Today, let’s be practical.
A couple of weeks ago, I published an article about IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
I received a lot of questions from you, so here I try to give you my answers to the issues that popped out the most frequently.
If there’s any issue you face, share it with us in the comments below. Now, let’s jump right in.
#1: Should we book a provision based on the budget?
We had a budget for advertising services approved for this year with monthly breakdown. Total amount of the budget was CU 130 000, however, until the year-end, we spent only CU 125 000. The bills from advertising company total CU 115 000, with CU 10 000 still unbilled at the year-end.
Can we make a provision for unused budget for advertising services? If yes, in what amount?
Answer to question #1
No, you cannot, unless you have some conditions in the contract with the advertising company about minimum billing per year.
If there are no such conditions, then there’s no past event and neither constructive nor legal obligation for payment was created.
Therefore, no provision based on the budget.
For the services used and not paid, you should make an accrual in the amount of CU 10 000 (unbilled at the year-end).
#2: When should we book a long-term provision (e.g. environmental and removal provision)?
We are constructing a plant (e.g. oilrig, nuclear power plant, etc.) and the local legislation requires us to remove the plant and restore the site at the end of the plant’s useful life.
The estimated useful life of the plant is 30 years and our experts estimate the costs related to its removal and restoring the site at CU 1 000 000, thereof:
- The amount of CU 800 000 relates to the removal of the plant and rectifying damages caused by the construction of the plant;
- The amount of CU 200 000 relate to rectifying the damages caused by the operation of the plant.
When should we book a provision? Should we spread its recognition straight-line over 30 years?
Note: Here, we don’t talk about measurement of this provision, but bear in mind that you should take many factors into account when estimating long-term provision, including time value of money (discounting), inflation, changes in estimates, probabilities, etc.
Answer to question #2
A provision should be recognized when there’s a present obligation as a result of past event.
Therefore, you cannot spread the recognition of this provision straight-line over 30 years, because the corresponding past event – construction of the plant – happens right when the plant is constructed.
What you should do instead:
- A provision for the removal of the plant and rectification of damages caused by its construction of CU 800 000 shall be recognized when the plant is being constructed, as the construction itself gives rise to an obligation to remove it.
This provision is debited or included in the cost of the plant.One practical point: Construction of such a plant can take years. Here, you should NOT recognize a provision at the end of the construction only, but you should gradually recognize the provision over the construction.
The reason is that right after the first works are performed on the site, the past event arose and the obligation was created. Your experts should advise you what cost is associated with the removal of the construction works performed up to the specific reporting date.
- A provision for the rectifying the damages caused by the operation of the plant of CU 200 000 shall be recognized when these damages are caused, i.e. during the plant’s operation.
Similarly as before, you should estimate how many damages you made on the site by the plant’s operation during the particular year and NOT automatically recognize a provision on a straight-line basis.This provision is NOT included in the cost of the plant, but expensed in profit or loss.
#3: What discount rate shall we use for determining the present value of our provision?
How shall we set the discount rate used in arriving at present value of a provision? Our provision will be settled after 30 years and therefore, the small shift in the discount rate can result in huge differences.
Answer to question #3
It’s true that IAS 37 does not give us much guidance about how to set the discount rate. It just says that the discount rate should be:
- Pre-tax rate;
- Reflecting current market assessment of the time value of money; and
- Reflecting the risks specific to the liability.
There are more ways to set the appropriate discount rate and let me offer you just one of them:
- You can take a government bond rate as a basis. This would be a risk-free and pre-tax rate. Make sure you take bonds with the similar maturity as your liability settlement time (e.g. when you expect to settle the liability in 30 years, then you should take bonds with maturity in 30 years).
If there are no such bonds, then you need to take more issues of government bond with various maturity dates, construct a yield curve and extrapolate along the yield curve to get your own discount rate.
- Careful about inflation! Make sure you don’t include inflation twice. In other words:
If you use nominal discount rate (just as it is), then make sure your future cash flows are expressed in the future estimated prices.
If your cash flows are in the current prices (they are not increased by estimated future inflation), then use a real discount rate excluding the effect of inflation.
- Sometimes, it is necessary to adjust the risk-free rates for the risks associated with the liability. Again, there’s no precise guidance in IAS 37 on how to do it.
As a suggested method, you can discount the risk-adjusted cash flow at the risk-free rate first and you get the present value of “A”. Then you can determine what rate will give you the present value of “A” from your future unadjusted cash flow. This will be your risk-adjusted rate.
#4: How should we calculate the amount of a provision for legal case?
We face a legal claim. Our lawyers believe that there’s:
- 70% chance of losing the case and we will have to pay CU 100 000 to settle the claim; and
- 30% of winning the case with zero payment.
Can we recognize a provision of CU 70 000 (CU 100 000*70% + CU 0*30%)?
Answer to question #4
No, this is not the correct approach.
The reason is that in this case, the outcome of the court proceedings will never be CU 70 000 – it will be either CU 100 000, or CU 0.
In other words, the expected value method is NOT appropriate in this case. Here, IAS 37 advises that the provision should measured at the most likely outcome.
As the probability of loss is 70%, this is the most likely outcome and the company would have to pay CU 100 000. Therefore, the provision of CU 100 000 shall be made.
#5: Should we book a provision even if we expect a reimbursement from our insurance company?
We caused a damage amounting to CU 30 000, but we hold an insurance policy covering “the third party liability” and as a result, we expect the insurance company to reimburse the damages. At the end of the reporting period, no reimbursement was made. Should we still recognize a provision and if yes, in what amount?
Answer to question #5
Yes, you should.
The reason is that your liability and your right to its reimbursement are two separate items.
As you have a present obligation as a result of past event, you should definitely make a provision amounting to CU 30 000.
In relation to the reimbursement, if it’s not certain or virtually certain, you should not recognize any asset. You should just disclose the existence of a contingent asset in the notes to the financial statements if it is probable.
If you face any similar issue with the provisions, please let me know in the comments. And if you find this article helpful and useful, share it with your friends. Thank you!