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ACCOUNTING STANDARDS BOARD SEPTEMBER 1998 FRS 12F

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PROVIS IONS,

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ACCOUNTINGSTANDARDSBOARD

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Financial Reporting Standard 12 ‘Provisions, Contingent Liabilities andContingent Assets’ is issued by theAccounting Standards Board in respect of its application in the United Kingdomand by the Institute of CharteredAccountants in Ireland in respect of itsapplication in the Republic of Ireland.

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PROVIS IONS,

CONTINGENT LIABIL IT IES

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ACCOUNTINGSTANDARDSBOARD

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©The Accounting Standards Board Limited 1998ISBN 1 85712 073 6

Financial Reporting Standard 12 is set out in paragraphs 1-102.

The Statement of Standard Accounting Practice, whichcomprises the paragraphs set in bold type, should beread in the context of the Objective as stated in paragraph 1 and the definitions set out in paragraph 2and also of the Foreword to Accounting Standards andthe Statement of Principles for Financial Reportingcurrently in issue.

The explanatory paragraphs contained in the FRSshall be regarded as part of the Statement of StandardAccounting Practice insofar as they assist in interpreting that statement.

Appendix VII ‘The development of the FRS’ reviewsconsiderations and arguments that were thought significant by members of the Board in reaching theconclusions on the FRS.

C O N T E N T S

ParagraphsSUMMARY

FINANCIAL REPORTING STANDARD 12

Objective 1Definitions 2Scope 3-10Provisions and other liabilities 11Relationship between provisions and contingent liabilities 12-13

Recognition 14-35PROVISIONS 14-26

Present obligation 15-16Past event 17-22Probable transfer of economic benefits 23-24Reliable estimate of the obligation 25-26

CONTINGENT LIABILITIES 27-30CONTINGENT ASSETS 31-35

Measurement 36-55Best estimate 36-41Risks and uncertainties 42-44Present value 45-50Future events 51-53Expected disposal of assets 54-55

Reimbursements 56-61Changes in provisions 62-63Use of provisions 64-65Recognising an asset when recognising a provision 66-67

ACCOUNTING STANDARDS BOARD SEPTEMBER FRS

Application of the recognition and measurement rules 68-88Future operating losses 68-70Onerous contracts 71-74Restructuring 75-88

Disclosure 89-97Date from which effective 98Withdrawal of SSAP 18 and amendment of FRS 3 99-100Application of the new requirements 101-102

ADOPTION OF FRS 12 BY THE BOARD

APPENDICES

I TABLES—Main requirements of the FRS

II DECISION TREE

III EXAMPLES—Recognition

IV EXAMPLES—Disclosures

V NOTE ON LEGAL REQUIREMENTS

VI COMPLIANCE WITH INTERNATIONAL ACCOUNTING STANDARDS

VII THE DEVELOPMENT OF THE FRS


S U M M A R Y

General

Financial Reporting Standard ‘Provisions,Contingent Liabilities and Contingent Assets’ sets outthe principles of accounting for provisions, contingentliabilities and contingent assets. Its objective is toensure that appropr iate recognition cr iter ia andmeasurement bases are applied to provisions,contingent liabilities and contingent assets and thatsufficient information is disclosed in the notes to thefinancial statements to enable users to understand theirnature, timing and amount.

Definitions

In the a provision is a liability that is of uncertaintiming or amount, to be settled by the transfer ofeconomic benefits. A contingent liability is either (i) apossible obligation arising from past events whoseexistence will be confirmed only by the occurrence ofone or more uncertain future events not whollywithin the entity’s control; or (ii) a present obligationthat arises from past events but is not recognisedbecause it is not probable that a transfer of economicbenefits will be required to settle the obligation orbecause the amount of the obligation cannot bemeasured with sufficient reliability. A contingent asset isa possible asset ar ising from past events whoseexistence will be confirmed only by the occurrence ofone or more uncertain future events not whollywithin the entity’s control.

SUMMARY

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Scope

The applies to all financial statements that areintended to give a true and fair view in accounting forprovisions, contingent liabilities and contingent assetsexcept:

• those resulting from financial instruments that arecarried at fair value

• those resulting from executory contracts, exceptwhere the contract is onerous

• those arising in insurance entities from contractswith policy-holders

• those covered by more specific requirements inanother or a .

Recognition

Provisions

A provision should be recognised when an entity has apresent obligation (legal or constructive) as a result of apast event, it is probable that a transfer of economicbenefits will be required to settle the obligation, and areliable estimate can be made of the amount of theobligation. Unless these conditions are met, noprovision should be recognised.

Present obligation

Where it is not clear whether a present obligationexists, a past event is deemed to give rise to a presentobligation if, taking account of all available evidence,it is more likely than not that a present obligationexists at the balance sheet date.


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Past event

For an event to be an obligating event, it is necessarythat the entity has no realistic alternative to settling theobligation created by the event. This will be the caseonly where the settlement of the obligation can beenforced by law or, in the case of a constructiveobligation, the event (which may be an action of theentity) creates valid expectations in other parties thatthe entity will discharge the obligation. The onlyliabilities recognised in an entity’s balance sheet arethose that exist at the balance sheet date. Where anentity can avoid future expenditure by its futureactions, for example by changing its method ofoperation, it has no present liability for that futureexpenditure and no provision is recognised.

An event that does not immediately give rise to anobligation may do so at a later date, because ofchanges in the law or because an act (for example, asufficiently specific public statement) by the entitygives rise to a constructive obligation. Where detailsof a proposed new law have yet to be finalised, anobligation arises only when the legislation is virtuallycertain to be enacted as drafted.

Probable transfer of economic benefits

For a liability to qualify for recognition there must benot only a present obligation but also the probabilityof a transfer of economic benefits to settle thatobligation. A transfer of economic benefits insettlement of an obligation is regarded as probable ifthe outflow is more likely than not to occur. Wherethere are a number of similar obligations (eg productwarranties or similar contracts) the probability that atransfer will be required in settlement is determinedby considering the class of obligations as a whole.

SUMMARY

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Reliable estimate of the obligation

An entity will normally be able to determine a rangeof possible outcomes and can therefore make anestimate of the obligation that is sufficiently reliable touse in recognising a provision. In the extremely rarecase where no reliable estimate can be made, a liabilityexists that cannot be recognised. That liability istherefore disclosed as a contingent liability.

Contingent liabilities

An entity should not recognise a contingent liability.

Contingent assets

An entity should not recognise a contingent asset.

Measurement

Best estimate

The amount recognised as a provision should be thebest estimate of the expenditure required to settle thepresent obligation at the balance sheet date. Theprovision is measured before tax, as the taxconsequences of the provision, and changes in it, aredealt with under ‘Accounting for deferredtax’.

Risks and uncertainties

The risks and uncertainties that inevitably surroundmany events and circumstances should be taken intoaccount in reaching the best estimate of the amount ofthe provision. Care is needed to avoid duplicatingadjustments for risk and uncertainty with consequentoverstatement of a provision.


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Present value

Where the effect of the time value of money ismaterial, the amount of a provision should be thepresent value of the expenditures expected to berequired to settle the obligation. The discount rate (orrates) should be a pre-tax rate (or rates) that reflect(s)current market assessments of the time value of moneyand the risks specific to the liability. The discountrate(s) should not reflect risks for which future cashflow estimates have been adjusted.

Future events

Future events that may affect the amount required tosettle the entity’s obligation should be reflected in theamount of a provision where there is sufficientobjective evidence that they will occur. The effect ofpossible new legislation is taken into consideration inmeasuring an existing obligation when sufficientobjective evidence exists that the legislation is virtuallycertain to be enacted.

Expected disposal of assets

Gains from the expected disposal of assets should notbe taken into account in measuring a provision.Instead such gains are assessed for recognition underthe principles of asset recognition, which include therequirements in ‘Impairment of Fixed Assetsand Goodwill’.

SUMMARY

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Reimbursements

Where some or all of the expenditure required tosettle a provision is expected to be reimbursed byanother party, the reimbursement should berecognised only when it is virtually certain thatreimbursement will be received if the entity settles theobligation. The reimbursement should be treated as aseparate asset. The amount recognised for thereimbursement should not exceed that of theprovision. In the profit and loss account, the expenserelating to a provision may be presented net of theamount recognised for a reimbursement.

Changes in provisions

Provisions should be reviewed at each balance sheetdate and adjusted to reflect the current best estimate.If it is no longer probable that a transfer of economicbenefits will be required to settle the obligation, theprovision should be reversed.

Where discounting is used, the size of a provision willchange in each period to reflect the passage of time.This change is recognised as interest expense anddisclosed separately from other interest on the face ofthe profit and loss account.

Use of provisions

A provision should be used only for expenditures forwhich the provision was originally recognised.


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Disclosure

For each class of provision, an entity should disclose:

• the carrying amount at the beginning and end ofthe period

• additional provisions made in the per iod,including increases to existing provisions

• amounts used (ie incurred and charged against theprovision)

• amounts reversed unused

• the change in the discounted amount arising fromthe passage of time and the effect of any change inthe discount rate.

Comparative information need not be disclosed forthese items. In addition the entity should give:

(i) a brief description of the nature of the obligation,and the expected timing of any resulting outflowsof economic benefits;

(ii) an indication of the uncertainties about theamount or timing of those outflows; and

(iii) the amount of any reimbursement, and of anyasset that has been recognised for that expectedreimbursement.

SUMMARY

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Unless the possibility of any transfer in settlement isremote, for each class of contingent liability at thebalance sheet date a brief description of the nature ofthe contingent liability should be disclosed and, wherepracticable, an estimate of its financial effect and anindication of the uncertainties relating to the amountor timing of any outflow. The entity should alsodisclose the possibility of any reimbursement.

Where an inflow of economic benefits is probable, theentity should give a brief description of the nature ofthe contingent assets at the balance sheet date and,where practicable, an estimate of their financial effect.

In extremely rare cases, disclosure of some or all of theinformation required can be expected to prejudiceseriously the position of the entity in a dispute withother parties on the subject matter of the provision,contingent liability or contingent asset. In such casesthe information need not be disclosed; but the generalnature of the dispute should be disclosed, togetherwith the fact that, and reason why, the information hasnot been disclosed.


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F I N A N C I A L R E P O R T I N G S T A N D A R D 1 2

Objective

The objective of this is to ensure that appropriaterecognition criteria and measurement bases are appliedto provisions, contingent liabilities and contingentassets and that sufficient information is disclosed in thenotes to the financial statements to enable users tounderstand their nature, timing and amount.

Definitions

The following definitions shall apply in the and inparticular in the Statement of Standard AccountingPractice set out in bold type.

Constructive obligation:-

An obligation that derives from an entity’s actionswhere:

(a) by an established pattern of past practice,published policies or a sufficiently specific currentstatement, the entity has indicated to other partiesthat it will accept certain responsibilities; and

(b) as a result, the entity has created a validexpectation on the part of those other parties thatit will discharge those responsibilities.

Contingent asset:-

A possible asset that arises from past events and whoseexistence will be confirmed only by the occurrence ofone or more uncertain future events not whollywithin the entity’s control.

FINANCIAL REPORTING STANDARD

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Contingent liability:-

(a) A possible obligation that arises from past eventsand whose existence will be confirmed only bythe occurrence of one or more uncertain futureevents not wholly within the entity’s control; or

(b) a present obligation that arises from past eventsbut is not recognised because:

(i) it is not probable that a transfer of economicbenefits will be required to settle theobligation; or

(ii) the amount of the obligation cannot bemeasured with sufficient reliability.

Legal obligation:-

An obligation that derives from:

(a) a contract (through its explicit or implicit terms);

(b) legislation; or

(c) other operation of law.

Liabilities:-

Obligations of an entity to transfer economic benefitsas a result of past transactions or events.


Obligating event:-

An event that creates a legal or constructive obligationthat results in an entity having no realistic alternativeto settling that obligation.

Onerous contract:-

A contract in which the unavoidable costs of meetingthe obligations under it exceed the economic benefitsexpected to be received under it.

Provision:-

A liability of uncertain timing or amount.

Restructuring:-

A programme that is planned and controlled bymanagement, and materially changes either:

(a) the scope of a business undertaken by an entity; or

(b) the manner in which that business is conducted.

Scope

The FRS applies to all financial statements thatare intended to give a true and fair view inaccounting for provisions, contingent liabilitiesand contingent assets, except:


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(a) those resulting from financial instrumentsthat are carried at fair value;

(b) those resulting from executory contracts,except where the contract is onerous;

(c) those arising in insurance entities fromcontracts with policy-holders; or

(d) those covered by another FRS or aStatement of Standard Accounting Practice(SSAP).

Reporting entities applying the FinancialReporting Standard for Smaller Entities (FRSSE)are exempt from the FRS.

The applies to financial instruments (includingguarantees) that are not carried at fair value.

Executory contracts are contracts under which neitherparty has performed any of its obligations or bothparties have partially performed their obligations to anequal extent. The does not apply to executorycontracts unless they are onerous.

The applies to provisions, contingent liabilities andcontingent assets of insurance entities other than thosearising from contracts with policy-holders.

Where another or a deals with a more specifictype of provision, contingent liability or contingentasset, an entity applies that standard instead of this .For example, certain types of provisions are alsoaddressed in standards on:


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• long-term contracts (see ‘Stocks and long-term contracts’).

• deferred tax (see ‘Accounting for deferredtax’).

• leases (see ‘Accounting for leases and hirepurchase contracts’). However, as contains no specific requirements to deal withoperating leases that have become onerous, the applies to such cases.

• pension costs (see ‘Accounting forpension costs’).

The defines provisions as liabilities of uncertaintiming or amount. The term ‘provision’ is also usedsometimes in the context of items such asdepreciation, impairment of assets and doubtful debts:these are adjustments to the carrying amounts of assetsand are not addressed in the .

The applies to provisions for restructuring (includingdiscontinued operations). Where a restructuring meetsthe definition of a discontinued operation, additionaldisclosures may be required by ‘ReportingFinancial Performance’.

Provisions and other liabilities

Provisions can be distinguished from other liabilitiessuch as trade creditors and accruals because there isuncertainty about the timing or amount of the futureexpenditure required in settlement. By contrast:


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(a) trade creditors are liabilities to pay for goods orservices that have been received or supplied andhave been invoiced or formally agreed with thesupplier; and

(b) accruals are liabilities to pay for goods or servicesthat have been received or supplied but have notbeen paid, invoiced or formally agreed with thesupplier, including amounts due to employees (forexample amounts relating to accrued holiday pay).Although it is sometimes necessary to estimate theamount or timing of accruals, the uncertainty isgenerally much less than for provisions.

Accruals are often reported as part of trade and othercreditors, whereas provisions are reported separately.

Relationship between provisions and contingentliabilities

In a general sense, all provisions are contingentbecause they are uncertain in timing or amount.However, in the the term “contingent” is used forliabilities and assets that are not recognised becausetheir existence will be confirmed only by theoccurrence of one or more uncertain future events notwholly within the entity’s control. In addition, theterm “contingent liability” is used for liabilities that do not meet the recognition criteria.


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The distinguishes between:

(a) provisions—which are recognised as liabilities(assuming that a reliable estimate can be made)because they are present obligations where it isprobable that a transfer of economic benefits willbe required to settle the obligations; and

(b) contingent liabilities—which are not recognised asliabilities because they are either:

(i) possible obligations, as it has yet to beconfirmed whether the entity has anobligation that could lead to a transfer ofeconomic benefits; or

(ii) present obligations that do not meet therecognition criteria in the because eitherit is not probable that a transfer of economicbenefits will be required to settle theobligation, or a sufficiently reliable estimate ofthe amount of the obligation cannot be made.

Recognition

PROVISIONS

A provision should be recognised when:

(a) an entity has a present obligation (legal orconstructive) as a result of a past event;

(b) it is probable that a transfer of economicbenefits will be required to settle theobligation; and


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(c) a reliable estimate can be made of theamount of the obligation.

If these conditions are not met, no provisionshould be recognised.

Present obligation

In rare cases it is not clear whether there is apresent obligation. In these cases, a past eventis deemed to give rise to a present obligation if,taking account of all available evidence, it ismore likely than not that a present obligationexists at the balance sheet date.

In almost all cases it will be clear whether a past eventhas given rise to a present obligation. In rare cases, forexample in a lawsuit, it may be disputed whethercertain events have occurred or whether those eventsresult in a present obligation. In such a case, an entitydetermines whether a present obligation exists at thebalance sheet date by taking account of all availableevidence, including, for example, the opinion ofexperts. The evidence considered includes anyadditional evidence provided by events occurring afterthe balance sheet date. On the basis of such evidence:

(a) where it is more likely than not that a presentobligation exists at the balance sheet date, theentity recognises a provision (if the recognitioncriteria are met); and

(b) where it is more likely that no present obligationexists at the balance sheet date, the entity disclosesa contingent liability, unless the possibility of atransfer of economic resources is remote (seeparagraph ).


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Past event

A past event that leads to a present obligation is calledan obligating event. For an event to be an obligatingevent, it is necessary that the entity has no realisticalternative to settling the obligation created by theevent. This is the case only:

(a) where the settlement of the obligation can beenforced by law; or

(b) in the case of a constructive obligation, where theevent (which may be an action of the entity)creates valid expectations in other parties that theentity will discharge the obligation.

Financial statements deal with the financial position ofan entity at the end of its reporting period and not itspossible position in the future. Therefore no provisionis recognised for costs that need to be incurred tooperate in the future. The only liabilities recognisedin an entity’s balance sheet are those that exist at thebalance sheet date.

It is only those obligations arising from past eventsexisting independently of an entity’s future actions (iethe future conduct of its business) that are recognised asprovisions. Examples of such obligations are penalties orclean-up costs for unlawful environmental damage, bothof which would lead to a transfer of economic benefitsin settlement regardless of the future actions of theentity. Similarly, an entity recognises a provision for thedecommissioning costs of an oil installation or a nuclearpower station to the extent that the entity is obliged torectify damage already caused. In contrast, because ofcommercial pressures or legal requirements, an entitymay intend or need to carry out expenditure to operatein a particular way in the future (for example, by fittingsmoke filters in a certain type of factory). Because theentity can avoid the future expenditure by its future


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actions, for example by changing its method ofoperation, it has no present obligation for that futureexpenditure and no provision is recognised.

An obligation always involves another party to whomthe obligation is owed. It is not necessary, however, toknow the identity of the party to whom the obligationis owed—indeed the obligation may be to the public atlarge. Because an obligation always involves acommitment to another party, it follows that amanagement or board decision does not give rise to aconstructive obligation at the balance sheet date unlessthe decision has been communicated before the balancesheet date to those affected by it in a sufficiently specificmanner to raise a valid expectation in them that theentity will discharge its responsibilities.

An event that does not give rise to an obligationimmediately may do so at a later date, because ofchanges in the law or because an act (for example, asufficiently specific public statement) by the entitygives rise to a constructive obligation. For example,when environmental damage is caused there may beno obligation to remedy the consequences. However,the causing of the damage will become an obligatingevent when a new law requires the existing damage tobe rectified or when the entity publicly acceptsresponsibility for rectification in a way that creates aconstructive obligation.

Where details of a proposed new law have yet to befinalised, an obligation arises only when the legislationis virtually certain to be enacted as drafted. For thepurposes of the , such an obligation is treated as alegal obligation. Differences in circumstancessurrounding enactment make it impossible to specify asingle event that would make the enactment of a lawvirtually certain. In many cases it will be impossibleto be virtually certain of the enactment of a law untilit is enacted.


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Probable transfer of economic benefits

For a liability to qualify for recognition there must benot only a present obligation but also the probability ofa transfer of economic benefits to settle that obligation.For the purpose of the , a transfer of economicbenefits or other event is regarded as probable if theevent is more likely than not to occur, ie theprobability that the event will occur is greater than theprobability that it will not. Where it is not probablethat a present obligation exists, an entity discloses acontingent liability, unless the possibility of a transfer ofeconomic resources is remote (see paragraph ).

Where there are a number of similar obligations (egproduct warranties or similar contracts) the probabilitythat a transfer will be required in settlement isdetermined by considering the class of obligations as awhole. Although the likelihood of outflow for anyone item may be small, it may well be probable thatsome transfer of economic benefits will be needed tosettle the class of obligations as a whole. If that is thecase, a provision is recognised (if the other recognitioncriteria are met).


The use of estimates is an essential part of thepreparation of financial statements and does notundermine their reliability. This is especially true inthe case of provisions, which by their nature are moreuncertain than most other balance sheet items. Exceptin extremely rare cases, an entity will be able todetermine a range of possible outcomes and cantherefore make an estimate of the obligation that issufficiently reliable to use in recognising a provision.

In the extremely rare case where no reliable estimatecan be made, a liability exists that cannot berecognised. That liability is disclosed as a contingentliability (see paragraph ).


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CONTINGENT LIABILITIES

An entity should not recognise a contingentliability.

A contingent liability is disclosed, as required byparagraph , unless the possibility of a transfer ofeconomic benefits is remote.

Where an entity is jointly and severally liable for anobligation, the part of the obligation that is expectedto be met by other parties is treated as a contingentliability. The entity recognises a provision for the partof the obligation for which a transfer of economicbenefits is probable (except in the extremely rarecircumstances where no reliable estimate can bemade).

Contingent liabilities may develop in a way not initiallyexpected. Therefore, they are assessed continually todetermine whether a transfer of economic benefits hasbecome probable. If it becomes probable that atransfer of future economic benefits will be requiredfor an item previously dealt with as a contingentliability, a provision is recognised in the financialstatements of the period in which the change inprobability occurs (except in the extremely rarecircumstances where no reliable estimate can be made).

CONTINGENT ASSETS

An entity should not recognise a contingentasset.

Contingent assets usually arise from unplanned orother unexpected events that g ive r ise to thepossibility of an inflow of economic benefits to theentity. An example is a claim that an entity ispursuing through legal processes, where the outcomeis uncertain.


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Contingent assets are not recognised in financialstatements because it could result in the recognition ofprofit that may never be realised. However, when therealisation of the profit is virtually certain, then therelated asset is not a contingent asset and itsrecognition is appropriate.

A contingent asset is disclosed, as required byparagraph , where an inflow of economic benefits isprobable.

Contingent assets are assessed continually to ensure thatdevelopments are appropriately reflected in the financialstatements. If it has become virtually certain that aninflow of economic benefits will arise, the asset and therelated profit are recognised in the financial statementsof the period in which the change occurs. If an inflowof economic benefits has become probable, an entitydiscloses the contingent asset (see paragraph ).

Measurement

Best estimate

The amount recognised as a provision shouldbe the best estimate of the expenditure requiredto settle the present obligation at the balancesheet date.

The best estimate of the expenditure required to settlethe present obligation is the amount that an entitywould rationally pay to settle the obligation at thebalance sheet date or to transfer it to a third party atthat time. It will often be impossible or prohibitivelyexpensive to settle or transfer an obligation at thebalance sheet date. However, the estimate of theamount that an entity would rationally pay to settle ortransfer the obligation gives the best estimate of theexpenditure required to settle the present obligation atthe balance sheet date.


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The estimates of outcome and financial effect aredetermined by the judgement of the entity’smanagement, supplemented by experience of similartransactions and, in some cases, reports fromindependent experts. The evidence considered willinclude any additional evidence provided by eventsafter the balance sheet date.

Uncertainties sur rounding the amount to berecognised as a provision are dealt with by variousmeans according to the circumstances. Where theprovision being measured involves a large populationof items, the obligation is estimated by weighting allpossible outcomes by their associated probabilities.The name for this statistical method of estimation is‘expected value’. The provision will therefore bedifferent depending on whether the probability of aloss of a given amount is, for example, per cent or per cent. Where there is a continuous range ofpossible outcomes, and each point in that range is aslikely as any other, the mid-point of the range is used.


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Where a single obligation is being measured, theindividual most likely outcome may be the bestestimate of the liability. However, even in such a case,the entity considers other possible outcomes. Whereother possible outcomes are either mostly higher ormostly lower than the most likely outcome, the bestestimate will be a higher or lower amount. Forexample, if an entity has to rectify a serious fault in amajor plant that it has constructed for a customer, theindividual most likely outcome may be for the repairto succeed at the first attempt at a cost of £ millionbut a provision for a larger amount is made if there is asignificant chance that further attempts will benecessary.


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Example

An entity sells goods with a warranty under whichcustomers are covered for the cost of repairs of anymanufacturing defects that become apparent withinthe first six months after purchase. If minor defectswere detected in all products sold, repair costs of £million would result. If major defects were detectedin all products sold, repair costs of £ million wouldresult. The entity’s past experience and futureexpectations indicate that, for the coming year, per cent of the goods sold will have no defects, per cent of the goods sold will have minor defectsand per cent of the goods sold will have majordefects. In accordance with paragraph an entityassesses the probability of a transfer for the warrantyobligations as a whole.

The expected value of the cost of repairs is:(% of nil) + (% of £m) + (% of £m) =£,

The provision is measured before tax, as the taxconsequences of the provision, and changes in it, aredealt with under ‘Accounting for deferredtax’.

Risks and uncertainties

The risks and uncertainties that inevitablysurround many events and circumstancesshould be taken into account in reaching thebest estimate of a provision.

Risk descr ibes var iability of outcome. A r iskadjustment may increase the amount at which aliability is measured. Caution is needed in makingjudgements under conditions of uncertainty, so thatprofit or assets are not overstated and expenses orliabilities are not understated. However, uncertaintydoes not justify the creation of excessive provisions ora deliberate overstatement of liabilities. For example,if the projected costs of a particularly adverse outcomeare estimated on a prudent basis, that outcome is notthen deliberately treated as more probable than isrealistically the case. Care is needed to avoidduplicating adjustments for risk and uncertainty withconsequent overstatement of a provision.

Disclosure of the uncertainties surrounding theamount of the expenditure is made under paragraph(b).

Present value

Where the effect of the time value of money ismaterial, the amount of a provision should bethe present value of the expenditures expectedto be required to settle the obligation.


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Because of the time value of money, provisionsrelating to cash outflows that arise soon after thebalance sheet date are more onerous than those wherecash outflows of the same amount ar ise later.Provisions are therefore discounted, where the effect ismaterial.

The discount rate (or rates) should be a pre-taxrate (or rates) that reflect(s) current marketassessments of the time value of money and therisks specific to the liability. The discountrate(s) should not reflect risks for which futurecash flow estimates have been adjusted.

The unwinding of the discount should beincluded as a financial item adjacent to interestbut should be shown separately from otherinterest either on the face of the profit and lossaccount or in a note.

Using a discount rate that reflects current marketassessments of the time value of money and the risksspecific to the liability is a method of reflecting therisk associated with the cash flows in the present valuecalculation. It is likely that this method will be theeasiest method of reflecting r isk. However, anacceptable alternative is to adjust the cash flows forrisk and to discount them using a risk-free rate (eg agovernment bond rate). Whichever method ofreflecting risk is adopted, care must be taken that theeffect of risk is not double-counted by inclusion inboth the cash flows and the discount rate.

If the cash flows to be discounted are expressed incurrent prices, a real discount rate will be used. If thecash flows are expressed in expected future prices, anominal discount rate will be used.


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Future events

Future events that may affect the amountrequired to settle an obligation should bereflected in the amount of a provision wherethere is sufficient objective evidence that theywill occur.

Expected future events may be particularly importantin measuring provisions. For example, an entity maybelieve that the cost of cleaning up a site at the end ofits life will be reduced by future changes intechnology. The amount recognised reflects areasonable expectation of technically qualified,objective observers, taking account of all availableevidence as to the technology that will be available atthe time of the clean-up. Thus it is appropriate toinclude, for example, expected cost reductionsassociated with increased experience in applyingexisting technology or the expected cost of applyingexisting technology to a larger or more complexclean-up operation than has previously been carriedout. However, an entity does not anticipate thedevelopment of a completely new technology forcleaning up unless it is supported by sufficientobjective evidence.

The effect of possible new legislation is taken intoconsideration in measuring an existing obligationwhen sufficient objective evidence exists that thelegislation is virtually certain to be enacted. Thevariety of circumstances that arise in practice makes itimpossible to specify a single event that will providesufficient, objective evidence in every case. Evidenceis required both of what legislation will demand andof whether it is virtually certain to be enacted andimplemented in due course. In many cases sufficientobjective evidence will not exist until the newlegislation is enacted.


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Gains from the expected disposal of assetsshould not be taken into account in measuringa provision.

Gains on the expected disposal of assets are not takeninto account in measuring a provision, even if theexpected disposal is closely linked to the event givingrise to the provision. Instead, an entity assesses suchgains for recognition under the principles of assetrecognition, which include the requirements in ‘Impairment of Fixed Assets and Goodwill’.

Reimbursements

Where some or all of the expenditure required tosettle a provision is expected to be reimbursedby another party, the reimbursement should berecognised only when it is virtually certain thatreimbursement will be received if the entitysettles the obligation. The reimbursementshould be treated as a separate asset. Theamount recognised for the reimbursementshould not exceed the amount of the provision.

In the profit and loss account, the expenserelating to a provision may be presented net ofthe amount recognised for a reimbursement.

Sometimes, an entity is able to look to another partyto pay part or all of the expenditure required to settlea provision (for example, through insurance contracts,indemnity clauses or suppliers’ warranties). The otherparty may either reimburse amounts paid by the entityor pay the amounts directly.


54

55

56

57

58

In most cases, the entity will remain liable for thewhole of the amount in question so that the entitywould have to settle the full amount if the third partyfailed to pay for any reason. In this situation, aprovision is recognised for the full amount of theliability, and a separate asset for the expectedreimbursement is recognised when it is virtuallycertain that reimbursement will be received if theentity settles the liability.

In some cases the entity will not be liable for the costsin question if the third party fails to pay. In such acase the entity has no liability for those costs and theyare not included in the provision.

As noted in paragraph , an obligation for which anentity is jointly and severally liable is a contingentliability to the extent that it is expected that theobligation will be settled by the other parties.

Changes in provisions

Provisions should be reviewed at each balancesheet date and adjusted to reflect the currentbest estimate. If it is no longer probable that atransfer of economic benefits will be requiredto settle the obligation, the provision should bereversed.

Where discounting is used, the carrying amount of aprovision increases in each period to reflect the passageof time. As required in paragraph , this increase isrecognised as an interest expense.


59

60

61

62

63

Use of provisions

A provision should be used only forexpenditures for which the provision wasoriginally recognised.

Only expenditures that relate to the original provisionare set against it. Setting expenditures against aprovision that was originally recognised for anotherpurpose would conceal the impact of two differentevents.

Recognising an asset when recognising a provision

When a provision or a change in a provision isrecognised, an asset should also be recognisedwhen, and only when, the incurring of thepresent obligation recognised as a provisiongives access to future economic benefits;otherwise the setting up of the provision shouldbe charged immediately to the profit and lossaccount.

Where a provision is recognised for a presentobligation that has been incurred to gain rights orother access to future economic benefits that are to beenjoyed over more than one period, the part of theprovision incurred that relates to such future benefits iscapitalised. For example, an obligation fordecommissioning costs is incurred by commissioningan oil rig but the commissioning also gives access tooil reserves over the years of the oil rig’s operation—an asset representing future access to oil reserves istherefore recognised at the same time as the provisionfor decommissioning costs.


64

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66

67

Application of the recognition and measurement rules

Future operating losses

Provisions should not be recognised for futureoperating losses.

Future operating losses do not meet the definition of aliability in paragraph and the general recognitioncriteria set out for provisions in paragraph .

An expectation of future operating losses is anindication that certain assets of the operation may beimpaired. An entity tests these assets for impairmentunder .

Onerous contracts

If an entity has a contract that is onerous, thepresent obligation under the contract should berecognised and measured as a provision.

Many contracts (for example, some routine purchaseorders) can be cancelled without paying compensationto the other party, and therefore there is no obligation.Other contracts establish both rights and obligationsfor each of the contracting parties. Where eventsmake such a contract onerous, the contract falls withinthe scope of the and a liability exists which isrecognised. Executory contracts that are not onerousfall outside the scope of the .

The defines an onerous contract as a contract inwhich the unavoidable costs of meeting theobligations under it exceed the economic benefitsexpected to be received under it. The unavoidablecosts under a contract reflect the least net cost ofexiting from the contract, ie the lower of the cost offulfilling it and any compensation or penalties arisingfrom failure to fulfil it.


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69

70

71

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73

Before a separate provision for an onerous contract isestablished, an entity recognises any impairment lossthat has occurred on assets dedicated to that contract.

Restructuring

The following are examples of events that may fallunder the definition of restructuring:

(a) sale or termination of a line of business;

(b) the closure of business locations in a country orregion or the relocation of business activities fromone country or region to another;

(c) changes in management structure, for example,eliminating a layer of management; and

(d) fundamental reorganisations that have a materialeffect on the nature and focus of the entity’soperations.

A provision for restructuring costs is recognised onlywhen the general recognition criteria for provisions setout in paragraph are met. Paragraphs - set outhow those criteria apply to restructurings.


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76

A constructive obligation to restructure arisesonly when an entity:

(a) has a detailed formal plan for therestructuring identifying at least:

(i) the business or part of a businessconcerned;

(ii) the principal locations affected;

(iii) the location, function, and approximatenumber of employees who will becompensated for terminating theirservices;

(iv) the expenditures that will be undertaken;and

(v) when the plan will be implemented;and

(b) has raised a valid expectation in thoseaffected that it will carry out therestructuring by starting to implement thatplan or announcing its main features tothose affected by it.

Evidence that an entity has started to implement arestructuring plan would be provided, for example, bydismantling plant or selling assets or by the publicannouncement of the main features of the plan. Apublic announcement of a detailed plan to restructureconstitutes a constructive obligation to restructureonly if it is made in such a way and in sufficient detail(ie setting out the main features of the plan) that itgives rise to valid expectations in other parties such ascustomers, suppliers and employees (or theirrepresentatives) that the entity will carry out therestructuring.


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78

For a plan to be sufficient to give rise to a constructiveobligation when communicated to those affected by it,its implementation needs to be planned to begin assoon as possible and to be completed in a timeframethat makes significant changes to the plan unlikely. Ifit is expected that there will be a long delay before therestructuring begins or that the restructuring will takean unreasonably long time, it is unlikely that the planwill raise a valid expectation on the part of others thatthe entity is at present committed to restructuring,because the timeframe allows opportunities for theentity to change its plans.

A management or board decision to restructure takenbefore the balance sheet date does not give rise to aconstructive obligation at the balance sheet date unlessthe entity has, before the balance sheet date:

(a) started to implement the restructuring plan; or

(b) announced the main features of the restructuringplan to those affected by it in a sufficiently specificmanner to raise a valid expectation in them thatthe entity will carry out the restructuring.

In some cases the entity starts to implement therestructuring plan, or announces its main features tothose affected by it, only after the balance sheet date.Disclosure may be required under ‘Accountingfor post balance sheet events’ if the restructuring is ofsuch importance that its non-disclosure would affectthe ability of the users of the financial statements tomake proper evaluations and decisions.


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80

Although a constructive obligation is not createdsolely by a management decision, an obligation mayresult from other earlier events together with such adecision. For example, negotiations with employeerepresentatives for termination payments, or withpurchasers for the sale of an operation, may have beenconcluded subject only to board approval. Once thatapproval has been obtained and communicated to theother parties, the entity has a constructive obligationto restructure, if the conditions of paragraph aremet.

In some countries the ultimate authority is vested in aboard whose membership includes representatives ofinterests other than management (eg employees);alternatively, notification to such representatives maybe necessary before the board decision is taken.Because a decision by the board in these circumstancesinvolves communication to these representatives, itmay result in a constructive obligation to restructure.

No obligation arises for the sale of an operationuntil the entity is committed to the sale, iethere is a binding sale agreement.

Even when an entity has taken a decision to sell anoperation and announced that decision publicly, itcannot be committed to the sale until a purchaser hasbeen identified and there is a binding sale agreement.Until there is such an agreement, the entity will beable to change its mind and indeed will have to takeanother course of action if a purchaser cannot befound on acceptable terms. When the sale of anoperation is envisaged as part of a restructuring, theassets of the operation are reviewed for impairment,under . When a sale is only part of arestructuring, a constructive obligation can arise forthe other parts of the restructuring before a bindingsale agreement exists.


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84

A restructuring provision should include onlythe direct expenditures ar ising from therestructuring, which are those that are both:

(a) necessarily entailed by the restructuring and

(b) not associated with the ongoing activities ofthe entity.

A restructuring provision does not include such costs as:

(a) retraining or relocating continuing staff;

(b) marketing; or

(c) investment in new systems and distr ibutionnetworks.

These expenditures relate to the future conduct of thebusiness and are not liabilities for restructuring at thebalance sheet date. Such expenditures are recognisedon the same basis as if they arose independently of arestructuring.

Identifiable future operating losses up to the date of arestructuring are not included in a provision, unlessthey relate to an onerous contract as defined inparagraph .

As required by paragraph , gains on the expecteddisposal of assets are not taken into account inmeasuring a restructuring provision, even if the sale ofassets is envisaged as part of the restructuring.


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88

Disclosure

For each class of provision, an entity shoulddisclose:

(a) the carrying amount at the beginning andend of the period;

(b) additional provisions made in the period,including increases to existing provisions;

(c) amounts used (ie incurred and chargedagainst the provision) during the period;

(d) unused amounts reversed during the period;and

(e) the increase dur ing the per iod in thediscounted amount arising from the passageof time and the effect of any change in thediscount rate.

Comparative information is not required.

An entity should disclose the following for eachclass of provision:

(a) a brief description of the nature of theobligation, and the expected timing of anyresulting transfers of economic benefits;

(b) an indication of the uncertainties about theamount or timing of those transfers ofeconomic benefits. Where necessary toprovide adequate information, an entityshould disclose the major assumptionsmade concerning future events, asaddressed in paragraph 51; and


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90

(c) the amount of any expectedreimbursement, stating the amount of anyasset that has been recognised for thatexpected reimbursement.

Unless the possibility of any transfer insettlement is remote, an entity should disclosefor each class of contingent liability at thebalance sheet date a brief description of thenature of the contingent liability and, wherepracticable:

(a) an estimate of its financial effect, measuredin accordance with paragraphs 36-55;

(b) an indication of the uncertainties relating tothe amount or timing of any outflow; and

(c) the possibility of any reimbursement.

In determining which provisions or contingentliabilities may be aggregated to form a class, it isnecessary to consider whether the nature of the itemsis sufficiently similar for a single statement about themto fulfil the requirements of paragraph (a) and (b) or(a) and (b). Thus it may be appropriate to treat as asingle class of provision amounts relating to warrantiesof different products, but it would not be appropriateto treat as a single class amounts relating to normalwarranties and amounts that are subject to legalproceedings.

Where a provision and a contingent liability arise fromthe same set of circumstances, an entity makes thedisclosures required by paragraphs - in a way thatshows the link between the provision and thecontingent liability.


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Where an inflow of economic benefits isprobable, an entity should disclose a briefdescription of the nature of the contingentassets at the balance sheet date and, wherepracticable, an estimate of their financial effect,measured using the pr inciples set out forprovisions in paragraphs 36-55.

It is important that disclosures for contingent assetsavoid giving misleading indications of the likelihoodof a profit arising.

Where any of the information required byparagraphs 91 and 94 is not disclosed because itis not practicable to do so, that fact should bestated.

In extremely rare cases, disclosure of some orall of the information required by paragraphs89-94 can be expected to prejudice seriously theposition of the entity in a dispute with otherparties on the subject matter of the provision,contingent liability or contingent asset. In suchcases an entity need not disclose theinformation, unless its disclosure is required bylaw; but should disclose the general nature ofthe dispute, together with the fact that, andreason why, the information has not beendisclosed.

Date from which effective

The accounting practices set out in the FRSshould be regarded as standard in respect offinancial statements relating to accountingperiods ending on or after 23 March 1999.Earlier adoption is encouraged but notrequired.


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Withdrawal of SSAP 18 and amendment of FRS 3

The FRS supersedes SSAP 18 ‘Accounting forcontingencies’.

In FRS 3 ‘Reporting Financial Performance’paragraph 18 is amended as follows:

(a) in the first sentence the words “or thedisposal of its assets” are deleted.

(b) in the fourth sentence the words “or disposalof its assets” are deleted.

Application of the new requirements

Changes in accounting policy arising from theinitial application of the FRS should be dealtwith as prior period adjustments in accordancewith FRS 3 (paragraphs 7, 29 and 62).Corrections of accounting estimates should bedealt with in the profit and loss account of theperiod of initial application, and their effectstated where material (FRS 3, paragraph 60).

The initial application of the will in somecircumstances entail a change in accounting policy,and, in other cases, a correction of accountingestimate. For example, where no provision waspreviously recognised for decommissioning costs butthe requires that a provision is recognised, orwhere a provision was previously recognised that is notpermitted by the (for example, a provision for self-insurance), the application of the recognitionprinciples set out in the is a change in accountingpolicy. In contrast, where, for example, an entityalready provides for its warranties but the initialapplication of the causes the provision to bemeasured at a different amount, the change is a changein accounting estimate.


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A D O P T I O N O F F R S 1 2 B Y T H E B O A R D

Financial Reporting Standard 12 - ‘Provisions,Contingent Liabilities and Contingent Assets’ wasapproved for issue by the ten members of theAccounting Standards Board.

Sir David Tweedie (Chairman)

Allan Cook (Technical Director)

David Allvey

Ian Brindle

Dr John Buchanan

John Coombe

Raymond Hinton

Huw Jones

Professor Geoffrey Whittington

Ken Wild

ADOPTION OF FRS BY THE BOARD

A P P E N D I X I

T A B L E S : M A I N R E Q U I R E M E N T S O F T H E F R S

This appendix summarises the main requirements ofthe FRS. It does not form part of the FRS and shouldbe read in the context of the full text.

Provisions and contingent liabilities

A contingent liability also arises in the extremely rarecase where there is a liability that cannot be recognisedbecause it cannot be measured reliably (paragraph ).Disclosures are required for the contingent liability(paragraph ).

APPENDIX I - TABLES: MAIN REQUIREMENTS OF THE FRS

Where, as a result of past events, there may be a transfer offuture economic benefits in settlement of (a) a presentobligation or (b) a possible obligation whose existence will beconfirmed by the occurrence of one or more uncertain futureevents not wholly within the entity’s control, and

there is a presentobligation thatprobably requires atransfer ofeconomic benefitsin settlement,

a provision isrecognised (paragraph 14); and

disclosures arerequired for theprovision (paragraphs89 and 90).

there is a possibleobligation or apresent obligationthat may, butprobably will not,require a transferof economicbenefits insettlement,

no provision isrecognised (paragraph 27); but

disclosures arerequired for thecontingent liability(paragraph 91).

there is a possibleobligation or apresent obligationwhere thelikelihood of atransfer ofeconomic benefitsin settlement isremote,

no provision isrecognised (paragraph 27); and

no disclosure isrequired (paragraph 91).

Contingent assets


Where, as a result of past events, there is a possible asset whose existence will be confirmed by the occurrence of one or more uncertain future events not wholly within the entity’scontrol, and

the inflow ofeconomic benefitsis virtually certain,

the asset is notcontingent (paragraph 33).

the inflow ofeconomic benefitsis probable but notvirtually certain,

no asset is recognised(paragraph 31); but

disclosures arerequired (paragraph 94).

the inflow is notprobable,

no asset is recognised(paragraph 31); and

no disclosure isrequired (paragraph 94).

Reimbursements

APPENDIX I - TABLES: MAIN REQUIREMENTS OF THE FRS

Where some or all of the expenditure required to settle aprovision is expected to be reimbursed by another party, and

the entity has noobligation for thepart of theexpenditure to bereimbursed by theother party,

the entity has noliability for theamount to bereimbursed(paragraph 60); and

no disclosure isrequired.

the obligation forthe amountexpected to bereimbursedremains with theentity and it isvirtually certainthatreimbursement willbe received if theentity settles theprovision,

the reimbursement isrecognised as aseparate asset in thebalance sheet and maybe offset against thecharge in the profitand loss account.The amountrecognised for theexpectedreimbursement doesnot exceed theliability (paragraphs56 and 57); and

the reimbursement isdisclosed togetherwith the amountrecognised for thereimbursement(paragraph 90(c)).

the obligation forthe amountexpected to bereimbursedremains with theentity and thereimbursement isnot virtuallycertain if the entitysettles theprovision,

the expectedreimbursement is notrecognised as an asset(paragraph 56); but

the expectedreimbursement isdisclosed (paragraph 90(c)).

A P P E N D I X I I

D E C I S I O N T R E E

This appendix summarises the main requirements ofthe FRS. It does not form part of the FRS and shouldbe read in the context of the full text.

Note: in rare cases it is not clear whether there is a presentobligation. In these cases, a past event is deemed to give rise toa present obligation if, taking account of all available evidence,it is more likely than not that a present obligation exists at thebalance sheet date (see paragraph 15).

APPENDIX II - DECISION TREE

Start

Yes Yes

No No

No Yes

No (rare)

Yes No

Yes

Present obligation as a

result of anobligating

event?

Possibleobligation?

Remote?Probableoutflow?

Reliableestimate?

ProvideDisclose

contingent liabilityDo nothing

A P P E N D I X I I I

E X A M P L E S : R E C O G N I T I O N

This appendix illustrates the application of the FRS toassist in clarifying its meaning. It does not form partof the FRS.

All the entities in the examples have 31 December year-ends.In all cases it is assumed that a reliable estimate can be madeof any outflows expected. In some examples thecircumstances described may have resulted in impairment ofthe assets—this aspect is not dealt with in the examples.

The cross-references in the examples are to paragraphs of theFRS that are particularly relevant. The appendix should beread in the context of the full text of the FRS.

References to “best estimate” are to the present value amountwhere the effect of the time value of money is material.

APPENDIX III - EXAMPLES: RECOGNITION

Example 1:Warranties

A manufacturer gives warranties at the time of sale topurchasers of its product. Under the terms of thecontract for sale the manufacturer undertakes to makegood, by repair or replacement, manufacturing defectsthat become apparent within three years from the dateof sale. On past experience, it is probable (ie morelikely than not) that there will be some claims underthe warranties.

Present obligation as a result of a pastobligating event—The obligating event is the sale ofthe product with a warranty, which gives rise to a legalobligation.

Transfer of economic benefits in settlement—Probable for the warranties as a whole (see paragraph).

Conclusion—A provision is recognised for the bestestimate of the costs of making good under thewarranty products sold before the balance sheet date(see paragraphs and ).


Example 2A:Contaminated land - legislation virtually certain to be enacted

An entity in the oil industry causes contamination butcleans up only when required to do so under the lawsof the particular country in which it operates. Onecountry in which it operates has had no legislationrequir ing cleaning up, and the entity has beencontaminating land in that country for several years.At December it is virtually certain that a draft lawrequiring a clean-up of land already contaminated willbe enacted shortly after the year-end.

Present obligation as a result of a pastobligating event—The obligating event is thecontamination of the land because of the virtualcertainty of legislation requiring cleaning up.

Transfer of economic benefits in settlement—Probable.

Conclusion—A provision is recognised for the bestestimate of the costs of the clean-up (see paragraphs and ).


Example 2B:Contaminated land and constructive obligation

An entity in the oil industry causes contamination andoperates in a country where there is no environmentalleg islation. However, the entity has a widelypublished environmental policy in which it undertakesto clean up all contamination that it causes. Theentity has a record of honouring this published policy.

Present obligation as a result of a pastobligating event—The obligating event is thecontamination of the land, which gives r ise to aconstructive obligation because the conduct of theentity has created a valid expectation on the part ofthose affected by it that the entity will clean upcontamination.


Conclusion—A provision is recognised for the bestestimate of the costs of clean-up (see paragraphs (thedefinition of a constructive obligation), and ).


Example 3:Offshore oilfield

An entity operates an offshore oilfield where itslicensing agreement requires it to remove the oil rig atthe end of production and restore the seabed. Ninetyper cent of the eventual costs of undertaking this workrelate to the removal of the oil rig and restoration ofdamage caused by building it, and ten per cent arisethrough the extraction of oil. At the balance sheetdate, the rig has been constructed but no oil has beenextracted.

Present obligation as a result of a pastobligating event—The construction of the oil rigcreates a legal obligation under the terms of thelicence to remove the rig and restore the seabed and isthus an obligating event. At the balance sheet date,however, there is no obligation to rectify the damagethat will be caused by extraction of the oil.


Conclusion—A provision is recognised for the bestestimate of the ninety per cent of the eventual coststhat relate to the removal of the oil rig and restorationof damage caused by building it (see paragraphs -). These costs are included as part of the cost ofthe oil r ig. The ten per cent of costs that arisethrough the extraction of oil are recognised as aliability when the oil is extracted.


Example 4:Refunds policy

A retail store has a policy of refunding purchases bydissatisfied customers, even though it is under no legalobligation to do so. Its policy of making refunds isgenerally known.

Present obligation as a result of a pastobligating event—The obligating event is the sale ofthe product, which gives r ise to a constructiveobligation because the conduct of the store has createda valid expectation on the part of its customers thatthe store will refund purchases.

Transfer of economic benefits in settlement—Probable, as a proportion of goods are returned forrefund (see paragraph ).

Conclusion—A provision is recognised for the bestestimate of the costs of refunds (see paragraphs (thedefinition of a constructive obligation), , and ).


Example 5A:Closure of a division—no implementation beforebalance sheet date

On December the board of an entity decidedto close down a division. Before the balance sheetdate ( December ) the decision was notcommunicated to any of those affected and no othersteps were taken to implement the decision.

Present obligation as a result of a pastobligating event—There has been no obligatingevent and so there is no obligation.

Conclusion—No provision is recognised (seeparagraphs and ).

Example 5B:Closure of a division—communication/implementation before balance sheet date

On December the board of an entity decidedto close down a division making a particular product.On December a detailed plan for closingdown the division was agreed by the board; letterswere sent to customers warning them to seek analternative source of supply and redundancy noticeswere sent to the staff of the division.

Present obligation as a result of a pastobligating event—The obligating event is thecommunication of the decision to the customers andemployees, which g ives r ise to a constructiveobligation from that date because it creates a validexpectation that the division will be closed.


Conclusion—A provision is recognised at December for the best estimate of the costs ofclosing the division (see paragraphs and ).


Example 6:Legal requirement to fit smoke filters

Under new legislation, an entity is required to fitsmoke filters to its factories by June . Theentity has not fitted the smoke filters.

(a) At the balance sheet date of 31 December 1999

Present obligation as a result of a pastobligating event—There is no obligation becausethere is no obligating event either for the costs offitting smoke filters or for fines under the legislation.

Conclusion—No provision is recognised for the costof fitting the smoke filters (see paragraphs , and).

(b) At the balance sheet date of 31 December 2000

Present obligation as a result of a pastobligating event—There is still no obligation for thecosts of fitting smoke filters because no obligatingevent (the fitting of the filters) has occur red.However, an obligation might arise to pay fines orpenalties under the legislation because the obligatingevent has occurred (the non-compliant operation ofthe factory).

Transfer of economic benefits in settlement—Assessment of probability of incurr ing fines andpenalties by non-compliant operation depends on thedetails of the legislation and the stringency of theenforcement regime.

Conclusion—No provision is recognised for the costsof fitting smoke filters. However, a provision isrecognised for the best estimate of any fines andpenalties that are more likely than not to be imposed(see paragraphs and -).


Example 7:Staff retraining as a result of changes in the income tax system

The government introduces a number of changes tothe income tax system. As a result of these changes anentity in the financial services sector will need toretrain a large proportion of its administrative and salesworkforce in order to ensure continued compliancewith financial services regulation. At the balance sheetdate no retraining of staff has taken place.

Present obligation as a result of a pastobligating event—There is no obligation because noobligating event (retraining) has taken place.

Conclusion—No provision is recognised (seeparagraphs and -).


Example 8:An onerous contract

An entity operates profitably from a factory that it hasleased under an operating lease. During December the entity relocates its operations to a newfactory. The lease on the old factory continues for thenext four years, it cannot be cancelled and the factorycannot be re-let to another user.

Present obligation as a result of a pastobligating event—The obligating event is thesigning of the lease contract, which gives rise to a legalobligation.

Transfer of economic benefits in settlement—When the lease becomes onerous, a transfer ofeconomic benefits is probable. (Until the leasebecomes onerous, the entity accounts for the lease byapplying ‘Accounting for leases and hirepurchase agreements’.)

Conclusion—A provision is recognised for the bestestimate of the unavoidable lease payments (seeparagraphs and ).


Example 9:A single guarantee

During Entity A gives a guarantee of certainborrowings of Entity B, whose financial condition atthat time is sound. Dur ing , the financialcondition of Entity B deteriorates and at June Entity B files for protection from its creditors.

(a) At 31 December 1999

Present obligation as a result of a pastobligating event—The obligating event is the givingof the guarantee, which gives rise to a legal obligation.

Transfer of economic benefits in settlement—Notransfer of benefits is probable at December .

Conclusion—No provision is recognised (seeparagraphs and ). The guarantee is disclosed as acontingent liability unless the probability of anytransfer is regarded as remote (see paragraph ).

(b) At 31 December 2000

Present obligation as a result of a pastobligating event—The obligating event is the givingof the guarantee, which gives rise to a legal obligation.

Transfer of economic benefits in settlement—At December it is probable that a transfer ofeconomic benefits will be required to settle the obligation.

Conclusion—A provision is recognised for the bestestimate of the obligation (see paragraphs and ).

Note: This example deals with a single guarantee. If anentity has a portfolio of similar guarantees, it will assess thatportfolio as a whole in determining whether a transfer ofeconomic benefit is probable (see paragraph 24). Where anentity gives guarantees in exchange for a fee, revenue isrecognised only when earned.


Example 10:A court case

After a wedding in ten people died, possibly as aresult of food poisoning from products sold by theentity. Legal proceedings are started seeking damagesfrom the entity but it disputes liability. Up to the dateof approval of the financial statements for the year to December , the entity’s lawyers advise that it isprobable that the entity will not be found liable.However, when the entity prepares the financialstatements for the year to December itslawyers advise that, owing to developments in thecase, it is probable that the entity will be found liable.

(a) At 31 December 2000

Present obligation as a result of a pastobligating event—On the basis of the evidenceavailable when the financial statements were approved,there is no obligation as a result of past events.

Conclusion—No provision is recognised (seeparagraphs -). The matter is disclosed as acontingent liability unless the probability of anytransfer is regarded as remote.

(b) At 31 December 2001

Present obligation as a result of a pastobligating event—On the basis of the evidenceavailable, there is a present obligation.


Conclusion—A provision is recognised for the bestestimate of the amount needed to settle the presentobligation (paragraphs -).


Example 11:Repairs and maintenance

Some assets require, in addition to routinemaintenance, substantial expenditure every few yearsfor major refits or refurbishment and the replacementof major components.

Example 11A:Refurbishment costs—no legislative requirement

A furnace has a lining that needs to be replaced everyfive years for technical reasons. At the balance sheetdate, the lining has been in use for three years.

Present obligation as a result of a pastobligating event—There is no present obligation.


The cost of replacing the lining is not recognisedbecause, at the balance sheet date, no obligation toreplace the lining exists independently of the entity’sfuture actions—even the intention to incur theexpenditure depends on the entity deciding tocontinue operating the furnace or to replace thelining. Instead of a provision being recognised, thedepreciation of the lining takes account of itsconsumption, ie it is depreciated over five years. There-lining costs then incurred are capitalised with theconsumption of each new lining shown bydepreciation over the subsequent five years.


Example 11B:Refurbishment costs—legislative requirement

An airline is required by law to overhaul its aircraftonce every three years.



The costs of overhauling aircraft are not recognised asa provision for the same reasons as the cost ofreplacing the lining is not recognised as a provision inexample A. Even a legal requirement to overhauldoes not make the costs of overhaul a liability becauseno obligation exists to overhaul the aircraftindependently of the entity’s future actions—the entitycould avoid the future expenditure by its futureactions, for example by selling the aircraft. Instead ofa provision being recognised, the depreciation of theaircraft takes account of the future incidence ofmaintenance costs, ie an amount equivalent to theexpected maintenance costs is depreciated over threeyears.


Example 12:Self-insurance

An entity that operates a chain of retail outlets decidesnot to insure itself in respect of the risk of minoraccidents to its customers: instead it will “self insure”.Based on its past exper ience, it expects to pay£, a year in respect of these accidents. Shouldprovision be made for the amount expected to arise ina normal year?


Conclusion—No provision is recognised. There isno present obligation because there is no other partyinvolved in insuring the risks (see paragraph ).


A P P E N D I X I V

E X A M P L E S : D I S C L O S U R E S

These examples are illustrative only and do not formpart of the FRS.

Examples 1 and 2 provide examples of the disclosuresrequired by paragraph 90.


Example 1:

Warranties

A manufacturer gives warranties at the time of saleto purchasers of its three product lines. Under theterms of the warranty the manufacturer undertakesto repair or replace items that fail to performsatisfactorily for two years from the date of sale. Atthe balance sheet date a provision of £, hasbeen recognised. The provision has not beendiscounted as the effect of discounting is notmaterial. The following information is disclosed:

“A provision of £60,000 has been recognised for expectedwarranty claims on products sold during the last threefinancial years. It is expected that most of this expenditurewill be incurred in the next financial year, and all will beincurred within two years of the balance sheet date.”

APPENDIX IV - EXAMPLES: DISCLOSURES

Example 2:

Decommissioning costs

In an entity involved in nuclear activitiesrecognises a provision for decommissioning costs of£ million. The provision is estimated using theassumption that decommissioning will take place in- years’ time. However, there is a possibilitythat it will not take place until - years’ time,in which case the present value of the costs will besignificantly reduced. The following information isdisclosed:

“A provision of £300 million has been recognised fordecommissioning costs. These costs are expected to beincurred between 2060 and 2070. However, there is apossibility that decommissioning will not take place until2100-2110. If the costs were measured based upon theexpectation that they would not be incurred until 2100-2110 the provision would be reduced to £136 million.The provision has been estimated using existingtechnology, at current prices, and discounted using a realdiscount rate of 2 per cent.”

Example 3 provides an example of the disclosures required byparagraph 97, where some of the information required is notgiven because it can be expected to prejudice seriously theposition of the entity.


Example 3:

Disclosure exemption

An entity is involved in a dispute with a competitor,who is alleging that the entity has infringed patentsand is seeking damages of £ million. The entityrecognises a provision for its best estimate of theobligation, but discloses none of the informationrequired by paragraphs and . The followinginformation is disclosed:

“Litigation is in process against the company relating to adispute with a competitor which alleges that the companyhas infringed patents and which is seeking damages of£100 million. The information usually required byFRS 12 is not disclosed on the grounds that it can beexpected to prejudice seriously the outcome of the litigation.The directors are of the opinion that the claim can besuccessfully resisted by the company.”

A P P E N D I X V

N O T E O N L E G A L R E Q U I R E M E N T S

Great Britain

The statutory requirements on accounting forprovisions and contingencies are set out in theCompanies Act . The main requirements that aredirectly relevant are set out in Schedules and A andare summarised below.

Schedule to the Act does not apply to banking andinsurance companies and groups. Banking companiesand groups are dealt with in Schedule and insurancecompanies and groups are dealt with in Schedule A.

Paragraph (b) of Schedule states the generalrequirement that “all liabilities and losses which havearisen or are likely to arise in respect of the financialyear to which the accounts relate or a previousfinancial year shall be taken into account ...”

Provisions represent one aspect of the manner inwhich this general requirement is met. Provisions aredefined in paragraph of Schedule in the followingmanner:

“References to provisions for liabilities or charges areto any amount retained as reasonably necessary for thepurposes of providing for any liability or loss which iseither likely to be incurred, or certain to be incurredbut uncertain as to amount or as to the date on whichit will arise.”

The defines a provision as:

“A liability of uncertain timing or amount.”

APPENDIX V - NOTE ON LEGAL REQUIREMENTS

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The requirements of the are expressed in morespecific terms than the requirements in Schedule .However, although the Act and the defineprovisions in different terms, the Board believes that,when taken in their respective contexts, the isconsistent with the requirements of Schedule .

The legal definition refers to “... any amount retainedas reasonably necessary for the purposes ...”. Thereference to reasonableness recognises that theappropriate amount to set aside as a provision for aspecific matter will often be a matter of judgement.The sets out the manner in which this judgementshould be exercised in the context of giving a true andfair view.

In addition, the legal definition refers to “... anyliability or loss ... [whether likely to be incurred orcertain to be incur red]” and this needs to beconsidered in conjunction with the generalrequirement that “liabilities or losses have arisen or arelikely to arise in respect of the financial year to whichthe accounts relate [or a previous financial year]”(paragraph (b) of Schedule ). These requirementsare consistent with the Board’s approach of requiringthere to be a past transaction or event that gives rise toan obligation, before a provision can be recognised.Without a past transaction or event the liability or losswill not have arisen or be likely to arise in respect ofthe financial year or a previous financial year. Before aliability can be recognised, the draft Statement ofPrinciples for Financial Reporting* requires sufficientevidence that a future transfer of benefits will occur.


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* Exposure Draft, November 1995

In addition to covering liabilities that are certain to beincurred, the statutory definition also refers toliabilities as losses that are “likely to be incurred”.This aspect of likelihood is covered in the in tworespects. The requires provisions to be recognisedarising from ‘constructive obligations’, which areliabilities that pass the test of sufficient certaintywithout constituting legal liabilities. The alsorequires the recognition of provisions where a transferof economic benefit is more likely than not to occur.

Where any amount is transferred to any provision forliabilities and charges or from any provision forliabilities and charges otherwise than for the purposefor which the provision was established, paragraph() and () of Schedule requires the followinginformation to be disclosed:

(a) the amount of the provisions as at the date of thebeginning of the financial year and as at thebalance sheet date respectively;

(b) any amounts transferred to or from provisionsduring that year; and

(c) the source and application respectively of anyamounts so transferred.

Paragraph () of Schedule requires particulars tobe given of each material provision included in theitem “other provisions” in the company’s balancesheet.


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Paragraph () of Schedule requires the followinginformation to be given in respect of any othercontingent liability not provided for:

(a) the amount or estimated amount of that liability;

(b) its legal nature; and

(c) whether any valuable security has been providedby the company in connection with that liabilityand, if so, what.

Northern Ireland

The statutory requirements in Northern Ireland areset out in the Companies (Northern Ireland) Order. They are identical to and parallel the referencesin the legislation for Great Britain cited above.

Republic of Ireland

The statutory requirements in the Republic of Irelandthat correspond to those cited above for Great Britainare shown in the following table.


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Great Britain Republic of Ireland

Schedule to the The Schedule to the CompaniesCompanies Act (Amendment) Act

Schedule A to the Regulation () of theCompanies Act European Communities

(Companies: Group Accounts) Regulations

Schedule to the European Communities (Credit Companies Act Institutions: Accounts)

Regulations

Schedule A to the European Communities Companies Act (Insurance Undertakings:

Accounts) Regulations

Paragraph (b) of Schedule Section (c)(ii) of the to the Companies Act Companies (Amendment)

Act

Paragraph of Schedule Paragraph of the Schedule toto the Companies Act the Companies (Amendment)

Act

Paragraph () and () of Paragraph () and () of theSchedule to the Companies Schedule to the CompaniesAct (Amendment) Act

Paragraph () of Schedule Paragraph () of the Scheduleto the Companies Act to the Companies (Amendment)

Act

Paragraph () of Schedule Paragraph () of the Scheduleto the Companies Act to the Companies (Amendment)

Act


A P P E N D I X V I

C O M P L I A N C E W I T H I N T E R N A T I O N A LA C C O U N T I N G S T A N D A R D S

Because the was developed jointly with theinternational standard on the same topic, IAS ‘Provisions, Contingent Liabilities and ContingentAssets’, all the requirements of the IAS are included inthe and there are no differences of substancebetween these common requirements. The ,additionally, deals with the circumstances under whichan asset should be recognised when a provision isrecognised and gives more guidance than the IAS onthe discount rate to be used in the present valuecalculation.

APPENDIX VI - COMPLIANCE WITH INTERNATIONAL ACCOUNTING STANDARDS

A P P E N D I X V I I

T H E D E V E L O P M E N T O F T H E F R S

The need for a standard

Provisions often have a substantial effect on an entity’sfinancial position and performance. They arise in awide range of circumstances and businesses coveringsuch matters as war ranties, onerous contracts,restructuring costs, environmental liabilities anddecommissioning costs. Published guidance on thesubject, however, has tended to concentrate onparticular forms of provision rather than the generalprinciples underlying all provisions.

To portray the financial position of an entity, it isimportant that a provision should be recognisedwhenever a relevant liability exists; but it is equallyimportant to recognise a provision only when such aliability exists. The basis of a liability is the existenceof an obligation to one or more third parties. Itfollows that the intention to incur expenditure doesnot, of itself, result in a liability. This point needs tobe made in an accounting standard because in somecases a mere intention to incur expenditure has beenused to justify recognising a provision.

In the absence of an accounting standard on provisionsthe practice has grown up of aggregating liabilitieswith expected liabilities of future years, and sometimeseven with expected expenditures related to ongoingoperations, in one large provision, often reported as anexceptional item. The effect of such ‘big bath’provisions has been not only to report excessiveliabilities at the outset but also to boost profitabilityduring the subsequent years, when the liabilities are infact being incurred.

APPENDIX VII - THE DEVELOPMENT OF THE FRS

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The addresses these concerns, first by requiringthat provisions should be recognised only where aliability exists at the per iod-end (based on thedefinition of a liability in ‘Reporting theSubstance of Transactions’ and in the Board’s draftStatement of Principles for Financial Reporting*) andsecondly by showing in examples how this principleshould apply to a number of commonly occurringcircumstances. The deals with recognition,measurement and disclosure for provisions. Becausecontingent liabilities and contingent assets are closelylinked to provisions, the also covers theirtreatment.

The Board has taken the opportunity to develop acomplete framework of disclosure requirements forprovisions, contingent liabilities and contingent assets.The new disclosure requirements give informationabout the significance of a provision and any changesin it during the year and show how provisions havebeen used as expenditure occurs.

In developing the , the Board has considered thecomments on its proposals set out initially in theDiscussion Paper ‘Provisions’ published in November and then in ‘Provisions andContingencies’ issued in June . At both stagesthe majority of respondents have supported the issueof an on provisions and the general principlesproposed as its basis.


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* Exposure Draft, November 1995

The has been developed as part of a joint projectwith the International Accounting StandardsCommittee. The parallel development of the andIAS ‘Provisions, Contingent Liabilities andContingent Assets’ has meant that each standard hasbeen able to benefit from the comments anddiscussion on the other project. Apart from the twominor additions to the noted in Appendix VI, thetwo standards are identical except for phraseology andstructure necessary to conform to established practicein each constituency.

The general principles

The central principle of the is that a provisionshould be recognised only where at the period-end aliability exists that can be measured reliably. An entitymay feel less well-off at the prospect of future cashflows entailed by its method of operation from themoment it becomes aware that they are likely to benecessary—it may wish to communicate suchprospects by a note—but future expenditure, howevernecessary, does not justify the recognition of aprovision unless a liability exists at the period-end.For a liability to exist the entity must have, as a resultof past transactions or events, an obligation to transfereconomic benefits in settlement. Future expenditurenot relating to present obligations should berecognised in the period when the obligation to incurthat expenditure arises.


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distinguished between a legal and aconstructive obligation. The responses indicated thatit would be helpful to clar ify the concept of aconstructive obligation as a present obligation arisingotherwise than by operation of law. The essence of anobligation is commitment to a third party: for aconstructive obligation, that commitment ar isesthrough actions of the entity—its establishing a patternof practice, publishing its policies or making a currentstatement setting out in detail its intended futureactions—that raise in those dealing with it or affectedby it a valid expectation that the entity will dischargeits responsibilities. A constructive obligation is oftenthe basis for recognising a provision for restructuring.The examples deal also with whether a constructiveobligation exists for habitual refunds, cleaning upcontamination and the closure of a division.

The proposals in defined ‘contingency’ anddealt with contingent losses and contingent gainsrather than contingent liabilities and contingent assets.The draft Statement of Principles deals with therecognition of assets and liabilities and therefore the now bases its analysis on contingent liabilities andcontingent assets.

The has clar ified the relationship betweenprovisions and contingent liabilities, which was thesource of some concern to those commenting on the proposals. proposed that somecontingent losses should be recognised while othersshould not. Under the contingent liabilities asdefined never qualify for recognition as liabilities—ifcircumstances change and a provision needs to berecognised there is no longer a contingent liability.


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Similarly, the effect of the definition of a contingentasset in the is that nothing that meets the criteriafor recognition as an asset will count as a contingentasset. This distinction is clearer than the equivalentproposal in that some contingent gains shouldbe recognised while others should not.

Scope

proposed that the should apply to allfinancial statements that are intended to give a trueand fair view of the reporting entity’s financialposition and profit or loss for a period. This proposalwas widely supported by the respondents. However,because the accounting framework for financialinstruments is under review, the Board has decided toexclude financial instruments carried at market valuefrom the scope of the . The special regulatoryposition of insurance companies (for which provisionsare particularly important) and the review of theaccounting framework for insurance companies haveled the Board to leave outside the scope of the provisions arising in insurance entities from contractswith policy-holders. Because there are otheraccounting standards that specifically considerprovisions in certain cases (eg pensions), the doesnot apply to provisions covered by more specificrequirements in other standards.


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Recognition

A present obligation

As explained above, the follows the generalpr inciple proposed in the Discussion Paper and —and already embodied in ‘ReportingFinancial Performance’ and ‘Fair Values inAcquisition Accounting’—that a provision should berecognised only where a liability exists that can bereliably estimated. The recognition criteria in the therefore require that:

(a) an entity has a present obligation (legal orconstructive) as a result of a past event;

(b) it is probable that a transfer of economic benefitswill be required to settle the obligation; and

(c) a reliable estimate can be made of the amount ofthe obligation.

Conditions (a) and (b) must be fulfilled for a liabilityto exist. Condition (c) requires that it should be ableto be measured with sufficient reliability. Theseconditions are therefore consistent with therecognition criteria set out in the draft Statement ofPrinciples.

Past event

For there to be a present obligation the requiresthat an obligating event has taken place. An obligatingevent creates a legal or constructive obligation thatresults in an entity having no realistic alternative tosettling that obligation. In the proposals for


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recognition were also based on the existence of apresent obligation, the key notion being that theentity had no realistic alternative to making a transferof economic benefits. The Board decided that itwould be helpful to include more guidance on theobligating event that gives rise to a present obligation.The notes that it is only those obligations arisingindependently of the entity’s future actions that arerecognised as provisions. Where the entity can avoidfuture expenditure by its future actions, it has nopresent liability for that future expenditure and noprovision is recognised. The examples in AppendixIII illustrate the effect in practice of applying the in assessing whether an obligating event has takenplace—in particular examples (offshore oilfield), (smoke filters), (staff retraining) and (repairs andmaintenance).

By basing the recognition of a provision on theexistence of a present obligation, the rules out therecognition of any provision made simply to allocateresults over more than one period or otherwise tosmooth the results reported. For example, in aregulated industry the results achieved in the currentperiod may cause the pricing structure in the nextperiod to be adjusted, eg the higher the profits in thisyear the lower the prices permitted for next year.There is no justification under the for a provisionto be recognised in such circumstances. The purposeof such a provision would be to transfer some of thecurrent year’s profit to the following year, whichwould suffer from lower prices because of the currentyear’s profits. However, there is no present obligationthat requires the transfer of economic benefits to settleit and nothing to justify recognition of a provision.


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Probable outflow of economic resources

An essential part of the definition of a liability is theexistence of an obligation to transfer economicbenefits. This condition will be met where thetransfer of economic benefits is probable, ie morelikely than not to occur. Where there are a number ofsimilar obligations the probability of a transfer isdetermined by considering the class of obligations as awhole.


Some respondents to were concerned that theproposals would allow scope for abuse and theavoidance of proper provision because they permittedthe non-recognition of a provision where a reliableestimate of the obligation could not be made. Inresponse to these concerns the notes that, exceptin extremely rare cases, an entity will be able todetermine a range of possible outcomes and cantherefore make an estimate that is sufficiently reliableto use in recognising a provision.

Contingent liabilities

The recognition of contingent losses on the basis ofwhether they were probable was supported by therespondents to . As explained in paragraphs and above, the bases its analysis on contingentliabilities rather than contingent losses and classifies asa provision, rather than a contingent liability, anobligation that is recognised because it will probablyrequire the transfer of economic benefits in settlement.The effect of these requirements of the on therecognition of losses is the same as proposed in .


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Contingent assets

The recognition of contingent gains on the basis ofwhether they were virtually certain was supported bythe respondents to . As explained inparagraphs and above, the bases its analysison contingent assets, rather than contingent gains, andrequires that a contingent asset should not berecognised. When, however, the realisation of a profitbecomes virtually certain, the related asset is not acontingent asset and recognition is appropr iate.Accordingly, the effect of the requirements of the on the recognition of gains is the same as proposed in .

Measurement

The requires a provision to be recognised at thebest estimate of the expenditure required to settle thepresent obligation at the balance sheet date. The risksand uncertainties that surround events should be takeninto account in calculating the amount of theprovision. Whatever method of estimation is adoptedfull disclosure of the uncertainties surrounding theamount of the expenditure is required.

For a liability where there is a market, the best estimateof that liability at the balance sheet date would be itsmarket value. The recognises that it will often beimpossible or prohibitively expensive to settle ortransfer an obligation at the balance sheet date becauseof the uncertainty relating to provisions. Byacknowledging this impossibility, the reflects someof the points raised by the respondents to .However, a provision should, in pr inciple, berecognised at the amount of the obligation that existedat the balance sheet date—ie the least cost amount tosettle the existing present obligation. Even where it isnot possible either to settle or transfer the obligation atthe balance sheet date, the process of estimating the


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amounts at which such hypothetical transactionswould take place provides a useful approach tocalculating the least cost amount.

Assuming that it is possible to specify all the possibleoutcomes and their associated probabilities, theamount to be provided for an obligation could beestimated as:

• the most likely outcome (ie the outcome with thehighest probability). The problem withcalculating the estimate using this method is thatit ignores the other possible outcomes: forexample, where the most likely outcome is nil itcould also lead to the inference that an entity hasno obligation.

• the maximum amount (ie the highest possibleoutcome). Use of this method to calculate theestimate could result in extremely large amountsbeing recognised even though the possibility ofthe outcome is remote.

• at least the minimum amount in the range (ie anyamount from the lowest possible outcome to thehighest possible outcome). This formula results ina wide range of possible estimates and wouldtherefore be likely to impair comparability infinancial reporting.

• the expected value (ie the amount that takes accountof all possible outcomes using probabilities toweight the outcomes). Expected value as amethod of estimation has a number of desirablefeatures. The method provides an estimate thatreflects the entire probability distribution, ie allthe possible outcomes weighted by theirprobabilities. For a given assessed distribution, the


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method has the advantage of objectivity in thatdifferent measurers would calculate the sameestimate. Furthermore, expected value is additive(ie the expected value of a number of items is thesum of the expected values of the individualitems).

Where there is a large population of items, theexpected value—adjusted as appropriate for risk—willprovide the best estimate of a provision.

Discounting

Some provisions that are to be recognised requireoutflows of economic benefits in settlement far in thefuture. For some provisions, therefore, the effect ofthe time value of money—the greater value of apresent sum than the certain payment of the same sumsome time in the future—can be material and shouldbe taken into account in estimating the amount to berecognised as a provision. Discounting was proposedfor provisions in and received the support ofthe majority of the respondents. The background tothe requirements on discounting is set out in theWorking Paper ‘Discounting in Financial Reporting’(published in April ). The proposals in the are consistent with that Paper.

The requires the unwinding of the discount to beincluded in the profit and loss account as a financialitem adjacent to but shown separately from interest.The respondents to were divided overwhether the unwinding discount should be shown asinterest or as an operating cost. Those who favouredshowing it as an operating cost tended to argue thatputting this amount in interest would be misleadingand confusing to users of accounts and would distortor obscure the view given by the interest and funding


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disclosures. The Board has met these concerns byrequiring that the unwinding discount should beshown clearly as a separate item from interest. TheBoard believes that the unwinding discount is afinancial item—it relates to the time value of money,reflecting the effect of the passage of time on anamount specified in money terms.

Provisions that are calculated at a discounted amountshould take into account risk as well as the time valueof money. Risk can be taken into account either bydiscounting at a risk-free rate cash flows that take riskinto account or by discounting at a risk-adjusted ratecash flows that take no account of r isk. Theimportant point is that risk should be taken intoaccount in the best way possible and that care shouldbe taken not to double-count the effect of r isk.Among the considerations to be borne in mind arewhether it is feasible to derive an appropriate risk-adjusted rate of interest and whether the incidence ofrisk over the discount period may follow a differentpattern from that of compound interest.

Where the amount recognised is discounted, the cashflows to be discounted are the pre-tax cash flows andthe discount rate should be the rate of return that will,after tax has been deducted, give the required post-taxrate of return. Because the tax consequences ofdifferent cash flows may be different, the pre-tax rateof return is not always the post-tax rate of returngrossed up by the standard rate of tax. The Boardrequires the effect of tax to be shown separately infinancial statements rather than netting tax directly offthe assets and liabilities. This is in line with thegeneral requirement that tax effects shall be shownseparately.


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did not refer to the treatment of gains fromthe expected disposal of assets in measuring provisions.The prohibits such gains from being taken intoaccount in measuring a provision. The principle ofthe is that provisions should be recognised andmeasured as liabilities independently of considerationsaffecting the recognition and measurement of assetsheld. As a practical matter, if in certain circumstancesgains on expected disposals were netted off against theprovision to be recognised, it would be difficult tolimit the assets whose expected disposal could be setoff. There would also need to be guidance on thetreatment when the provision was both recognised andused before the gain was achieved.

Reimbursements

The requires that a provision and any expectedreimbursement should be recognised separately as aliability and an asset—although shown net in theprofit and loss account. This approach is consistentwith the general principle contained in and isdesigned to reflect the fact that the entity oftencontinues to be liable if the third party from which thereimbursement is due fails to pay. Reimbursement isrecognised only when it is virtually certain to bereceived if the entity settles the liability.

Application of the recognition and measurement rules

The includes paragraphs applying its recognitionand measurement rules to operating losses, onerouscontracts and reorganisations. Although the text haschanged from , the applies the same basicprinciples as the and has the same effect.


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Restructuring provisions

The most controversial aspect of the proposals in related to the date on which a provision forrestructur ing should be recognised—the proposed that the date when the entity becamedemonstrably committed to a reorganisation should bethe date a provision was recognised. On thisprinciple, no provision should be recognised if theonly relevant event before the balance sheet date was aboard decision. The majority of those disagreeingwith this proposal argued that it was unrealisticallystrict and that a provision should be recognised wherethere was a formal board decision before the year-endand either implementation of that decision beganbefore the signing of the financial statements or thedecision was communicated in sufficient detail tothose affected by it before that date.

The Board has discussed the issues raised by therespondents but has concluded that, for the consistentapplication of its pr inciples, it must require aconstructive obligation to restructure to exist at thebalance sheet date for a provision for restructuring tobe recognised. This is required also for consistencywith the treatment of assets: the entity includes in itsfinancial statements only those assets that it controls atthe balance sheet date and does not include assets thatcome under its control only between the balance sheetdate and the signing of the financial statements.

A constructive obligation to restructure arises onlywhen the entity has a detailed formal plan for thereorganisation and, by beginning to implement thatplan or communicating it to those affected, raises inthem a valid expectation that it will carry out the


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restructuring as expected. Therefore a board decisionalone (unless one of a supervisory board whosemembers include employees and possibly otheraffected interests (see paragraph of the )) doesnot amount to a constructive obligation to restructure.

Disclosure

Respondents raised no major concerns with thedisclosures proposed by .

The reordering of the to incorporate more fullycontingent liabilities and contingent assets has led tothe disclosure requirements for these to be set outalongside those for provisions, making clear theconsistent basis for the requirements. As part of thisrearrangement, the dispensation from providingdisclosures that can be expected to prejudice seriouslythe position of the entity in its negotiations with otherparties now applies to contingent liabilities andcontingent assets as well as to provisions. Therespondents to overwhelmingly supported a‘seriously prejudicial’ exemption for disclosures onprovisions.

Decommissioning costs and repairs and maintenanceprovisions

The examples in Appendix III describe two caseswhere the effect of applying the requirements remainscontroversial, although the treatment in the examplesreceived general support from the major ity ofrespondents on . These are example ondecommissioning costs and example on repairs andmaintenance.


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Decommissioning costs

Before the introduction of the , the treatmentgenerally accorded to decommissioning costs was toaccount for them on the ‘units of production’ method.Under this method, the amount required fordecommissioning is built up year by year, in line withproduction levels, to reach the amount of theexpected decommissioning costs by the timeproduction ceases. The requires that, to the extentthat decommissioning costs relate to damage alreadydone or goods and services already received, thatpresent obligation should be recognised as a provision.The following points should be noted whenconsidering the effects of the ’s requirements ondecommissioning costs.

• On installation of the oil rig, the effect of the timevalue of money is that the true measure of the extracost of the rig represented by decommissioningcosts is the discounted amount of the eventual cost.

• Decommissioning costs will be included in thecost of the oil rig only to the extent that they areincurred by the installation of the rig. If anydamage is incurred by production, the costs ofrestoring that damage is a cost of production—theclassic case of this in another industry is open-castmining where the production process itselfincreases the damage caused and the consequentcost of restoration.

• The unwinding of the discount reflects the effectof the passage of time and that unwinding ismatched in principle by interest or income earnedas a result of having a liability that has not yetrequired the transfer of economic resources insettlement. Setting aside a sinking fund equal tothe discounted amount of the liability at any timewould provide sufficient cumulative interest


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income to settle the decommissioning liabilitydirectly without any additional transfer ofresources.

• Some respondents have been concerned that theprofile over time of the charge ar ising fordecommissioning costs (lower at first but rising overtime) could lead to payments of dividends early inthe production process in excess of what thebusiness could bear after taking into account itslong-term liability for decommissioning costs.However, provided that the assets in the businessearn a return in excess of the interest rate used todiscount the decommissioning costs, there will be atleast sufficient assets to settle the decommissioningcosts liabilities when these need to be paid.

Repairs and maintenance

It is the present practice of some entities to recogniseas a provision the future costs of repair ing ormaintaining part of their fixed assets. Example illustrates the application of the to repairs andmaintenance for fixed assets. Because future repairsand maintenance are not present obligations of theentity resulting from past events, no provision shouldbe made for them, even if they are required bylegislation if the asset is to continue to be used. Thereare no grounds for recognising a provision for futurerepairs and maintenance expenditures because theserelate to the future operation of the business, therestoration of service potential, and are thereforeeither to be capitalised as assets or written off asoperating expenses when incurred. Where a part ofthe asset can be identified as declining in servicepotential because of the need for repairs ormaintenance, it should be depreciated to show thedeclining service potential. Expenditure on repairsand maintenance should be capitalised to show therestoration of service potential.


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In some operating leases the lessee is required to incurperiodic charges for maintenance of the leased asset orto make good dilapidations or other damage occurringduring the rental period. The principle illustrated inexample does not preclude the recognition of suchliabilities once the event giving rise to the obligationunder the lease has occurred.


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Further copies, £8.00 post-free, can be obtained from:

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