Have you ever heard a joke about two accountants applying for a job?
During their interview, they were given a task to calculate a net profit figure based on available data.
After some while, interviewer asked them a question: “What result did you get? What is the net profit of this company?”
The first accountant replied: the net profit is 150 mil. USD.
And the second one asked: “What would you like it to be?”
Now guess which one got the job! 🙂
In fact, manipulation of profit figure by making and releasing various provisions back and forth was very popular “creative accounting practice” in the past.
No wonder, as there were no rules for making provisions. Therefore, many companies utilized so-called “big bath provisioning” in order to smooth profits.
This situation was addressed in 1998 when the standard IAS 37 Provisions, Contingent Liabilities and Contingent Assets was issued with its effective date from 1 July 1999.
What is the objective of IAS 37?
The Standard IAS 37 Provisions, Contingent Liabilities and Contingent assets sets the criteria for recognition and measurement of
- Contingent liabilities;
- Contingent assets; and
requires a number of disclosures about these items in order to understand them better.
What is a provision?
Provision is a liability of uncertain timing or amount.
The word “uncertain” is very important here, because if timing and amount are certain or almost certain, then you don’t deal with the provision but with a payable or an accrual.
To understand provisions better, let’s break down the definition of a liability in IAS 37:
A liability is a present obligation arising from past event that is expected to be settled by an outflow of economic benefits from an entity.
In other words, if there is no past event, then there is no liability and no provision should be recognized.
Past event can create 2 types of obligation:
- Legal obligation that arises from legislation, a contract or other legal act; or
- Constructive obligation that arises from some business practice or customs and created an expectation in other parties to fulfill the obligation (in other words, people simply expect some company to fulfill the obligation even if it’s not in the law or any contract).
It does not really matter what type of obligation you deal with – whichever it is, it leads to a provision. However, if you identify the obligation, it can help you to decide whether recognize a provision or not.
When to recognize a provision?
The standard IAS sets 3 criteria for recognizing a provision:
- There must be a present obligation as a result of a past event;
- The outflow of economic benefits to satisfy the obligation must be probable (i.e. more than 50% probable)
- The amount of economic benefits required to satisfy the obligation must be reliably estimated.
If all 3 criteria are met, then you should recognize a provision.
If just one of them is not met, then you should either:
- Disclose a contingent liability (read more about it below), or
- Do nothing if the outflow of economic benefits is remote.
To get better understanding and guidance on provisions and contingencies, IAS 37 presents a decision tree, too.
If you are unsure whether to recognize a provision in a particular situation or not, just ask yourself a simple question:
Can the obligation be avoided by some future actions?
If yes, then you should NOT book a provision. For example, if a government introduced new tax legislation, does the tax consulting company need to spend a cash for training of its employees and thus recognize a provision for that training?
No, it does not have to. Tax consulting company can avoid the training and decide to stop its activities (OK, that’s a bit far-fetched and unlikely, but you get the point).
If you cannot avoid the obligation by some future action, then you have to recognize a provision.
For example, when you promised a free warranty service for defective products at the point of sale, then you have a present obligation. If your past statistics show that you needed to spend some cash for warranty repairs, then you need to make a provision.
How to measure a provision?
The amount of the provision should be measured at the best estimate of the expenditures required to satisfy the obligation at the end of the reporting period.
As you can see, here’s some judgement and estimates involved. Management should really incorporate all available information in their estimates and they must not forget about:
- Risks and uncertainties (like inflation),
- Time value of money (discounting when the settlement is expected in the long-term future)
- Some probable future events, etc.
There are 2 basic methods of measuring a provision:
- Expected value method: You would use this method when you have a range of possible outcomes or you measure the provision for large amount of items. In this case, you need to weight each outcome by its probability (for example, warranty repair costs for 10 000 products).
- The most likely outcome: This method is suitable in the case of a single obligation or just 1 item (for example, provision for loss in the court case).
How to account for a provision?
There are several events associated with the accounting for provisions:
- Recognition of a provision: In most cases, you should recognize a provision in profit or loss. Sometimes, a provision is recognized in the cost of another asset, for example, provision for removing the asset and restoring the site after its use.Don’t forget to split the provision in the current and non-current part for the presentation purposes in your statement of financial position.
- Unwinding the discount: When a provision has a long-term nature (beyond 12 months), then there’s some discounting involved as you need to present it in its present value.In each reporting period, you account for an interest on the opening balance of the provision and this is called „unwinding the discount“.Special For You! Have you already checked out the IFRS Kit ? It’s a full IFRS learning package with more than 40 hours of private video tutorials, more than 140 IFRS case studies solved in Excel, more than 180 pages of handouts and many bonuses included. If you take action today and subscribe to the IFRS Kit, you’ll get it at discount! Click here to check it out!You should recognize the interest in profit or loss and it also increases the amount of a provision.
- Utilization of a provision: When you incur expenditures associated with the settlement of your obligation, you should „utilize a provision“.In most cases, you simply recognize this utilization directly with incurring the invoices from suppliers or any related payments (e.g. Debit Provision / Credit Cash).
- Reimbursement: Sometimes, entities have right to reimbursement of related expenditures by the third party (e.g. from an insurance company).In this case, a right to reimbursement is recognized as a separate asset (no netting off with the provision itself), but you can net off the expenses for provision with the income from reimbursement in the profit or loss.
Provisions in specific circumstances
Standard IAS 37 specifies the treatment of provisions in a few specific situations:
Future operating losses
You should not make a provision for future operating loss.
Because there is no past event. The future operating losses can be avoided by some future actions, for example – by selling a business.
However, you should test your assets for impairment under IAS 36 Impairment of Assets.
Onerous contract is a contract in which unavoidable costs of fulfilling exceed the benefits from the contract.
In other words, it is a loss contract that cannot be avoided.
You should make a provision in the amount lower of:
- Unavoidable costs of fulfilling the contract and
- Penalty for not meeting your obligations from the contract
Restructuring is a plan of management to change the scope of business or a manner of conducting a business.
You should recognize a provision for restructuring only when the general criteria for recognizing provisions are met.
In the case of restructuring, an obligation to restructure arises only if:
- There is a detailed formal plan for restructuring with relevant information in it (about business, location, employees, time schedule and expenditures)
- A valid expectation related to restructuring has been raised in the affected parties.
IAS 37 also clarifies which type of expenses can / cannot be included in the provision.
What are contingencies?
Except for provisions, we can deal both with contingent liabilities and contingent assets.
A contingent liability is either:
- A possible obligation (not present) from past event that will be confirmed by some future event; or
- A present obligation from past event, but either:
- The ouflow of economic benefits to satisfy this obligation is not probable (less than 50%), or
- The amount of obligation cannot be reliably measured (this is very rare, in fact).
For example, you might face a lawsuit, but your lawyers estimate the probability of losing the case at 30% – in this case, it’s not probable that you will have to incur any expenditures to settle the claim and you should not book a provision. It’s typical contingent liability.
If you identify you have a contingent liability, you do NOT recognize it – no journal entry. You should only make appropriate disclosures in the notes to the financial statements.
A contingent asset is a possible asset arising from past events that will be confirmed by some future events not fully under the entity’s control.
Similarly as with contingent liabilities, you should not book anything in relation to contingent assets, but you make appropriate disclosures.
Provisions and further specific guidance
Standard IAS 37 gives further guidance for certain situations in its appendix and also, several interpretations clarify the accounting for provisions in some specific cases:
- IFRIC 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities deals with the provision for removing the asset and restoring the site after the end of its useful life;
- IFRIC 5 Rights to Interests Arising from Decommissioning, Restoration and Environmental Rehabilitation Funds is related to IFRIC 1 and it applies when a company contributes to a fund for reimbursement of these expenses.
- IFRIC 6 Liabilities Arising from Participating in a Specific Market – Waste Electrical and Electronic Equipment: this IFRIC specifies when the producers of electrical and similar appliances sold to household are liable for decommissioning of electrical waste
- IFRIC 17 Distributions of Non-cash Assets to Owners
- IFRIC 21 Levies
Here’s the list of articles published on IFRSbox related to the standard IAS 37:
You can watch a video with IAS 37 here:
If you liked this article or you have anything to say, please leave a comment below this video and share, thank you!
The vast majority of modern commercial leases are clear in their contractual requirements for tenants and lessees to maintain the property in a good condition, along with the need for them to redecorate, remove any additions they have made to the property, or reinstall any parts of the property they may have removed, when the lease comes to an end.
The finer details of how such repairs and redecorations – known as dilapidations – need to be made will differ from lease to lease, but what is important across all contracts is the need to plan for the costs of such work during the time of the lease, rather than waiting until the lease ends and then facing a potential significant charge or claim from the landlord.
Dilapidations planning has both financial and business benefits. While not all dilapidations are treated as tax deductible (see below), many are, and provision that is made for those dilapidations during the term of the lease can help to reduce tax bills throughout the course of the lease, rather than solely at the point the work is done (often at the end of the lease).
Businesses that fail to make provision for dilapidations during the life of a lease can also find themselves facing an unplanned sizeable bill at the point when the lease ends. In some cases, when this bill runs into six or even seven figures, businesses can find themselves ‘trapped’ in a property, having to operate from premises that aren’t fit for purpose or best suited to the future growth of the business, because they can’t afford the one-off cost of the dilapidations.
Remember Accounting Standards require a business to recognise a provision in its financial statements when it has an obligation at the reporting date; arising from a past event; where the settlement of which will probably give rise to a transfer of economic value and; that transfer of economic value can be estimated reliably.
In most cases the obligations under a lease arise from the date the lease is signed so tenants can make a provision for dilapidations within their annual profit and loss accounts, in anticipation of the cost of future repairs and renovations that will need to be made in line with their lease obligations. Such provisions, provided they meet certain requirements, may well be tax deductible, and deductions can be claimed at the time the provision is made, rather than at the point when the dilapidations work is carried out.
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The provision will be tax deductible if it relates to specific repairs or works, and those works aren’t considered to be capital expenditure. HMRC gives examples of what would be regarded as capital works, including:
- the cost of rebuilding the leased premises
- the cost of reinstating any part of the leased premises demolished by the tenant
- the cost of demolishing any structure which the tenant has added.
The proportion of a specific provision made for works that are regarded as capital in nature will not be deductible for tax purposes; however, when a lease ends and that capital expenditure is made, some of it may qualify under capital allowances.
A full tax deduction can be taken for the remainder of the provision, as and when that provision is made. Once again, there are criteria for the provision to be tax deductible, so it is important to seek expert financial advice at an early stage of dilapidation account planning. It’s also important to seek the advice of a chartered surveyor, to get an accurate assessment of the future dilapidations that a tenant could face, so that adequate provision can be made in the annual accounts.
Lease end adjustments
When the repair and reinstatement works are carried out at the end of a lease, and the final costs are known, it may materialise that the tenant has either under-estimated or over-estimated the costs of the dilapidations, and an adjustment will be needed. If the accounting provision turns out to be in excess of the dilapidations expenditure, the difference is added back to the taxable income and taxed in the year of the works. If the provision is less than is needed, any additional actual expenditure can be deducted within the year the work is completed.
Dilapidations accounting is a potentially complex area, and one which can have major implications for a tenant or commercial property lessee. But the key message is that with careful planning, making provision for dilapidations can bring significant benefits, both in terms of accounting and business development.
This post was written by Richard Vass. For more information or to ask Richard a question fill in the form below.
We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.
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