Provisions and Events After the Reporting Period
Liabilities
Provisions and Events After the Reporting Period
Syllabus tag: KASNEB CPA | Intermediate Level | CA23 Financial Reporting and Analysis | Topic 6 Provisions and Events After the Reporting Period
Lesson objectives
By the end of this topic, you will be able to:
- Apply the three recognition criteria for a provision
- Distinguish a provision from a contingent liability and a contingent asset
- Measure a provision using expected value or most likely outcome
- Discount a long-term provision and account for the unwinding
- Distinguish adjusting from non-adjusting events after the reporting period
Why this matters
Before IAS 37, companies created large provisions in good years and released them in bad ones, smoothing reported profit at will. The standard exists to stop that, which is why its recognition criteria are strict.
The three criteria
A provision is recognised only when all three hold:
- There is a present obligation from a past event
- An outflow of economic benefits is probable — more likely than not
- The amount can be reliably estimated
Fail any one and no provision may be made.
Legal or constructive. An obligation need not be legal. Where a company has created a valid expectation by past practice or public statement — a shop that always refunds unwanted goods despite having no legal duty — a constructive obligation exists.
Provision, contingent liability, contingent asset
| Likelihood of outflow | Treatment |
|---|---|
| Probable (more likely than not) | Provide |
| Possible but not probable | Disclose as a contingent liability |
| Remote | Ignore |
Contingent assets are treated asymmetrically: disclosed only when an inflow is probable, and recognised only when it is virtually certain. Prudence means unrealised losses are recognised earlier than unrealised gains.
The one thing that cannot be provided for
Future operating losses. There is no obligation from a past event — the company can simply stop trading. A company expecting losses next year may not provide for them this year.
That prohibition is the whole point of the standard. Providing for future losses was the mechanism by which profit smoothing worked.
Measurement: expected value
Where the provision covers a large population of items, use expected value.
Chui Ltd sold 60,000 units with a warranty. Experience suggests 80% will have no defect, 15% a minor defect costing KES 800, and 5% a major defect costing KES 4,000.
Expected cost per unit = (0.80 × 0) + (0.15 × 800) + (0.05 × 4,000) = 0 + 120 + 200 = KES 320
Provision = 60,000 × 320 = KES 19,200,000
No single unit will cost 320. The figure is only meaningful across the population, which is precisely why the method suits warranties and not individual lawsuits.
Measurement: most likely outcome
Where there is a single obligation — one court case, one contract — use the most likely outcome rather than an average. A claim expected to settle at KES 6,500,000 is provided at 6,500,000, not at a probability-weighted figure that no outcome could produce.
Discounting
Where the effect is material, a provision is measured at present value.
A restoration obligation of KES 8,000,000 payable in 5 years, discounted at 7%:
Provision = 8,000,000 / 1.07^5 = KES 5,703,889
Each year the provision is increased by the unwinding of the discount, charged as a finance cost:
Year 1 unwinding = 5,703,889 × 7% = KES 399,272
The provision grows to 8,000,000 by the settlement date. The unwinding is a finance cost, not an operating expense, because it reflects the passage of time rather than any new obligation.
Onerous contracts
A contract is onerous when the unavoidable costs of meeting it exceed the benefits expected from it. The provision is the lower of:
- the net cost of fulfilling the contract, and
- any penalty for exiting it
Where fulfilling would cost KES 3,400,000 and the exit penalty is 2,900,000, the provision is KES 2,900,000 — because a rational company would pay the penalty rather than the larger fulfilment cost.
:::checkpoint A company announces a restructuring three weeks before its year end but has not yet informed the affected employees. Can it provide for the restructuring costs? Set out your reasoning against the three criteria. :::
Events after the reporting period
Events between the reporting date and the date the accounts are authorised for issue fall into two categories.
Adjusting events provide evidence of conditions that already existed at the reporting date. Adjust the figures.
- A customer goes into liquidation shortly after year end, confirming the receivable was already doubtful
- A court case settles, confirming an obligation existed
- Inventory is sold below cost, confirming net realisable value
Non-adjusting events relate to conditions arising after the reporting date. Disclose if material; do not adjust.
- A fire destroys a factory after year end
- A major share issue
- A business combination announced after the reporting date
The test is not whether the event is important. It is when the underlying condition arose. A fire after year end is dramatic and non-adjusting; a liquidation after year end is quiet and adjusting, because the customer was already in difficulty at the reporting date.
One exception overrides everything: if events after the reporting date show the going concern assumption is no longer appropriate, the accounts must be restated on a different basis entirely.
:::checkpoint Two events occur after year end: a warehouse burns down, and a customer owing KES 4,000,000 is declared insolvent. Both are material. Explain the different treatment each receives and why. :::