A contingent liability is a potential obligation that may arise from an event that has not yet occurred. A contingent liability is not recognized in a company’s financial statements. Instead, only disclose the existence of the contingent liability, unless the possibility of payment is remote. There are three possible scenarios for contingent liabilities, all of which involve different accounting transactions. They are noted below. Show Record a Contingent LiabilityRecord a contingent liability when it is probable that a loss will occur, and you can reasonably estimate the amount of the loss. If you can only estimate a range of possible amounts, then record that amount in the range that appears to be a better estimate than any other amount; if no amount is better, then record the lowest amount in the range. “Probable” means that the future event is likely to occur. You should also describe the liability in the footnotes that accompany the financial statements. Disclose a Contingent LiabilityDisclose the existence of a contingent liability in the notes accompanying the financial statements if the liability is reasonably possible but not probable, or if the liability is probable, but you cannot estimate the amount. “Reasonably possible” means that the chance of the event occurring is more than remote but less than likely. Do Not Disclose a Contingent LiabilityDo not record or disclose a contingent liability if the probability of its occurrence is remote. Examples of Contingent LiabilitiesExamples of contingent liabilities are the outcome of a lawsuit, a government investigation, and the threat of expropriation. A warranty can also be considered a contingent liability. A recent Financial Accounting Standards Board (FASB) meeting addressed updating the so-called “building blocks” of financial statements. Board members want to simplify the definitions of assets and liabilities and make them easier to understand. Major changes to these definitions could affect how items are classified on companies’ balance sheets. Standard-setting framework The Conceptual Framework is a set of guidelines the FASB references when writing and amending accounting standards. The FASB issued its first Concepts Statement in 1978. Six more were published by 2000. Concepts Statements are used to write U.S. Generally Accepted Accounting Principles (GAAP), but they aren’t considered part of the FASB’s official authoritative guidance. Statement of Financial Accounting Concepts (CON) No. 6, Elements of Financial Statements, was published in 1985. It defines the building blocks with which financial statements are constructed, including the following definitions: Assets. Probable future economic benefits obtained or controlled by a particular entity as the result of past transactions or events. Liabilities. Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Several terms in these definitions — including “probable,” “future economic benefit,” “past transaction or event,” “future sacrifice of economic benefits,” and “control” — have sparked debates among accountants and caused problems with financial reporting. Work in progress The overall Conceptual Framework remains incomplete, and the FASB’s effort to update it has been a long-running endeavor. In 2004, the FASB partnered with the International Accounting Standards Board (IASB) to try to converge the U.S. and international financial reporting frameworks. However, the fallout from the 2008 financial crisis forced the FASB and IASB to set aside the joint project to deal with more pressing issues, and the convergence effort never resumed. Now the boards are working independently on updating their frameworks. On August 30, the FASB agreed to consider trimming the definition of an asset to “the present right of the entity to an economic benefit.” The board was less decisive about where it could head with the definition of a liability, which depends on how an asset is defined. The background materials the FASB staff prepared for the meeting said that a liability, “in many respects, is a mirror image of the definition of an asset.” One proposal presented was to redefine a liability as “a present obligation of the entity to transfer an economic benefit.” The FASB hasn’t committed to any changes yet, however. Board members want to see how the proposed definitions work in real life when the FASB is wrestling with a standard-setting question. For example, in July, the FASB’s Emerging Issues Task Force (EITF) tried to resolve how to account for the costs and fees for setting up cloud-computing arrangements, and part of the question hinged on whether these service contracts meet the definition of an asset. Testing the proposed definitions in these types of debates would be helpful. FASB Chairman Russell Golden suggested that the board also not confirm the definition of a liability or asset until it considers related terms such as revenues and expenses. Stay tuned In addition to focusing on key accounting terms, the FASB’s Conceptual Framework project also targets presentation and measurement concepts. Contact your CPA for the latest developments on this long-running endeavor. © 2017
IAS 37 Provisions, Contingent Liabilities and Contingent Assets outlines the accounting for provisions (liabilities of uncertain timing or amount), together with contingent assets (possible assets) and contingent liabilities (possible obligations and present obligations that are not probable or not reliably measurable). Provisions are measured at the best estimate (including risks and uncertainties) of the expenditure required to settle the present obligation, and reflects the present value of expenditures required to settle the obligation where the time value of money is material. IAS 37 was issued in September 1998 and is operative for periods beginning on or after 1 July 1999.
The objective of IAS 37 is to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets and that sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount. The key principle established by the Standard is that a provision should be recognised only when there is a liability i.e. a present obligation resulting from past events. The Standard thus aims to ensure that only genuine obligations are dealt with in the financial statements – planned future expenditure, even where authorised by the board of directors or equivalent governing body, is excluded from recognition. IAS 37 excludes obligations and contingencies arising from: [IAS 37.1-6]
Provision: a liability of uncertain timing or amount. Liability:
Contingent liability:
Contingent asset:
An entity must recognise a provision if, and only if: [IAS 37.14]
An obligating event is an event that creates a legal or constructive obligation and, therefore, results in an entity having no realistic alternative but to settle the obligation. [IAS 37.10] A constructive obligation arises if past practice creates a valid expectation on the part of a third party, for example, a retail store that has a long-standing policy of allowing customers to return merchandise within, say, a 30-day period. [IAS 37.10] A possible obligation (a contingent liability) is disclosed but not accrued. However, disclosure is not required if payment is remote. [IAS 37.86] In rare cases, for example in a lawsuit, it may not be clear whether an entity has a present obligation. In those cases, a past event is deemed to give rise to a present obligation if, taking account of all available evidence, it is more likely than not that a present obligation exists at the balance sheet date. A provision should be recognised for that present obligation if the other recognition criteria described above are met. If it is more likely than not that no present obligation exists, the entity should disclose a contingent liability, unless the possibility of an outflow of resources is remote. [IAS 37.15] The amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date, that is, the amount that an entity would rationally pay to settle the obligation at the balance sheet date or to transfer it to a third party. [IAS 37.36] This means:
In reaching its best estimate, the entity should take into account the risks and uncertainties that surround the underlying events. [IAS 37.42] If some or all of the expenditure required to settle a provision is expected to be reimbursed by another party, the reimbursement should be recognised as a separate asset, and not as a reduction of the required provision, when, and only when, it is virtually certain that reimbursement will be received if the entity settles the obligation. The amount recognised should not exceed the amount of the provision. [IAS 37.53] In measuring a provision consider future events as follows:
A restructuring is: [IAS 37.70]
Restructuring provisions should be recognised as follows: [IAS 37.72]
Restructuring provisions should include only direct expenditures necessarily entailed by the restructuring, not costs that associated with the ongoing activities of the entity. [IAS 37.80] When a provision (liability) is recognised, the debit entry for a provision is not always an expense. Sometimes the provision may form part of the cost of the asset. Examples: included in the cost of inventories, or an obligation for environmental cleanup when a new mine is opened or an offshore oil rig is installed. [IAS 37.8] Provisions should only be used for the purpose for which they were originally recognised. They should be reviewed at each balance sheet date and adjusted to reflect the current best estimate. If it is no longer probable that an outflow of resources will be required to settle the obligation, the provision should be reversed. [IAS 37.61] Since there is common ground as regards liabilities that are uncertain, IAS 37 also deals with contingencies. It requires that entities should not recognise contingent liabilities – but should disclose them, unless the possibility of an outflow of economic resources is remote. [IAS 37.86] Contingent assets should not be recognised – but should be disclosed where an inflow of economic benefits is probable. When the realisation of income is virtually certain, then the related asset is not a contingent asset and its recognition is appropriate. [IAS 37.31-35] Reconciliation for each class of provision: [IAS 37.84]
A prior year reconciliation is not required. [IAS 37.84] For each class of provision, a brief description of: [IAS 37.85]
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