Question

argument, 20 marks) Question Two: Provisions are particular kinds of liabilities. It therefore follows that provisions should be recognized when the definition of a liability has been met. The key requirement of a liability is A present obligation and thus this requirement is critical also in the context of the recognition of a provision. IAS 37 Provisions, Contingent liabilities and Contingent Assets deals with this area. 1) Explain the definition of provisions and why there was a need for detailed guidance on accounting for provision? (10 marks) 2) Explain the circumstances under which a provision should be recognized in the financial statement according to IAS 37 Provisions, Contingent liabilities and Contingent Assets. (10 marks)

Answer 1

1) A provision is a liability of uncertain timing or amount. It is an amount set aside to cover a probable future expense or reduction in the value of an asset. Companies may try to exploit these uncertainties in order to achieve results they believe their various stakeholder may want. Companies may make some fake provisions for some potential future expenses with the impact of making the profit seem lower in the current period to avoid paying more taxes or to avail other tax related benefits. Moreover, as the double entry for a provision is to debit an expense and credit the liability, this would also reduce the profit. In the next year, the accountant could reverse the provision, by debiting the liability and crediting profit or loss. This effectively moves profit from current year to next year. This is not good for the users of financial statements as the financial statements have been manipulated and users get a false impression of the performance of the company. Thus, to control all such instances, there was a need for detailed guidance on accounting for provision which would ensure that companies report only on those provisions that meet certain criteria.

2) IAS 37 stipulates the circumstances for provisions, contingent liabilities and contingent assets which must be met in order for a provision to be recognised, so that companies should be prevented from manipulating profits. Accordingly, 3 such criteria are required to be met before a provision can be recognised. These are:

a) There needs to be a present obligation from past event. The obligation could be legal/contractual(arising from court case or some kind of contractual arrangement) or constructive obligation(an expectation through an established course of past practice).

b) There needs to be a reliable estimate.The main rule is that if it is a one-off item, the best estimate will be the most likely outcome. If it is made up of number of items, expected value should be calculated using the probability of events happening.

c)There needs to be a probable outflow of economic resources. It simply means that it is more likely than not that the entity will have to pay money out.