still change its mind.

• Once the announcement is made, an obligation exists

Measurement of provisions

• The amount recognised should be the best estimate of the amount needed to settle the obligation

• Probability analysis can be used to determine the expected value when there is a range of possible outcomes

• eg warranty repairs– 75% chance of no repairs– 20% chance of minor defects – 5% chance of major defects

Contingent liability• A possible obligation that arises 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; or

• A present obligation that arises from past events but is not recognised because:

– It is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or

– The amount of the obligation cannot be measured with sufficient reliability. IAS 37

Contingent liability - disclosure

• No entries are made in the accounts themselves, but the circumstances and an estimate of the financial consequences are disclosed in the notes to the accounts.

Example – possible obligation

• The company is defending a legal action. If the judgement goes against them they estimate the fines and costs will result in a outflow of £2m.

• If the legal opinion is that the company is likely to lose – make a provision

• If the legal opinion is that the company is unlikely to lose, but that it is possible – disclose as a contingent liability

• If the legal opinion is that the possibility of loss is remote no disclosure is required

Contingent asset

• A possible asset that arises 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 entityIAS 37

Contingent asset - treatment

• A contingent asset is never recognised in the accounts (prudence)

• If future benefits are probable it should be disclosed in the notes

• If future benefits are merely possible or remote, no disclosure is made

Reserves

• A company is free to set aside money from retained earnings and designate it for a particular purpose. For example a reserve for the replacement of non-current assets.

• It is used where there is no obligation, but the company wishes to indicate an intention fro future spending.

• It is set up by transfer from retained earnings in the statement of changes in equity, not in the incomes statement.

Events after the reporting period

• Those events, favourable and unfavourable, that occur between the end of the reporting period and the date when the financial statements are authorised for issue.

• Two types of events can be identified:– Those that provide evidence of conditions that existed at

the end of the reporting period (adjusting events after the balance sheet); and

– Those that are indicative of conditions that arose after the end of the reporting period (non-adjusting events after the end of the reporting period )

IAS 10

Adjusting events - examples

• Receipt of information after the end of the reporting period indicates an asset was impaired at the end of the reporting period – bad debts, NRV of inventory

• The settlement after the end of the reporting period of a court case indicating that the company had a present obligation at the end of the reporting period .

Adjusting events - treatment

• The information is reflected in the accounts in the same way as if it had been known at the end of the reporting period – Bad debts written off or provided for– Inventory written down to NRV is lower than cost– Provision made for payments due under a legal

case

Non-adjusting events - examples

• A major business combination after the end of the reporting period

• Destruction of property by fire after the end of the reporting period

• Start of major litigation arising solely out of events that occurred after the end of the reporting period

Non-adjusting events - treatment

• If non-adjusting events are material, non-disclosure could influence the economic decision of users taken on the basis of the financial statements

• Accordingly an entity shall disclose for each material category of non-adjusting event after the end of the reporting period :– The nature of the event: and– An estimate of its financial effect, or a statement that such

an estimate cannot be madeIAS 10

Good points

• Attempts to ensure all liabilities are included• Prevents companies setting up unnecessary

provision when profits are high, in order to charge expenses against those provisions when profits are lower – “big-bath provisions” and profit smoothing

• Ensures that bad news occurring after the end of the reporting period is not hidden from users

Problems

• In practice, judgment is required to decide when a provision or contingent liability should be recognised

• Measurement can also be difficult• The treatment of contingent assets and liabilities is

not symmetrical. • It can be difficult to decide if additional information

after the end of the reporting period relates to condition which existed at the end of the reporting period, or arose after it.

Problems – contingent liabilities

• Probable means >50% chance – provide in full• Possible means <50% chance – provide nothing, just

disclose• There is no guidance on the distinction between

possible and remote • In practice a small difference in judgement between

49% probable and 51% probable means a large difference in the accounts

• This is addressed by an exposure draft