KAS 17 – PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS

EXPLANATORY NOTE

Explanatory notes to the Kosovo Accounting Standards are intended to provide additional understanding of the standards and technical guidance as to their use and application. In case of any divergence between Explanatory Notes and Standards, the Standards prevail.

Determination of Provisions and Contingencies

1. Provisions and contingencies are items that may result in future expense or benefit to an enterprise, depending upon the outcome of events that have not yet occurred at the financial statement reporting date. These include provisions, contingent liabilities and contingent gains.

2. Provisions should be accrued by recording a charge against income and a liability ONLY if:

  • The present obligation is the result of past events.
  • It is probable that an outflow of resources will be used to retire the obligation.
  • A reliable estimate can be made of the amount of the obligation.

3. Present obligation. The standard opines that in almost all cases it will be clear that a past event has given rise to a present obligation. However, in exceptional cases, for example: in case of a lawsuit when it is not clear whether a present obligation has arisen, an enterprise should determine whether a present obligation exists at the balance sheet date by taking into account all available evidence including, say, opinion of an expert (legal counsel).

4. Past event. Not all past events lead to a present obligation. Only an “obligating event” which, according to the standard is an even that leaves the enterprise with no realistic option but to settle the obligation, leads to a present obligation. Thus, past events which are obligating events alone need to be provided for (i.e., recognized as “provisions”). For example, past events, like unlawful environmental damage by an enterprise, would be considered obligating events which would then necessitate the recognition of a provision for cost like cleanup cost or penalties and fines. Similarly, recognition of a provision for (future) decommissioning costs (say, of an oil installation or a nuclear power station), to the extent that the enterprise is obliged to rectify damage already caused, is essential. In contrast, however, when it is deemed possible that an enterprise can avoid future expenditure by it future action, no provision is to be recognized for the anticipated future expenditure.

5. Probable outflow of resources. For a provision to qualify for recognition it is essential that it is not only a present obligation of the reporting enterprise but also it should be “probable” that an outflow of resources embodying benefits to settle the obligation will in fact result. For the purposes of this standard, a unique definition of the term “probable” has been propounded in the related International Accounting Standard 37. The IAS interprets “probable” to mean “more likely than not”. Put differently, this means that the probability of the event occurring should be greater than the probability of it not occurring. In contrast, where it is not probable that a present obligation exists, an enterprise need only disclose (as opposed to recognizing a provision) a contingent liability, unless the possibility is remote.

6. Reliable estimate of the obligation. The standard recognized that except in extremely rare cases, an enterprise will usually be able to make an estimate of the obligation that is sufficiently reliable to use in recognizing a provision. Such an estimate would normally be derived from a range of possible outcomes.

7. Contingent liabilities occur if it is reasonably possible but not probable that a liability exists, or the amount cannot be reasonably estimated. In this case, an accrual is not necessary, but disclosure must be made. If the possibility of a liability and future payment is remote, then neither an accrual nor disclosure is necessary

8. Contingent assets are normally not accrued, even when probable, to avoid overstating revenues. However, disclosure should be made when receipt is probable, with care taken to avoid misleading statements regarding the likelihood of receipt.

9. The particular accounting treatment required can be determined from the following table.

There is a present obligation that probably requires an outflow of resources / There is a possible obligation or a present obligation that may, but probably will not, require an outflow of resources / There is a possible obligation or a present obligation where the likelihood of an outflow of resources is remote
A provision is recognized / No provision is recognized / No provision is recognized
Disclosures are required for the provision / Disclosures are required for the contingent liabilities / No disclosure is required

10. A contingent liability also arises in the extremely rare case where there is a liability that cannot be recognized because it cannot be measured reliably. Disclosures are required for the contingent liability.

Provisions

11. For all estimated liabilities which are included within the definition of provisions, the amount to be recorded and presented on the balance sheet should be the best estimate as of the balance sheet date of an amount of expenditure which will be required to settle the obligation. This is often referred to as the “expected value” of the obligation, which is operationally defined as the amount the enterprise would pay, currently, to either settle the actual obligation or provide consideration to a third party to assume it. For estimated liabilities comprised of large numbers of relatively small, similar items, weighting by probability of occurrences can be used to compute the aggregate expected value; this is often used to compute accrued warranty reserves, for example. For those estimated liabilities comprised of only a few (or single) discrete obligations, the most likely outcome may be used to measure the liability when there is a range of outcomes having roughly similar likelihoods; but, if possible outcomes include amounts much greater (and lesser) than the most likely, it may be necessary to accrue a larger amount if there is a significant chance that the larger obligation will have to be settled, even if that is not the most likely outcome as such.

12. The “risks and uncertainties” surrounding events and circumstances should be taken into account in arriving at the best estimate of a provision. However, “uncertainty” should not justify the creation of excessive provisions or a deliberate overstatement of liabilities.

13. The standard also addresses the use of “present values” or “discounting” (i.e., recording the estimated liability at present value, after taking into account the time value of money). While the entire subject of present value measurement in accounting has been widely debated, and in practice there is a notable lack of consistency (with some standards requiring it, others prohibiting it, and many others remaining silent on the issue), the related IAS has stood fast on the subject of present value measurement, despite some opposition voiced in response to the exposure draft and a plea for more guidance. The standard requires the use of discounting when the effect would be material. Thus, provisions estimated to be due farther into the future will have more need to be discounted than those due currently.

14. Provisions include many liabilities that are estimated in compliance with the matching principle. Provisions that must be considered for appropriate disclosure include estimated losses on receivables (normally called the allowance for doubtful accounts); estimated warranty obligations; litigations, claims, and assessments; and anticipated losses on the disposal of a segment of the business. If the amount of the loss can vary considerably, no amount should be accrued as a provision unless there is substantial certainty that at least some minimum amount will be paid. In this case, the minimum amount is accrued. In addition, footnote disclosure of the situation and the range of potential loss should be made.

15. A provision that is accrued must be reported on the balance sheet as a liability, and on the income statement as an expense or loss in the period in which the reporting criteria are first met. The following examples illustrate the accrual of a provision and recognition of a liability.

Example of product warranty liability

Company A sold merchandise for 200,000 cash during the current period. Experience has indicated that warranty and guarantee costs will approximate 0.5% of sales. The related accounting entries are:

In the first year of sale:

As sales take place (total to end of year):

Dr. Cash...... 200,000

Cr. Sales revenue...... 200,000

At year-end (or periodically):

Dr. Warranty expense (200,000 x .05)...... 1,000

Cr. Warranty liability...... 1,000

Subsequently, actual warranty expenditures of 987 were made during the warranty period:

Dr. Warranty liability...... 987

Cr. Cash...... 987

Instead, if the actual expenditures were 1,100 the entry would be:

Dr. Warranty liability...... 1,000

Dr. Warranty expense...... 100

Cr. Cash...... 1,100

In subsequent periods, the actual warranty costs would continue to be charged to the warranty expense account as incurred. At the end of each accounting period, the warranty liability account would be increased or decreased according to the estimate of the level of the liability desired.

Example of provision relating to litigation

Assume that Company B was sued during the last quarter of the current year because of an accident involving a vehicle owned and operated by the company. The plaintiff is seeking 50,000 damages. If, in the opinion of management and company counsel, it is likely that damages will be assessed and a reasonable estimate is 25,000, this is the indicated entry.

Dr. Estimated loss from pending lawsuit...... 25,000

Cr. Estimated liability from pending lawsuit ...... 25,000

When the estimate varies from the actual amount paid out, the difference is normally accounted for as a change in estimate in accordance with KAS 5. If the difference between the estimate and amount required to be paid is material and the amount due becomes known after the date of the balance sheet but before the financial statements are issued, the item is treated as a subsequent event in accordance with KAS 5.

Loss Contingencies

16. Potential loss contingencies, such as guarantees of indebtedness, threat of expropriation of assets, standby letters of credit (guarantees of the credit of a third party), and risks due to fire, flood and other hazards, also must be assessed and accounted for in conformity with KAS 17.

17. Loss contingencies are disclosed in the notes to the financial statements. The note must describe the nature of the contingency and give an estimate of the possible loss or range of loss, or state that a reasonable estimate of the possible loss cannot be made.

Example of a contingent liability disclosure follows. It is s an example of a potential loss from a legal action.

Commitments and contingencies footnote disclosure

The enterprise has been engaged in a joint venture with a subsidiary of New Entertainment Corporation. The joint venture entity is involved in the production and distribution of films. The enterprise has given notice of its intention to discontinue participation in this joint venture after the completion of the first five pictures. Production of these pictures has been substantially completed.

The enterprise is contingently responsible for the repayment of approximately 275,000 of the joint venture entity’s bank financing with respect to the production of the first five pictures and for 50% of any prints and advertising expenditures not funded by third parties with respect to these films. The co-venturer and others have disputed the enterprise’s right to terminate its involvement in the joint venture and have commenced arbitration proceedings. The enterprise considers its withdrawal to be proper under the agreement.

The enterprise and its subsidiaries are also involved in certain litigation arising out of the ordinary course and conduct of its business. Certain litigation results from activities in acquired companies which pre-dated the purchase by the enterprise. The outcome of litigation is not currently determinable. However, although such matters cannot be predicted with certainty, management does not consider the enterprise’s exposure to litigation to be material to these financial statements.

Gain Contingencies

18. For a gain contingency to arise, the characteristics of a contingency must be present. A gain contingency implies an increase in assets or a decrease in liabilities, depending on future events.

19. Contingent gains are rarely accrued. However, they may be a note disclosure, provided the note does not give misleading implications. The different treatment accorded gain contingencies in comparison to loss contingencies is justified by the conservatism constraint.

20. Although contingent gains are also possible, the accounting profession has adopted a conservative position of non-recognition of gains until they are virtually certain, as it has in other areas. Contingent gains may at most be disclosed in footnotes, and then only if there is a high probability of realization.

The following chart summarize the treatment of contingent assets or gains:

The inflow of economic benefits is virtually certain / The inflow of economic benefits is probable, but not virtually certain / The inflow is not probable
The asset is not contingent / No asset is recognized.
Disclosures are required / No asset is recognized.
No disclosure is required