Chapter 19
Provisions and contingencies

List of examples

Chapter 19
Provisions and contingencies

1 INTRODUCTION

Section 21– Provisions and Contingencies – addresses the recognition, measurement and disclosure of provisions and the disclosure of contingent liabilities and contingent assets.

The principle of Section 21 for the recognition and measurement of provisions is consistent with that applied by IAS 37 – Provisions, Contingent Liabilities and Contingent Assets. A provision should be recognised by an entity if the entity has a present obligation (legal or constructive) as a result of a past event, payment is probable and the amount expected to settle the obligation can be measured reliably. [FRS 102.21.4].

The approach to contingent liabilities and contingent assets under Section 21 is also consistent with that taken by IAS 37. These items should not be recognised on balance sheet but may require disclosure. [FRS 102.21.12]. The only exception to this is for contingent liabilities of an acquiree in a business combination, which should be recognised on the balance sheet of the acquirer. [FRS 102.19.14].

However, IAS 37 provides more guidance than Section 21 in certain areas. In addition, there are some minor differences between Section 21 and the equivalent guidance under IFRS. These are addressed at 2 below.

There were no substantial changes made to Section 21 by the FRC as a result of Amendments to FRS 102 Triennial review 2017 – Incremental improvements and clarifications (Triennial review 2017).

2 COMPARISON BETWEEN SECTION 21 AND IFRS

As stated at 1 above, Section 21 and IAS 37 apply the same principle to the recognition and measurement of provisions. The approach to the disclosure of provisions, contingent liabilities and contingent assets is also consistent between Section 21 and IAS 37. The key differences between Section 21 and IFRS are set out at 2.1 to 2.3 below.

2.1 Scope – provisions, contingent liabilities and contingent assets covered by another section

Section 21 does not apply to provisions, contingent liabilities and contingent assets covered by another section of FRS 102. However, where those other sections contain no specific requirements to deal with contracts that have become onerous, Section 21 applies to those contracts. [FRS 102.21.1]. This will include, for example, onerous leases and loss-making revenue contracts other than construction contracts. The recognition of provisions for loss making construction contracts is addressed by Section 23. [FRS 102.23.26].

Under IAS 37, where a provision, contingent liability or contingent asset is covered by another IFRS and that IFRS contains no specific requirements to deal with onerous contracts, there is no general requirement that IAS 37 be applied to those contracts. However, IAS 37 states that it does apply to:

  • any lease that becomes onerous before the commencement date of the lease;
  • short-term leases and leases of low-value assets which are recognised as an expense in accordance with paragraph 6 of IFRS 16 – Leases – and have become onerous; and
  • contracts with customers that are, or have become, onerous. [IAS 37.5].

2.2 Scope – financial guarantee contracts

Financial guarantee contracts are included in the scope of Section 21 when an entity has chosen to apply the requirements of Sections 11 – Basic Financial Instruments – and 12 – Other Financial Instruments Issues, for the recognition and measurement of financial instruments. Section 21 does not apply to financial guarantee contracts where:

  1. an entity has chosen to apply IAS 39 – Financial Instruments: Recognition and Measurement – and / or IFRS 9 – Financial Instruments – to its financial instruments; or
  2. an entity has elected under FRS 103 – Insurance Contracts – to continue the application of insurance contract accounting. [FRS 102.21.1A]. See 3.2.1.B below.

Under IFRS, financial guarantee contracts are generally accounted for by the issuer in accordance with IAS 32 – Financial Instruments: Presentation, IAS 39, IFRS 9 and IFRS 7 – Financial Instruments: Disclosures. Financial guarantee contracts issued are generally measured at fair value on initial recognition (subject to certain exemptions), regardless of whether or not it is considered probable that the guarantee will be called, unless the entity has elected under IFRS 4 – Insurance Contracts – or IFRS 17 – Insurance Contracts – to continue the application of insurance contract accounting. Financial guarantee contracts held are not within the scope of IAS 39 or IFRS 9, nor IFRS 4. As no IFRS applies specifically to the holder of financial guarantee contracts, the holder of financial guarantee contracts may look to the requirements of IAS 37 addressing contingent assets or reimbursement assets in developing an appropriate accounting policy.

2.3 Disclosures

The disclosures required by Section 21 are discussed at 3.10 below.

Section 21 does not refer specifically to the following two specific disclosures required by IAS 37. These are:

  • the disclosure of major assumptions concerning future events that may affect the amount required to settle an obligation where this is necessary to provide adequate information; [IAS 37.85(b)] and
  • a separate line item in the reconciliation of opening and closing provision balances showing the increase during the period in the discounted amount arising from the passage of time and the effect of any change in discount rate. [IAS 37.84(e)]. Section 21 allows the line showing additions to provisions in the period to include adjustments that arise from changes in measuring the discounted amount. [FRS 102.21.14(a)(ii)].

Section 21 requires an entity to disclose the expected amount and timing of any payments resulting from an obligation. [FRS 102.21.14(b)]. IAS 37 requires disclosure only of the expected timing of payments resulting from an obligation. [IAS 37.85(a)].

Like IAS 37, Section 21 offers an exemption from certain disclosures that would otherwise be required in those extremely rare cases where disclosure of some or all of the information required can be expected to prejudice seriously the position of the entity in a dispute with other parties. [FRS 102.21.17]. Under the seriously prejudicial exemption in IAS 37, entities must disclose the general nature of the dispute, together with the fact that, and the reason, the information otherwise required by the standard has not been disclosed. [IAS 37.92]. Section 21 includes much more fulsome disclosure requirements in the case where information is considered seriously prejudicial. These requirements are set out at 3.10.5 below and significantly reduce the usefulness of the seriously prejudicial exemption under Section 21.

Section 21 requires an entity to disclose the nature and business purpose of any financial guarantee contracts it has issued, regardless of whether a provision is required or contingent liability disclosed. [FRS 102.21.17A]. This is not specifically required under IFRS. In addition, to the extent a provision is recognised, or contingent liability disclosed, for financial guarantee contracts, the general provisions or contingent liabilities disclosures set out at 3.10 below are also required. This is not required under IFRS as financial guarantee contracts are excluded from the scope of IAS 37.

3 REQUIREMENTS OF SECTION 21 FOR PROVISIONS AND CONTINGENCIES

3.1 Terms used in Section 21

The following terms are used in Section 21 with the meanings specified. [FRS 102 Appendix I].

Term Definition
Provision A liability of uncertain timing or amount.
Liability A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
Contingent liability
  1. a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or
  2. a present obligation that arises from past events but is not recognised because:
    1. it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or
    2. the amount of the obligation cannot be measured with sufficient reliability.
Contingent asset A possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.
Onerous contract A contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.
Probable More likely than not.
Constructive obligation An obligation that derives from an entity's actions where:
  1. by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and
  2. as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.
Financial guarantee contract A contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payments when due in accordance with the original or modified terms of a debt instrument.
Executory contract A contract under which neither party has performed any obligations or both parties have partially performed their obligations to an equal extent. [FRS 102.21.1B(c)].
Present value A current estimate of the present discounted value of the future net cash flows in the normal course of business.
Restructuring A programme that is planned and controlled by management and materially changes either:
  1. the scope of the business undertaken by the entity; or
  2. the manner in which that business is conducted.
Impracticable Applying a requirement is impracticable when the entity cannot apply it after making every reasonable effort to do so.

3.2 Scope

Section 21 applies to all provisions, contingent liabilities and contingent assets other than those covered by other sections of FRS 102. Where those other sections contain no specific requirements to deal with contracts that become onerous, Section 21 applies to those contracts. [FRS 102.21.1].

Financial guarantee contracts are included in the scope of Section 21 when an entity has chosen to apply the requirements of Sections 11 and 12 for the recognition and measurement of financial instruments. Section 21 does not apply to financial guarantee contracts where:

  • the entity has chosen to apply IAS 39 and / or IFRS 9 to its financial instruments (see Chapter 10); or
  • the entity has elected under FRS 103 to continue the application of insurance contract accounting. [FRS 102.21.1A].

Where an entity has chosen to apply IAS 39 and / or IFRS 9 to its financial instruments, the issuer of financial guarantee contracts will account for those contracts as financial instruments under those standards. However, financial guarantee contracts held are not within scope of IAS 39, IFRS 9, or FRS 103 and therefore would fall in scope of Section 21 regardless of whether the elections set out in paragraph 1A of Section 21 are applied.

The requirements of Section 21 relating to financial guarantee contracts are discussed at 3.3.5.F below.

The following table lists the specific types of transaction or circumstances referred to in Section 21 that might give rise to a provision, contingent liability or contingent asset. In some cases, the transaction is identified in Section 21 only to prohibit recognition of any liability, such as for future operating losses (see 3.3.4.A below). This chapter does not address those items identified below as falling outside the scope of Section 21.

Types of transactions or circumstances referred to In scope Out of scope Another section
Restructuring costs •
Product warranties / refunds •
Legal claims •
Reimbursement rights •
Future operating costs (e.g. training) •
Future operating losses •
Onerous contracts •
Financial guarantee contracts •
Provisions for depreciation, impairment or doubtful debts • Section 17 / Section 27 / Section 11 / Section 12
Executory contracts (unless onerous) •
Financial Instruments in the scope of Section 11 • Section 11
Financial Instruments in the scope of Section 12 • Section 12
Contingent liabilities acquired in a business combination • Section 19
Leases (unless onerous operating leases) • Section 20
Construction contracts • Section 23
Employee benefits • Section 28
Income taxes • Section 29
Insurance contracts • FRS 103

3.2.1 Items outside the scope of Section 21

3.2.1.A Executory contracts, except where the contract is onerous

Section 21 does not apply to executory contracts unless they are onerous. Executory contracts are contracts under which neither party to the contract has performed any of their obligations or where both parties have performed their obligations to an equal extent. [FRS 102.21.1B(c)]. This means that contracts such as supplier purchase contracts and capital commitments, which would otherwise fall within the scope of Section 21, are exempt unless the contract becomes onerous. Onerous contracts are addressed at 3.3.5.A below.

3.2.1.B Financial instruments

Section 21 does not apply to financial instruments (including loan commitments) that are within the scope of Section 11 – Basic Financial Instruments – or Section 12 – Other Financial Instruments Issues. [FRS 102.21.1B(a)].

As noted at 3.2 above, an entity must apply Section 21 to financial guarantee contracts unless it has chosen to apply IAS 39 or IFRS 9 to its financial instruments or FRS 103 to continue to account for these guarantees as insurance contracts. [FRS 102.21.1A].

3.2.1.C Insurance contracts

Insurance contracts (including reinsurance contracts) that an entity issues and reinsurance contracts that the entity holds fall within the scope of FRS 103 and not FRS 102. [FRS 102.21.1B]. An insurance contract is defined as ‘a contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder’. [FRS 102 Appendix I]. A reinsurance contract is ‘an insurance contract issued by one insurer (the reinsurer) to compensate another insurer (the cedant) for losses on one or more contracts issued by the cedant’. [FRS 102 Appendix I].

Section 21 also excludes from its scope financial instruments issued by an entity with a discretionary participation feature that are within the scope of FRS 103. [FRS 102.21.1B]. These features are most commonly found in life insurance policies and are essentially contractual rights of the holder to receive, as a supplement to guaranteed benefits, significant additional benefits whose amount or timing are contractually at the discretion of the issuer and based on the performance of the insurer, a fund or a specified pool of investments. [FRS 102 Appendix I].

3.2.1.D Areas covered by other sections of FRS 102

Section 21 does not apply to those provisions covered by other sections of FRS 102. [FRS 102.21.1]. However, other than financial instruments and insurance contracts which are explicitly excluded from its scope, Section 21 does not provide any more examples of what transactions or circumstances this exclusion is intended to cover. Examples of other transactions and circumstances which are covered elsewhere and that we would therefore expect to fall outside the scope of Section 21 are included in the table at 3.2 above. However, where those other sections of the FRS do not contain specific requirements on accounting for onerous contracts, Section 21 should be applied. [FRS 102.21.1].

Section 21 notes that the word ‘provision’ is sometimes used in the context of items such as depreciation, impairment of assets and doubtful debts. Such provisions are not covered by Section 21 because they are adjustments to the carrying amount of assets rather than recognition of liabilities. [FRS 102.21.3].

3.2.1.E Provisions compared to other liabilities

The feature distinguishing provisions from other liabilities, such as trade creditors and accruals, is the existence of uncertainty about the timing or amount of the future expenditure required in settlement. This distinction is not explicitly made in FRS 102 but is explained in IAS 37, which compares provisions to:

  1. trade payables – liabilities to pay for goods or services that have been received or supplied and have been invoiced or formally agreed with the supplier; and
  2. accruals – liabilities to pay for goods or services that have been received or supplied but have not been paid, invoiced or formally agreed with the supplier, including amounts due to employees (for example, amounts relating to accrued vacation pay). Although it is sometimes necessary to estimate the amount or timing of accruals, the uncertainty is generally much less than for provisions. [IAS 37.11].

For trade creditors and their associated accruals, there is little uncertainty regarding either the amount of the obligation (which would be determined by the contracted price for the goods and services being provided) or of the timing of settlement (which would normally occur within an agreed period following transfer of the goods and services in question and the issue of an invoice). In practice, however, contracts can be more complex and give rise to a wide range of possible outcomes in terms of the amount or timing of payment. In these circumstances, the difference between provisions and other liabilities is less obvious and judgement may be required to determine where the requirement to make an estimate of an obligation indicates a level of uncertainty about timing or amount that is more indicative of a provision. Such judgements, if significant to the amounts recognised in the financial statements, would merit disclosure (see Chapter 6 at 8.3). [FRS 102.8.6].

One reason why this distinction matters is that provisions are subject to narrative disclosure requirements regarding the nature of the obligation and the uncertainties over timing and amount; and to quantitative disclosures of movements arising from their use, remeasurement or release that do not apply to other payables (see 3.10 below). In fact, although questions of recognition and measurement are important, transparency of disclosure is also a very significant matter in relation to accounting for provisions and ensuring that their effect is properly understood by users of the financial statements.

3.3 Determining when a provision should be recognised

Section 21 requires that a provision should be recognised only when:

  1. an entity has an obligation at the reporting date as a result as a result of a past event;
  2. it is probable (i.e. more likely than not) that the entity will be required to transfer economic benefits in settlement; and
  3. the amount of the obligation can be measured reliably. [FRS 102.21.4].

No provision should be recognised unless all of these conditions are met. Each of these conditions is discussed separately below.

Where all of these three conditions are met, a provision should be recognised as a liability in the statement of financial position. In most cases, the recognition of a provision results in an immediate expense in profit or loss. However, in some cases, it may be appropriate to recognise the amount of the provision as part of the cost of an asset such as inventories or property plant and equipment. [FRS 102.21.5]. A common case when a provision is recognised as part of the cost of an asset is in relation to decommissioning costs (see 4.1 below).

3.3.1 The entity has an obligation at the reporting date as a result of a past event

An obligation at the reporting date can be either a legal obligation that can be enforced by law, or a constructive obligation. A constructive obligation arises when an entity has created a valid expectation in other parties that it will discharge the obligation. [FRS 102.21.6]. This may be as a result of past practice, published policies or a sufficiently specific current statement. [FRS 102 Appendix I]. The entity must have no realistic alternative to settling the obligation, whether legal or constructive, in order to meet condition (a) of the recognition criteria for provisions set out at 3.3 above. [FRS 102.21.6].

The following example from Section 21 illustrates how a constructive obligation may be created. [FRS 102.21A.5].

The assessment of whether an entity has a constructive obligation may not always be straightforward, but in our opinion will have to be accompanied by evidence of communication between the entity and the affected parties in order to be able to conclude that they have a valid expectation that the entity will honour its obligations. In this context, an internal memo or board decision is not sufficient. It is not necessary for the entity to know the identity of the other party. In Example 19.1 above, the other party comprises all the retail store customers and they were aware of the entity's returns policy. Restructuring provisions give rise to another case where judgment is needed to determine whether a valid expectation exists, as discussed at 3.3.5.B below.

In addition to an entity having an obligation at the reporting date, the obligation must arise as a result of a past event. Obligations that will arise from an entity's future actions do not satisfy condition (a) of the recognition criteria set out at 3.3 above, regardless of how likely the future actions are to occur, and even if they are contractual. [FRS 102.21.6]. This is illustrated in the following scenarios. [FRS 102.21.6, 21A.8].

Sometimes it is not always clear whether a present obligation exists as a result of a past event, in which case judgement is required. A common example is a lawsuit, in which the responsibility of the defendant has not yet been established. IAS 37, which shares consistent principles with Section 21 regarding the recognition of provisions, suggests that entities would recognise an obligation if, taking account of all available evidence it is ‘more likely than not’ that a present obligation exists at the end of the reporting period. [IAS 37.15]. In this context, ‘all available evidence’ would include the opinion of experts together with any additional evidence provided by events after the reporting period. [IAS 37.16]. Indeed, Section 32 – Events after the End of the Reporting Period – cites the settlement of a court case as such an example of facts that might indicate the existence of an obligation at the reporting date. [FRS 102.32.5(a)].

3.3.2 A transfer of economic benefits is probable

A transfer of economic benefits is considered probable if it is more likely than not to occur. [FRS 102.21.4]. In practice this is taken as meaning a probability of greater than 50%.

Where an entity has a number of similar obligations, the probability that a transfer of economic benefits will occur should be based on the class of obligations as a whole. Whilst this is not explicitly stated in Section 21, it is implied in an example in the Appendix, where a manufacturer recognises a provision for warranties given at the time of sale to purchasers of its product. The obligating event is the sale of a product with a warranty and an outflow of resources in settlement is determined to be probable for the warranties as a whole (i.e. it is more likely than not that the entity will have to honour some warranties claims). [FRS 102.21A.4]. Warranty provisions are discussed further at 3.3.5.C below.

3.3.3 The amount of the obligation can be measured reliably

Section 21 provides no guidance on how this condition should be applied. The general concept of reliability in Section 2 – Concepts and Pervasive Principles – (see Chapter 4) requires only that information is free from material error and bias and faithfully represents that which it either purports to represent or could reasonably be expected to represent. Financial statements are not free from bias (i.e. not neutral) if, by the selection or presentation of information, they are intended to influence the making of a decision or judgement in order to achieve a predetermined result or outcome. [FRS 102.2.7]. In addition, to be reliable, the information in financial statements must be complete within bounds of materiality and cost. [FRS 102.2.10]. Combined with the requirement that a provision is measured at the ‘best estimate’ of the amount required to settled the obligation at the reporting date, [FRS 102.21.7], it could be argued that only in rare cases would a lack of a reliable measure prohibit recognition of an obligation. Under the hierarchy set out in Section 10 – Accounting Policies, Estimates and Errors – entities may consider the requirements of IAS 37 which takes the view that a sufficiently reliable estimate can almost always be made for a provision where an entity can determine a range of possible outcomes. Hence IAS 37 contends that it will only be in extremely rare cases that a range of outcomes cannot be determined. [IAS 37.25]. Whether such a situation is as rare as IAS 37 asserts may be open to question, especially for entities trying to determine estimates relating to potential obligations that arise from litigation and other legal claims. However, given the consistent principles applied by Section 21 and IAS 37 to the recognition of provisions, we would expect entities applying FRS 102 to apply a similarly thorough approach in assessing whether a reliable estimate can be made of the amount of an obligation.

In the event that a present obligation cannot be measured reliably, it is regarded as a contingent liability, [FRS 102 Appendix I], (see 3.4 below).

3.3.4 Cases where recognition of a provision is prohibited

3.3.4.A Future operating losses

Section 21 prohibits the recognition of provisions for future operating losses. [FRS 102.21.11B]. This is illustrated by Example 1 in the Appendix to Section 21, which is reproduced below. [FRS 102.21A.1].

As alluded to in Example 19.3, it would be wrong to assume that the prohibition of provisions for future operating losses in Section 21 has effectively prevented the effect of future operating losses from being anticipated. They may sometimes be recognised as a result of requirements in another section of FRS 102. For example:

  • under Section 27 – Impairment of Assets – the carrying amount of an asset is compared with its recoverable amount when there is an indicator of impairment. If the recoverable amount is lower than the carrying amount then the asset must be impaired to its recoverable amount. The calculation of the recoverable amount should include the effect of any future operating losses (or sub-standard operating profits) on the value of the asset. See Chapter 24;
  • under Section 27, inventories are written down to selling price less costs to complete and sell to the extent that they will not be recovered from future revenues, rather than leaving the difference between carrying amount and selling prices less costs to complete and sell to show up as a future operating loss. See Chapter 11 at 3.4; and
  • under Section 23 – Revenue – provision is made for losses expected on construction contracts when it is probable that contract costs will exceed contract revenue. See Chapter 20 at 3.9.9.

This is therefore a rather more complex issue than Section 21 acknowledges. Indeed, Section 21 itself has to navigate closely the dividing line between the general prohibition of the recognition of future losses and the recognition of contractual or constructive obligations that are expected to give rise to losses in future periods.

3.3.4.B Staff training costs

Example 19.2 at 3.3.1 above reproduces an example from Section 21 where the government introduces changes to the income tax system. An entity needs to retrain a large proportion of its administrative and sales workforce in order to ensure continued compliance with tax regulations. Section 21 argues that there is no present obligation until the actual training has taken place and so no provision should be recognised. In many cases the need to incur training costs could also be avoided by the entity by its future actions. For example, the cost could be avoided by hiring new staff who were already appropriately trained.

3.3.5 Examples of provisions in Section 21

3.3.5.A Onerous contracts

Although future operating losses in general cannot be provided for, Section 21 requires that ‘if an entity has an onerous contract, the present obligation under the contract shall be recognised and measured as a provision’. [FRS 102.21.11A].

FRS 102 defines an onerous contract as a ‘contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.’ [FRS 102 Appendix I]. This seems to require that the contract is onerous to the point of being directly loss-making, not simply uneconomic by reference to current prices.

The unavoidable costs under a contract reflect the least net cost of exiting from the contract. This is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it. [FRS 102.21A.2]. This evaluation does not require an intention by the entity to fulfil or to exit the contract. It does not even require there to be specific terms in the contract that apply in the event of its termination or breach. Its purpose is to recognise only the unavoidable costs to the entity. In the absence of specific clauses in the contract relating to termination or breach the unavoidable cost could include an estimation of the cost of walking away from the contract and having the other party go to court for compensation for the resultant breach.

There is a subtle yet important distinction between making a provision in respect of the unavoidable costs under a contract (reflecting the least net cost of what the entity has to do) compared to making an estimate of the cost of what the entity intends to do. The first is an obligation, which merits the recognition as a provision. The second is a choice of the entity, which fails the recognition criteria because it does not exist independently of the entity's future actions, [FRS 102.21.6], and is therefore akin to a future operating loss.

Section 21 gives the example of a contractual requirement to make payments under an operating lease for an asset which is no longer used by a business as an example of an onerous contract. However, it provides no specific guidance on the recognition or measurement of provisions for onerous leases. The most common examples of onerous contracts in practice relate to leasehold property. The recognition and measurement of provisions for vacant leasehold property is discussed at 4.10 below. The recognition and measurement of provisions for occupied leasehold property is discussed in detail in Chapter 27 at 6.2.1 of EY International GAAP 2019.

3.3.5.B Restructuring provisions

An entity should recognise a provision for restructuring costs only when it has a legal or constructive obligation at the reporting date to carry out the restructuring. [FRS 102.21.11D].

The specific requirements within Section 21 for the recognition of a restructuring provision seek to define the circumstances that give rise to a constructive obligation to restructure. Section 21 restricts the recognition of a restructuring provision to cases when an entity:

  • has a detailed formal plan for the restructuring identifying at least:
    • the business or part of a business concerned;
    • the principal locations affected;
    • the location, function, and approximate number of employees who will be compensated for terminating their services;
    • the expenditures that will be undertaken; and
    • when the plan will be implemented; and
  • has raised a valid expectation in those affected that it will carry out the restructuring by starting to implement that plan or announcing the main features to those affected by it. [FRS 102.21.11C].

A restructuring is defined as ‘a programme that is planned and controlled by management, and materially changes either:

  • the scope of a business undertaken by an entity; or
  • the manner in which that business is conducted’. [FRS 102 Appendix I].

In practice a restructuring may include changes such as the sale or termination of a line of business, the closure of business locations in a country or region, changes in management structure or fundamental reorganisations that have a material effect on the nature and focus of the entity's operations. Whilst the definition of a restructuring may be widely interpreted, there must be a material change to either the scope of the business or the way in which it is conducted, which goes beyond normal changes arising as a result of operating in a dynamic business environment. This may be a subjective judgement. However, it is important in order to prevent entities from classifying all kinds of operating costs as restructuring costs, thereby inviting the user of the accounts to perceive them differently from the ‘normal’ costs of operating in a dynamic business environment.

The following examples taken from the Appendix to Section 21 illustrate how a constructive obligation for a restructuring may or may not be created. [FRS 102.21A.6-7].

In practice it can be very difficult to determine whether it is appropriate to recognise a provision for the future costs of a restructuring programme. The determination of whether an organisational change is a material change or just part of a process of continuous improvement is a subjective judgement. Once it has been established that the activities in question constitute a restructuring rather than an ongoing operating cost, it can be difficult to determine whether management's actions before the reporting date have been sufficient to have ‘raised a valid expectation in those affected’. [FRS 102.21.11C(b)]. Even if a trigger point is easily identifiable, such as the date of an appropriately detailed public announcement, it might not necessarily commit management to the whole restructuring, but only to specific items of expenditure such as redundancy costs. When the announcement is less clear, referring for example to consultations, negotiations or voluntary arrangements, particularly with employees, judgement is required. Furthermore, taken on its own, the ‘valid expectation’ test is at least as open to manipulation as one based on the timing of a board decision. Entities anxious to accelerate or postpone recognition of a liability could do so by advancing or deferring an event that signals such a commitment, such as a public announcement, without any change to the substance of their position.

In these situations it is important to consider all the related facts and circumstances and not to focus on a single recognition criterion. The objective of the analysis is to determine whether there is a past obligating event at the reporting date. The guidance in Section 21 about restructuring, referring as it does to constructive obligations and valid expectations is ultimately aimed at properly applying the principle in Section 21 that only those obligations arising from past events and existing independently of an entity's future actions are recognised as provisions. [FRS 102.21.6]. In essence, a restructuring provision qualifies for recognition if, as at the reporting date, it relates to a detailed plan of action from which management cannot realistically withdraw.

Section 21 does not address which costs may or may not be included within a restructuring provision. IAS 37, which contains consistent principles to Section 21 on the measurement of provisions, imposes criteria to restrict the types of cost that can be provided for. They specify that a restructuring provision should include only the direct expenditures arising from the restructuring, which are those that are both:

  • necessarily entailed by the restructuring; and
  • not associated with the ongoing activities of the entity. [IAS 37.80].

IAS 37 gives specific examples of costs that may not be included within the provision, because they relate to the future conduct of the business. Such costs include:

  • retraining or relocating continuing staff;
  • marketing; and
  • investing in new systems and distribution networks. [IAS 37.81].

Given the consistent principles of Section 21 with IAS 37 in respect of the recognition of provisions, including restructuring provisions, entities may consider it appropriate under the hierarchy in Section 10 to apply the criteria above in quantifying a restructuring provision under Section 21. The application of these criteria would ensure that entities do not contravene the general prohibition in Section 21 against provisions for operating losses. [FRS 102.21.11B].

Costs that should and should not be included in a restructuring provision under IAS 37 are discussed further in Chapter 27 at 6.1.4 of EY International GAAP 2019.

3.3.5.C Warranty provisions

Warranty provisions are specifically addressed by Example 4 in the Appendix to Section 21, which is reproduced in Examples 19.7 and 19.8 at 3.7.1 and 3.7.2 below.

In Examples 19.7 and 19.8 the assessment of the probability of an outflow of economic resources is made across the population of warranties as a whole, and not using each potential claim as the unit of account. This makes it more likely that a provision will be recognised, because the probability criterion is considered in terms of whether at least one item in the population will give rise to a payment. Recognition then becomes a matter of reliable measurement and entities calculate an expected value of the estimated warranty costs.

3.3.5.D Refunds policy

Example 5 from the Appendix of Section 21 (reproduced in Example 19.1 above) addresses a retail store that has a policy of refunding goods returned by dissatisfied customers. There is no legal obligation to do so, but the company's policy of making refunds is generally known. The example argues that the conduct of the store has created a valid expectation on the part of its customers that it will refund purchases. The obligating event is the original sale of the item, and the probability of some economic outflow is greater than 50%, as there will nearly always be some customers demanding refunds. Hence, a provision should be made for the best estimate of the amount required to settle the refunds. [FRS 102.21A.5].

The assessment of whether a provision is required may be straightforward when the store has a very specific and highly publicised policy on refunds. However, some stores' policies on refunds might not be so clear cut. A store may offer refunds under certain conditions, but not widely publicise its policy. In these circumstances, there might be doubt as to whether the store has created a valid expectation on the part of its customers that it will honour all requests for a refund.

3.3.5.E Litigation and other legal costs

The Appendix to Section 21 includes an example of a court case to illustrate how the principles of Section 21 distinguish between a contingent liability and a provision in such situations. This example is reproduced in Example 19.6 at 3.4 below. However, the assessment of the particular case in the example is clear-cut. In most situations, assessing the need to provide for legal claims is one of the most difficult tasks in the field of provisioning. This is due mainly to the inherent uncertainty in the judicial process itself, which may be very long and drawn out. Furthermore, this is an area where either provision or disclosure might risk prejudicing the outcome of the case, because they give an insight into the entity's own view on the strength of its defence that can assist the claimant. Similar considerations apply in other related areas, such as tax disputes.

Whether an entity should make provision for the costs of settling a case or to meet any award given by a court will depend on a reasoned assessment of the particular circumstances, based on appropriate legal advice. The evidence to be considered should also include any additional evidence occurring after the end of the reporting period that confirms whether the entity had a present obligation at the reporting date. This is relevant if, for example, the court case is settled in the period between the reporting date and the date on which the financial statements are authorised for issue. [FRS 102.32.5(a)].

3.3.5.F Financial guarantee contracts

A financial guarantee contract is a ‘contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payments when due in accordance with the original or modified terms of a debt instrument’. [FRS 102 Appendix I].

As discussed at 3.2 above, in some cases, financial guarantee contracts may be excluded from the scope of Section 21. For financial guarantee contracts in the scope of Section 21, a provision should be recognised if the general recognition criteria for provisions are met. This would include it being probable that the issuer would be required to make a payment under the guarantee.

3.4 Contingent liabilities

A contingent liability is defined as:

  • a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or
  • a present obligation that arises from past events but is not recognised because:
    • it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or
    • the amount of the obligation cannot be measured with sufficient reliability. [FRS 102 Appendix I].

The term ‘possible’ is not defined in FRS 102. Literally, it could mean any probability greater than 0% and less than 100%. However, since ‘probable’ is defined as ‘more likely than not’, [FRS 102 Appendix I], it would be reasonable to use the term ‘possible’ in the context of contingent liabilities as meaning a probability of 50% or less. Accordingly, the above definition restricts contingent liabilities to those where either the existence of an obligation or an outflow of economic resources is less than 50% probable, or in those rare cases when a probable obligation cannot be measured with sufficient reliability.

Section 21 requires that contingent liabilities should not be recognised as liabilities on the balance sheet. The only exception to this is contingent liabilities of an acquiree in a business combination. [FRS 102.21.12]. Such contingent liabilities are covered by the requirements of Section 19 – Business Combinations and Goodwill (see Chapter 17).

Information about contingent liabilities should be disclosed unless the probability of an outflow of resources is remote (see 3.10 below). [FRS 102.21.12]. When an entity is jointly and severally liable for an obligation (see 3.7.6 below), the part of the obligation that is expected to be met by other parties is treated as a contingent liability and disclosed. [FRS 102.21.12].

Although it is not explicitly required by Section 21, we would expect contingent liabilities to be assessed continually to determine whether an outflow of resources embodying economic benefits has become probable. Where this becomes the case, then the provision should be recognised in the period in which the change in probability occurs, except in the circumstances where no reliable estimate can be made. This is illustrated by Example 9 to Section 21, which is reproduced below. [FRS 102.21A.9].

3.5 Contingent assets

A contingent asset is defined as ‘a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity’. [FRS 102 Appendix I]. In contrast to the case of contingent liabilities (see 3.4 above), the word ‘possible’ in the context of contingent assets is not confined to a probability level of 50% or less because Section 21 states that a contingent asset should never be recognised. [FRS 102.21.13].

Only when the flow of economic benefits to the entity is virtually certain is the related asset not contingent and capable of recognition. [FRS 102.21.13]. ‘Virtually certain’ is not defined in FRS 102. However, in addressing the same requirements in IAS 37, this has been interpreted as being as close to 100% as to make the remaining uncertainty insignificant. We would expect a similar interpretation under FRS 102.

Contingent assets should be disclosed when an inflow of economic benefits is probable, [FRS 102.21.13], with ‘probable’ meaning ‘more likely than not’. [FRS 102 Appendix I]. The disclosure requirements for contingent assets are discussed at 3.10.4 below.

As with contingent liabilities, we would expect contingent assets to be assessed continually to ensure that developments are appropriately reflected in the financial statements. If it has become virtually certain that an inflow of economic benefits will arise, the asset and the related income should be recognised in the period in which the change occurs.

3.6 How probability determines whether to recognise or disclose

The following matrix summarises the treatment of contingencies under Section 21:

Likelihood of outcome Accounting treatment: contingent liability Accounting treatment: contingent asset
Virtually certain Recognise Recognise
Probable Recognise Disclose
Possible, but not probable Disclose No disclosure permitted
Remote No disclosure required No disclosure permitted

FRS 102 does not put a numerical measure of probability on either ‘virtually certain’ or ‘remote’. In our view, the use of such measures would downgrade a process requiring the exercise of judgement into a mechanical exercise. It is difficult to imagine circumstances when an entity could reliably determine an obligation to be, for example, 92%, 95% or 99% likely, let alone be able to compare those probabilities objectively. Accordingly, we think it is reasonable to regard ‘virtually certain’ as describing a likelihood that is as close to 100% as to make any remaining uncertainty insignificant; to see ‘remote’ as meaning a likelihood of an outflow of resources that is not significant; and for significance to be a matter for judgement and determined according to the merits of each case.

3.7 Initial measurement

3.7.1 Best estimate of provision

Section 21 requires the amount recognised as a provision to be the best estimate of the amount required to settle the obligation at the reporting date. This is the amount an entity would rationally pay to settle the obligation at the end of the reporting period or to transfer it to a third party at that time. [FRS 102.21.7].

It is implicit in the definition of a provision that there are often uncertainties around the amount of the outflow required by an entity. Section 21 sets out different approaches to dealing with these uncertainties in arriving at an estimate of the provision, depending upon whether it arises from a single obligation or from a large population of items.

Where a provision arises from a single obligation, the individual most likely outcome may be the best estimate of the amount required to settle the obligation. However, even in such a case, the other possible outcomes should be considered. When the other possible outcomes are mostly higher than the most likely outcome, the best estimate will be higher than the individual most likely amount. Conversely, when other possible outcomes are mostly lower, the best estimate will be lower than the individual most likely amount. [FRS 102.21.7(b)]. In effect, this adjustment builds into the measure of the provision an allowance to reflect the risk that the actual outcome is an amount other than the individual most likely outcome.

When the provision involves a large population of items, the best estimate of the amount required to settle the obligation should reflect the weighting of all possible outcomes by their associated probabilities, i.e. a probability-weighted expected value calculation should be performed. [FRS 102.21.7(a)]. This method is illustrated by Example 4 in the Appendix to Section 21, which considers the estimation of a provision for product warranties, as set out below. [FRS 102.21A.4].

Where the provision involves a large population of items and there is a continuous range of possible outcomes, and each point in that range is as likely as any other, the mid-point of the range is used as the best estimate of the amount required to settle the obligation. [FRS 102.21.7(a)].

3.7.2 Discounting the estimated cash flows to a present value

When the effect of the time value of money is material, the amount of a provision should be the present value of the amount expected to be required to settle the obligation. The discount rate (or rates) should be a pre-tax rate (or rates) that reflect(s) current market assessments of the time value of money and the risks specific to the liability. The risks specific to the liability should be reflected either in the discount rate or in the estimation of the amounts required to settle the obligation, but not both. [FRS 102.21.7].

This requirement is illustrated in the following example taken from the Appendix to Section 21. [FRS 102.21A.4].

FRS 102 gives no further guidance on how an entity should determine the appropriate discount rate to use. However, the example above refers to a government bond rate with a similar term as the related obligation. This is consistent with the application of similar requirements in IAS 37.

The main types of provision where the impact of discounting will be significant are those relating to decommissioning and other environmental restoration liabilities, which are discussed at 4.1 and 4.2 below.

3.7.2.A Real or nominal rate

Section 21 does not indicate whether the discount rate should be a real discount rate or a nominal discount rate. The discount rate to be used depends on whether:

  • the future cash flows are expressed in current prices, in which case a real discount rate (which excludes the effects of general inflation) should be used; or
  • the future cash flows are expressed in expected future prices, in which case a nominal discount rate (which includes a return to cover expected inflation) should be used.

Either alternative is acceptable, and these methods may produce the same amount for the initial present value of the provision. However, the effect of the unwinding of the discount will be different in each case (see 3.8.1 below).

3.7.2.B Adjusting for risk and using a government bond rate

Section 21 requires that risk is taken into account in the calculation of a provision, but gives little guidance as to how this should be done. It merely states that the risks specific to the liability should be reflected in either the discount rate or in the estimate of the amounts required to settle the obligation, but not in both. [FRS 102.21.7]. One may use a discount rate that reflects the risk associated with the liability (a risk-adjusted rate). The following example, taken from the Accounting Standard Board's (ASB's) Working Paper Discounting in Financial Reporting1 shows how an entity might calculate such a risk adjusted rate.

As can be seen from this example, the risk-adjusted discount rate is a lower rate than the unadjusted (risk-free) discount rate. This may seem counter-intuitive initially, because the experience of most borrowers is that banks and other lenders will charge a higher rate of interest on loans that are assessed to be higher risk to the lender. However, in the case of a provision a risk premium is being suffered to eliminate the possibility of the actual cost being higher (thereby capping a liability), whereas in the case of a loan receivable a premium is required to compensate the lender for taking on the risk of not recovering its full value (setting a floor for the value of the lender's financial asset). In both cases the actual cash flows incurred by the paying entity are higher to reflect a premium for risk. In other words, the discount rate for an asset is increased to reflect the risk of recovering less and the discount rate for a liability is reduced to reflect the risk of paying more.

A problem with changing the discount rate to account for risk is that this adjusted rate is a theoretical rate, as it is unlikely that there would be a market assessment of the risks specific to the liability alone. [FRS 102.21.7]. However the lower discount rate in the above example is consistent with the premise that a risk-adjusted liability should be higher than a liability without accounting for the risk that the actual settlement amount is different to the estimate. It is also difficult to see how a risk-adjusted rate could be obtained in practice. In the above example, it was obtained only by reverse-engineering; it was already known that the net present value of a risk-adjusted liability was £138, so the risk-adjusted rate was just the discount rate applied to unadjusted cash flow of £150 to give that result.

The alternative approach, to adjust the cash flows instead of using a risk-adjusted discount rate, [FRS 102.21.7], is conceptually more straightforward, but still presents the problem of how to adjust the cash flows for risk. It could be inferred from Example 19.7 at 3.7.1 above that estimated cash flows which reflect the probabilities of cash outflows represent risk adjusted cash flows. However, whilst a best estimate based solely on the expected value approach or the mid-point of a range addresses the uncertainties relating to there being a variety of possible outcomes, it does not fully reflect risk, because the actual outcome could still be higher or lower than the estimate. Nevertheless, adjusting estimated cash flows to reflect risk may be easier than attempting to risk-adjust the discount rate.

Where the risks specific to the liability are reflected in the estimated cash flows, they should not also be included in the discount rate. [FRS 102.21.7]. The discount rate to be applied in this case should therefore be a risk free rate. As suggested in Example 19.8 at 3.7.2 above, it would be appropriate to apply a government bond rate with a similar currency and remaining term as the provision. It follows that because a risk-adjusted rate is always lower than the risk-free rate, an entity cannot justify the discounting of a provision at a rate higher than a government bond rate with a similar currency and term as the provision.

In recent years, government bond rates have been more volatile as markets have changed rates to reflect (among other factors) heightened perceptions of sovereign debt risk. The question has therefore arisen whether government bond rates, at least in certain jurisdictions, should continue to be regarded as the default measure of a risk-free discount rate. Whilst the current volatility in rates has highlighted the fact that no debt (even government debt) is totally risk free, the challenge is to find a more reliable measure as an alternative. Any adjustment to the government bond rate to ‘remove’ the estimate of sovereign debt risk is conceptually flawed, as it not possible to isolate one component of risk from all the other variables that influence the setting of an interest rate. Another approach might be to apply some form of average bond rate over a period of 3, 6 or 12 months to mitigate the volatility inherent in applying the spot rate at the period end. However, this is clearly inappropriate given the requirements in Section 21 to determine the best estimate of an obligation by reference to the expenditure required to settle it ‘at the reporting date’ [FRS 102.21.7] and to determine the discount rate on the basis of ‘current market assessments’ of the time value of money. [FRS 102.21.7].

With ‘risk’ being a measure of potential variability in returns, it remains the case that in most countries a government bond will be subject to the lowest level of variability in that jurisdiction. As such, it normally remains the most suitable of all the observable measures of the time value of money in a particular country. When government bond rates are negative or, more likely, result in a negative discount rate once adjusted for risk, we believe that it is not appropriate to apply a floor of zero to the discount rate as this would result in an understatement of the liability. As discussed above, and at 3.7.2.A, there are various approaches to determining an appropriate discount rate. It may sometimes be the case that one or more of the acceptable approaches result in a negative discount rate whereas the application of an alternative permitted approach would not. In order to avoid some of the presentational difficulties associated with a negative discount rate, entities faced with a negative real discount rate before risk adjustment may wish to consider the alternative approach of discounting expected future cash flows expressed in future prices, at a nominal discount rate (see 3.7.2.A above), if the nominal rate is not negative. Similarly, entities that are faced with a negative risk-adjusted discount rate only because of risk adjustment (i.e. where risk free rates themselves are not negative) may wish to adopt the alternative approach of adjusting the estimated future cash flows to reflect the risks associated with the liability, rather than risk-adjusting the discount rate.

3.7.2.C Own credit risk is not taken into account

In adjusting either the estimated cash flows or discount rate for risk, an entity should not adjust for its own credit risk (i.e. the risk that the entity could be unable to settle the amount finally determined to be payable). This is because Section 21 requires either the discount rate or estimated cash flows to reflect ‘the risks specific to the liability’. [FRS 102.21.7]. Credit risk is a risk of the entity rather than a risk specific to the liability.

3.7.3 Anticipating future events that may affect the estimate of cash flows

The amount that an entity expects will be required to settle an obligation in future may depend upon expectations and assumptions concerning future events, such as changes in legislation or technological advances. Section 21 does not address the extent to which such expectations should be built into an entity's best estimate of the amount required to settle the obligation. IAS 37 provides guidance in this area. Given the consistent principles of Section 21 and IAS 37 regarding the measurement of provisions, entities may therefore look to IAS 37 for further guidance. IAS 37 states that ‘future events that may affect the amount required to settle an obligation shall be reflected in the amount of a provision where there is sufficient objective evidence that they will occur’. [IAS 37.48].

The requirement for objective evidence means that it is not appropriate to reduce the best estimate of future cash flows simply by assuming that a completely new technology will be developed before the liability is required to be settled. There will need to be sufficient objective evidence that such future developments are likely. For example, an entity may believe that the cost of cleaning up a site at the end of its life will be reduced by future changes in technology. The amount recognised has to reflect a reasonable expectation of technically qualified, objective observers, taking account of all available evidence as to the technology that will be available at the time of the clean-up. It would be appropriate to include, for example, expected cost reductions associated with increased experience in applying existing technology. [IAS 37.49].

Similarly, if new legislation is to be anticipated, IAS 37 requires that there needs to be evidence both of what the legislation will demand and whether it is virtually certain to be enacted and implemented. In many cases sufficient objective evidence will not exist until the new legislation is enacted. [IAS 37.50].

3.7.4 Provisions should exclude gains on expected disposal of assets

An entity should exclude gains from the expected disposal of assets from the measurement of a provision. [FRS 102.21.8]. We would instead expect such gains to be recognised at the time specified by the relevant section of FRS 102 dealing with the assets concerned. This is likely to be of particular relevance in relation to restructuring provisions which are discussed at 3.3.5.B above.

3.7.5 Reimbursement of amounts required to settle a provision

An entity may sometimes be reimbursed all or part of an amount required to settle a provision, for example through an insurance claim. The reimbursement should be recognised only when it is virtually certain that the entity will receive the reimbursement on settlement of the obligation. [FRS 102.21.9]. It should be recognised as an asset in the statement of financial position and should not be offset against the provision. [FRS 102.21.9]. However, the expense relating to a provision can be presented net of reimbursement in the income statement. [FRS 102.21.9]. The amount recognised for the reimbursement should not exceed the amount of the provision. [FRS 102.21.9].

Except when an obligation is determined to be joint and several (see 3.7.6 below), any form of net presentation in the balance sheet is prohibited. This is because the entity would remain liable for the whole cost if the third party failed to pay for any reason, for example as a result of the third party's insolvency.

3.7.6 Joint and several liability

When an entity is jointly and severally liable for an obligation, it recognises only its own share of the obligation, based on the amount that it is probable that the entity will pay. The remainder that is expected to be met by other parties is treated as a contingent liability. [FRS 102.21.12].

Arguably, the economic position in the case of joint and several liability is no different than if the entity was liable for the whole obligation but expected to be reimbursed part of the amount required to settle the provision under the terms of an insurance contract. In both cases, the entity is exposed to further loss in the event that the other parties are unable or unwilling to pay. However, in the case of joint and several liability, the entity and the parties with whom it shares liability each have a direct (albeit shared) obligation for the past event. This contrasts with the case where the entity expects to be reimbursed part of the amount required to settle a provision. In this case, the insurance company from whom the reimbursement is expected has a contractual relationship only with the entity and has no direct obligation for the past event itself. Accordingly, any disclosed liability should not be reduced on the basis that the entity holds valid insurance against the obligation.

3.8 Subsequent measurement of provisions

After initial recognition, provisions should be reviewed at each reporting date and adjusted to reflect the current best estimate of the amount required to settle the obligation. [FRS 102.21.11]. Any adjustments to the amounts previously recognised should be recognised in profit or loss unless the provision was originally recognised as part of the cost of an asset. [FRS 102.21.11].

An entity should charge against a provision only those expenditures for which the provision was originally recognised. [FRS 102.21.10]. Therefore, if a provision is no longer required, the amount of the provision should be reversed. Provisions may not be redesignated or used for expenses for which the provision was not originally recognised.

When a provision is measured at the present value of the amount required to settle the obligation, the unwinding of the discount should be recognised as a finance cost in profit or loss in the period it arises. [FRS 102.21.11]. However, the amount of finance cost recognised as an unwinding of the discount depends upon whether the provision has been discounted at a real or a nominal rate, and also whether the entity has used a risk free or risk adjusted discount rate. This is not addressed by Section 21 but is discussed at 3.8.1 and 3.8.2 below. In addition, Section 21 provides no guidance on the effect of changes in interest rates on the discount rates applied. This is discussed at 3.8.3 below.

3.8.1 Unwinding of the discount: impact of using real or nominal discount rates

As discussed at 3.7.2.A above, Section 21 provides no guidance on whether a real or nominal discount rate should be used to discount a provision. Whilst both methods may produce the same figure for the initial present value of the provision, the effect of the unwinding of the discount will be different in each case. This is best illustrated by way of an example.

Although the total expense in each year is the same under either method, what will be different is the allocation of the change in provision between operating costs (assuming the original provision was treated as an operating expense) and finance charges. It can be seen from the second table in the above example that using the real discount rate will give rise to a much lower finance charge each year. However, this does not lead to a lower provision in the balance sheet at the end of each year. Provisions have to be revised annually to reflect the current best estimate of the amount required to settle the obligation. [FRS 102.21.11]. Thus, the provision in the above example at the end of each year needs to be adjusted to reflect current prices at that time (and any other adjustments that arise from changes in the estimate of the provision), as well as being adjusted for the unwinding of the discount. For example, the revised provision at the end of Year 1 is £100,173, being £105,000 discounted for two years at 2.381%. After allowing for the unwinding of the discount, this required an additional provision of £4,770.

3.8.2 Unwinding of the discount: impact of using risk-free or risk-adjusted discount rates

The decision made by an entity to use a risk free or risk adjusted discount rate impacts on the unwinding of the discount and the amount recognised in finance costs in respect of the unwind. This is illustrated in the following example:

In Example 19.11 above, the unwinding of different discount rates gives rise to different provisions. The difference of £10 (£22 – £12) relates to the risk adjustment that has been made to the provision. As the actual date of settlement comes closer, the estimates of the range of possible outcomes (and accordingly the expected value of the outflow) and the premium the entity would accept for certainty will converge. As such, the effect of any initial difference related to the decision to apply a risk-free or risk-adjusted rate will be lost in the other estimation adjustments that would be made over time.

3.8.3 The effect of changes in interest rates on the discount rate applied

Section 21 requires the discount rate to reflect current market assessments of the time value of money. [FRS 102.21.7]. It follows that where interest rates change, the provision should be recalculated on the basis of revised interest rates. This will give rise to an adjustment to the carrying value of the provision, but Section 21 does not address how this should be classified in the income statement. We believe that the adjustment to the provision is a change in accounting estimate, as defined in Section 10. Accordingly, it should be reflected in the line item of the income statement in which the expense establishing the provision was originally recorded. Where the original provision was recorded as part of the cost of an asset such as inventory or property, plant and equipment, the effect of any subsequent adjustment to discount rates should be added to or deducted from the cost of the asset to which the provision relates.

Calculating this adjustment is not straightforward either, because Section 21 gives no guidance on how it should be done. For example, should the new discount rate be applied during the year or just at the year-end and should the rate be applied to the new estimate of the provision or the old estimate? Because Section 21 requires the value of a provision to reflect the best estimate of the expenditure required to settle the obligation to be assessed as at the end of the reporting period, [FRS 102.21.7], it would appear that the effect of a change in the estimated discount rate is accounted for prospectively from the end of the reporting period. This is illustrated in the following example:

3.9 Funding commitments (other than loan commitments)

The requirements of FRS 102 regarding funding commitments, other than commitments to make a loan, are set out in Section 34 – Specialised Activities, rather than in Section 21. Nevertheless, an entity is required to consider the requirements of both Section 21 and Section 2 when accounting for funding commitments. [FRS 102.34.58]. Loan commitments fall within the scope of Section 11 and Section 12. [FRS 102.34.57]. In our opinion, it would also be appropriate to regard other commitments to provide resources that will result in the recognition of a financial instrument as being within the scope of Sections 11 and 12 (see Chapter 10).

3.9.1 Recognition of a funding commitment as a liability

Section 34 requires that an entity recognises a liability and, usually, a corresponding expense, when it has made a commitment that it will provide resources to another party, if, and only if:

  1. the definition and recognition criteria for a liability have been satisfied (see 3.3 above);
  2. the obligation (which may be a constructive obligation) is such that the entity cannot realistically withdraw from it; and
  3. the entitlement of the other party to the resources does not depend on the satisfaction of performance-related conditions. [FRS 102.34.59].

The definition of a liability requires that there be a present obligation, and not merely an expectation of a future outflow. [FRS 102.34A.1]. A general statement that the entity intends to provide resources to certain classes of potential beneficiaries in accordance with its objectives does not in itself give rise to a liability, as the entity may amend or withdraw its policy, and potential beneficiaries do not have the ability to insist on their fulfilment. Similarly, a promise to provide cash conditional on the receipt of future income in itself may not give rise to a liability where the entity cannot be required to fulfil it if the future income is not received and it is probable that the economic benefits will not be transferred. [FRS 102.34A.2].

A liability is recognised only for a commitment that gives the recipient a valid expectation that payment will be made and from which the grantor cannot realistically withdraw. One of the implications of this is that a liability only exists where the commitment has been communicated to the recipient. [FRS 102.34A.3].

Commitments that are performance-related will be recognised when those performance-related conditions are met. [FRS 102.34.60]. Performance-related conditions are defined in FRS 102 as conditions that require the performance of a particular level of service or units of output to be delivered, with payment of, or entitlement to, the resources conditional on that performance. [FRS 102 Appendix I]. Commitments are not recognised if they are subject to performance-related conditions. In such a case, the entity is required to fulfil its commitment only when the performance-related conditions are met and no liability exists until that time. [FRS 102.34A.4].

A commitment may contain conditions that are not performance-related conditions. For example, a requirement to provide an annual financial report to the grantor may serve mainly as an administrative tool because failure to comply would not release the grantor from its commitment. This may be distinguished from a requirement to submit a detailed report for review and consideration by the grantor of how funds will be utilised in order to secure payment. A mere restriction on the specific purpose for which the funds are to be used does not in itself constitute a performance-related condition. [FRS 102.34A.5].

Whether an arrangement gives rise to a funding commitment and when such commitments are recognised is a matter of judgement based on the facts and circumstances of the case, as illustrated in Example 19.13 below.

Applying the requirements in respect of funding commitments discussed above:

  • In Option 1, the contract is unenforceable, there is no announcement or conditions preceding payment and there is no exchange of benefits. Accordingly, an expense would be recognised only when the entity transfers cash to the university.
  • For Option 2, it may be appropriate for the entity to conclude that the entity's announcement of the donation to be paid by instalments indicates that there is a constructive obligation because the entity has created a valid expectation that it will make all of the payments promised. Alternatively, it could determine that once the first instalment is paid, the entity has created a valid expectation that it will make the remaining payments. This is a matter of judgement. In this case the entity would recognise an expense and a liability, measured at the net present value of the 5 instalments of £200,000, at the point when it is determined that a constructive obligation exists.
  • Option 3 involves an enforceable contract with no exchange of benefits. Therefore a liability and an expense are recognised on signing the enforceable contract, measured at the present value of the 5 instalments of £200,000.
  • Under Option 4, the contract is unenforceable and the donation is subject to a performance condition. In these circumstances, no liability exists until the performance condition is met (i.e. when the additional funds have been raised). [FRS 102.34.60]. Only then would a liability and expense be recognised, measured at the net present value of the £1m promised.
  • Option 5 involves an enforceable contract. Therefore a liability is recognised when the contract is signed. In addition, there is an exchange of benefits relating to the research and development activities performed on behalf of the entity. Whether these benefits have a value close to the present value of the 5 instalments of £200,000 is a matter of judgement. If it is determined that this is an exchange transaction, the entity would apply the criteria in Section 18 – Intangible Assets other than Goodwill – to determine whether an asset or expense could be recognised for the related research and development costs (see Chapter 16).

Where the arrangement gives rise to an exchange transaction rather than a donation, the expenditure incurred by the donor is recorded in accordance with the relevant section of FRS 102. An exchange transaction is a reciprocal transfer in which each party receives and sacrifices approximately equal value. Assets and liabilities are not recognised until each party performs their obligations under the arrangement.

3.10 Presentation and disclosure

3.10.1 Presentation of provisions

For UK companies and LLPs preparing financial statements using statutory formats rather than ‘adapted formats’, provisions within the scope of Section 21 would fall within the statutory caption ‘Other provisions’ within the heading ‘Provisions for liabilities’. ‘Other provisions’ can be shown either on the face of the balance sheet or in the notes to the accounts. See Chapter 6 at 5.3.11.

Companies and LLPs using ‘adapted formats’ must present current and non-current provisions separately on the face of the balance sheet. [FRS 102.4.2A]. See Chapter 6 at 5.1.9.

3.10.2 Disclosures about provisions

For each class of provision an entity should provide a reconciliation showing:

  1. the carrying amount at the beginning and end of each period;
  2. additions during the period, including adjustments that result from changes in measuring the discounted amount;
  3. amounts charged against the provision during the period; and
  4. unused amounts reversed during the period. [FRS 102.21.14].

Disclosure (b) requires additions in the period and adjustments that result from changes in measuring the discounted amount to be disclosed as one line item in the reconciliation. This differs from the disclosure requirements of IAS 37, which requires the disclosure of additions during the period and the increase in the discounted amount of the provision arising from the passage of time and the effect of any changes in discount rates as separate line items within the reconciliation. [IAS 37.84].

In addition, for each class of provision, an entity should disclose:

  1. a brief description of the nature of the obligation and the expected amount and timing of any resulting payments;
  2. an indication of the uncertainties about the amount or timing of those outflows; and
  3. the amount of any expected reimbursements, stating the amount of any asset that has been recognised for the expected reimbursement. [FRS 102.21.14].

Disclosure (a) requires disclosure of the expected amount and timing of any resulting payments. This differs from IAS 37 which requires disclosure only of the expected timing of outflows. [IAS 37.85(a)]. In many cases, the expected amount of the payments will be the same as the carrying amount of the provision at the end of the period. However, where a provision has been discounted to its present value it is unclear from Section 21 whether the disclosure of the expected amount of payments should be expressed based on current prices or expected future prices.

Comparative information is not required for any of the disclosures about provisions. [FRS 102.21.14].

Where a transfer has been made to any provision for liabilities, or from any provision for liabilities other than for the purpose for which the provision was established, UK Company Law (i.e. the Regulations) and the LLP Regulations require disclosure, in tabular form, of:

  • the amount of provisions at the beginning and the end of the year and as at the balance sheet date;
  • any amounts transferred to or from provisions during the year; and
  • the source and application of any amounts so transferred.

Particulars must be given of each provision included within the statutory heading ‘other provisions’ in any case where the amount of that provision is material. [1 Sch 59, 2 Sch 70, 3 Sch 77, 1 Sch 57 (LLP)].

3.10.3 Disclosures about contingent liabilities

Unless the possibility of any outflow of resources in settlement is remote, an entity should disclose, for each class of contingent liability at the reporting date, a brief description of the nature of the contingent liability and, when practicable:

  • an estimate of its financial effect, measured in accordance with paragraphs 7 to 11 of Section 21 (see 3.7 above);
  • an indication of the uncertainties relating to the amount or timing of any outflow; and
  • the possibility of any reimbursement. [FRS 102.21.15].

If it is impracticable to make one or more of these disclosures, that fact should be stated. [FRS 102.21.15]. Applying a requirement is impracticable when the entity cannot apply it after making every reasonable effort to do so. [FRS 102 Appendix I].

Section 21 does not define or put a numerical measure of probability on the term ‘remote’. In our view, it is reasonable to interpret ‘remote’ as meaning a likelihood of an outflow of resources that is not significant (see 3.6 above).

The Regulations and LLP Regulations require disclosure of the particulars and the total amount of any financial commitments, guarantees and contingencies that are not included in the balance sheet. [1 Sch 63(2), 2 Sch 77(1), 3 Sch 81(2), 1 Sch 60(2) (LLP)]. An indication of the nature and form of any valuable security given by the entity in respect of those commitments, guarantees and contingencies must be given. [1 Sch 63(3), 2 Sch 77(2), 3 Sch 81(3), 1Sch 60(3) (LLP)]. The total amount of those commitments concerning pensions must be separately disclosed. [1 Sch 63(4), 2 Sch 77(3), 3 Sch 81(4), 1 Sch 60(4)]. The entity must also state separately the total amount of those commitments, guarantees and contingencies which are undertaken on behalf of, or for the benefit of:

  1. any parent undertaking or fellow subsidiary undertaking of the entity,
  2. any subsidiary undertaking of the entity, or
  3. any undertaking in which the entity has a participating interest. [1 Sch 63(7), 2 Sch 77(6), 3 Sch 81(7), 1 Sch 60(7) (LLP)].

3.10.4 Disclosures about contingent assets

If an inflow of economic benefits is probable (more likely than not) but not virtually certain, an entity should disclose:

  • a description of the nature of the contingent assets at the end of the reporting period; and
  • when practicable, an estimate of their financial effect, measured using the principles set out in paragraphs 7 to 11 of Section 21 (see 3.7 above).

If it is impracticable to make one or more of these disclosures, that fact should be stated. [FRS 102.21.16]. Applying a requirement is impracticable when the entity cannot apply it after making every reasonable effort to do so. [FRS 102 Appendix I].

3.10.5 Disclosure when information is seriously prejudicial

In extremely rare cases, disclosure of some or all of the information required (by the disclosure requirements at 3.10.2 to 3.10.4 above) can be expected to prejudice seriously the position of the entity in a dispute with other parties on the subject matter of the provision, contingent liability or contingent asset. In such circumstances, an entity need not disclose all of the information required (by 3.10.2 to 3.10.4 above) insofar as it relates to the dispute, but should disclose at least the following: [FRS 102.21.17]

  • in relation to provisions:
    1. a table showing the reconciliation required by 3.10.2 above in aggregate, including the source and application of any amounts transferred to or from provisions during the reporting period;
    2. particulars of each provision in any case where the amount of the provision is material; and
    3. the fact that, and reason why, the information required by 3.10.2 above has not been disclosed.
  • in relation to contingent liabilities:
    1. particulars and the total amount of contingent liabilities (excluding those which arise out of insurance contracts) that are not included in the statement of financial position;
    2. the total amount of contingent liabilities which are undertaken on behalf of or for the benefit of:
      1. any parent or fellow subsidiary of the entity;
      2. any subsidiary of the entity;
      3. any entity in which the reporting entity has a participating interest,
      4. shall each be stated separately; and
    3. the fact that, and reason why, the information required by 3.10.3 above has not been disclosed.

In relation to contingent assets, the entity should disclose the general nature of the dispute, together with the fact that, and reason why, the information required by 3.10.4 above has not been disclosed. [FRS 102.21.17].

3.10.6 Disclosures about financial guarantee contracts

An entity should disclose the nature and business purpose of any financial guarantee contracts it has issued. [FRS 102.21.17A]. This appears to be required regardless of whether the financial guarantee contract meets the recognition criteria for provisions or the disclosure criteria for contingent liabilities discussed at 3.3 and 3.4 above. In addition, if applicable, the disclosures required for provisions (see 3.10.2 above) or contingent liabilities (see 3.10.3 above) should also be provided. [FRS 102.21.17A].

The Regulations and LLP Regulations also require disclosure of the particulars of any financial commitments that have not been provided for and are relevant to assessing the entity's state of affairs. [1 Sch 63(2), 2 Sch 77(1), 3 Sch 81(2), 1 Sch 60(2) (LLP)].

3.10.7 Disclosures about funding commitments (other than loan commitments)

An entity that has made a funding commitment (see 3.9 above) is required to disclose the following:

  1. the commitment made;
  2. the time-frame of that commitment;
  3. any performance-related conditions attached to that commitment; and
  4. details of how that commitment will be funded. [FRS 102.34.62].

Separate disclosure is required for recognised and unrecognised commitments. Within each category, disclosure can be aggregated provided that such aggregation does not obscure significant information. [FRS 102.34.63]. Accordingly, material commitments should be disclosed separately.

For funding commitments that are not recognised, it is important that full and informative disclosures are made of their existence and of the sources of funding for these unrecognised commitments. [FRS 102.34A.6].

4 OTHER EXAMPLES OF PROVISIONS

Section 21 provides specific guidance in respect of a limited number of situations, which are discussed at 3.3.4 and 3.3.5 above. This section considers other common provisions not addressed specifically by Section 21. As there is no specific guidance on accounting for these provisions within FRS 102, entities may, under the hierarchy set out in Section 10, refer to the requirements and guidance of IFRS in formulating an appropriate accounting policy for these obligations. Accordingly, it would be appropriate to refer to Chapter 27 of EY International GAAP 2019.

4.1 Decommissioning provisions

Decommissioning costs arise when an entity is required to dismantle or remove an asset at the end of its useful life and to restore the site on which it has been located, for example, when an oil rig or nuclear power station reaches the end of its economic life.

Section 17 – Property, Plant and Equipment – observes that the cost of an item of property, plant and equipment includes the initial estimate of the costs, recognised and measured in accordance with Section 21, of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period. [FRS 102.17.10(c)]. See Chapter 15 at 3.4.1. However, Section 21 provides no specific guidance on decommissioning provisions.

Examples in the appendices to IAS 37 illustrate that the decommissioning liability is recognised as soon as the obligation arises, rather than being built up as the asset is used over its useful life. This is because the construction of the asset (and the environmental damage caused by it) creates the past obliging event requiring restoration in the future.

Given that Section 21 and IAS 37 apply the same principles to the recognition and measurement of provisions, we believe that this approach is also appropriate for entities reporting under FRS 102. The accounting for decommissioning provisions under IFRS is discussed in detail in Chapter 27 at 6.3 of EY International GAAP 2019. Chapter 27 also discusses:

  • IFRIC 1 – Changes in Existing Decommissioning, Restoration and Similar Liabilities – which provides guidance on how to account for the effect of changes in measurement of existing provisions for obligations to dismantle, remove or restore items of property, plant and equipment; and
  • IFRIC 5 – Rights to Interests arising from Decommissioning, Restoration and Environmental Rehabilitation Funds – which addresses the accounting by an entity when it participates in a ‘decommissioning fund’, with the purpose of segregating assets to fund some or all of the costs of decommissioning or environmental liabilities for which it has to recognise a provision under IAS 37.

Section 21 provides no specific guidance on the matters addressed within IFRIC 1 and IFRIC 5. However, the approach applied by IFRIC 1 is consistent with the approach commonly applied in practice by entities within and outside of the oil and gas industry.

4.2 Environmental provisions

IAS 37 sets out two examples of circumstances where environmental provisions would be required, both in relation to contaminated land. The examples illustrate that an entity can have an obligation to clean up contaminated land either as a result of legislation or as a result of a widely publicised environmental policy. The accounting applied in these examples is consistent with the principles of Section 21. These examples and the recognition and measurement of environmental provisions are discussed in Chapter 27 at 6.4 of EY International GAAP 2019.

4.3 Liabilities associated with emissions trading schemes

A number of countries around the world either have, or are developing, schemes to encourage reduced emissions of pollutants, in particular of greenhouse gases. These schemes comprise tradable emissions allowances or permits, an example of which is a ‘cap and trade’ model whereby participants are allocated emission rights or allowances equal to a cap (i.e. a maximum level of allowable emissions) and are permitted to trade those allowances.

Whilst there is currently no guidance under IFRS on accounting for cap and trade emission rights schemes, a discussion of the methods applied in practice can be found in Chapter 27 at 6.5 of EY International GAAP 2019.

4.4 EU Directive on Waste Electrical and Electronic Equipment

This Directive, which came into force in the UK on 2 January 2007, regulates the collection, treatment, recovery and environmentally sound disposal of waste electrical or electronic equipment (WE&EE). It applies to entities involved in the manufacture and resale of electrical or electronic equipment, including entities (both European and Non-European) that import such equipment into the EU.

The Directive states that the cost of waste management for historical household equipment should be borne by producers of that type of equipment that are in the market during a period to be specified in the applicable legislation of each Member State (the measurement period). The Directive states that each Member State should establish a mechanism to have producers contribute to costs proportionately e.g. in proportion to their respective share of the market by type of equipment.

IFRIC 6 – Liabilities arising from Participating in a Specific Market – Waste Electrical and Electronic Equipment –clarifies that the obligation under the Directive is linked to participation in the market during the measurement period, with their being no obligation unless and until a market share exists during the measurement period. The obligation is not linked to the production or sale of the items to be disposed of. The application of IFRIC 6 is discussed in Chapter 27 at 6.7 of EY International GAAP 2019.

4.5 Levies charged on entities operating in a specific market

When governments or other public authorities impose levies on entities in relation to their activities, it is not always clear when the liability to pay a levy arises and when a provision should be recognised. In May 2013, the IFRS Interpretations Committee issued IFRIC 21 – Levies – to address this question. It requires that, for levies within its scope, an entity should recognise a liability only when the activity that triggers payment, as identified by the relevant legislation, occurs. [IFRIC 21.8]. Given that Section 21 and IAS 37 apply the same principles to the recognition and measurement of provisions, entities may wish to apply the guidance in IFRIC 21 to the recognition of liabilities for levies under FRS 102. IFRIC 21 is discussed further in Chapter 27 at 6.8 of EY International GAAP 2019.

4.5.1 UK Apprenticeship levy

Since 6 April 2017, UK employers with an annual pay bill in excess of £3 million are required to pay a levy of 0.5% of that bill. Payments are made via the PAYE system, along with payroll taxes. Amounts paid by the employer are recorded in the employer's account on the government controlled ‘Digital Apprenticeship System’ (DAS). Payments made under the levy are credited to the employer's DAS account and are immediately available to fund certain approved apprenticeship training for, or assessment of, new hires or existing employees. Payments to the training provider are made directly by the government, with a corresponding reduction is made to the employer's DAS balance. The employer cannot recover cash directly from the DAS account, and amounts paid into the DAS expire after 24 months, i.e. they cannot be applied against training costs incurred after that time.

Government also contribute to apprenticeship costs, through a ‘top-up’ of £1 for every £10 paid in through the levy system, and through, in some cases, co-investment funding.

As discussed above, IFRIC 21 provides specific guidance on accounting for levies under IFRS. Whilst there is no equivalent guidance in Section 21, entities may wish to apply it to the recognition of liabilities for levies under FRS 102, since Section 21 is consistent with the principles of IAS 37. However, whilst IFRIC 21 addresses the recognition of liabilities to pay levies, entities are required to apply other Standards to decide whether recognition of a liability to pay a levy gives rise to an asset or expense. [IFRIC 21.3]. In our view, for employers that expect to enter into apprenticeships that meet the requirements for utilisation of funds in their DAS account within the 24 month life of those funds, the payment under the levy represents a prepayment for approved training services expected to be received and should be recognised an asset until the approved training occurs. An expense will be recognised when the training is delivered. Employers that do not expect to incur qualifying training costs before their entitlement to the funds expire should recognise the payment of the levy as an expense.

Both the government ‘top-up’ element of funding, and any benefit received under co-investment funding would meet the definition of government grants within FRS 102, and should therefore be accounted for in accordance with Section 24. See Chapter 21.

4.6 Repairs and maintenance of owned assets

IAS 37 includes an example within the appendices illustrating how the principles for the recognition of a provision are applied strictly in the case of an obligation to incur repairs and maintenance costs in the future on owned assets. This is the case even when this expenditure is substantial, distinct from what may be regarded as routine maintenance and essential to the continuing operations of the entity, such as major refit or refurbishment of the asset. This is discussed in Chapter 27 at 5.2 of EY International GAAP 2019.

Repairs and maintenance provisions for owned assets are generally prohibited under IAS 37. Given that Section 21 and IAS 37 apply the same principles to the recognition and measurement of provisions, we would also not generally expect provisions for repairs and maintenance of owned assets to be recognised under FRS 102.

4.7 Dilapidations and other provisions relating to leased assets

Whilst it is not generally appropriate to recognise provisions that relate to repairs and maintenance of owned assets (including assets held under finance leases) the position can be different in the case of obligations relating to assets held under operating leases.

Operating leases often contain clauses which specify that the lessee should incur periodic charges for maintenance, make good dilapidations or other damage occurring during the rental period or return the asset to the configuration that existed as at inception of the lease. These contractual provisions may restrict the entity's ability to change its future conduct to avoid the expenditure. The contractual obligations in a lease could therefore create an environment in which a present obligation could exist as at the reporting date from which the entity cannot realistically withdraw.

The recognition of provisions relating to leased assets is discussed in Chapter 27 at 6.9 of EY International GAAP 2019.

4.8 Self-insurance

Another situation where entities sometimes make provisions is self-insurance which arises when an entity decides not to take out external insurance in respect of a certain category of risk because it would be uneconomic to do so. The same position may arise when a group insures its risks with a captive insurance subsidiary, the effects of which have to be eliminated on consolidation. In fact, the term ‘self-insurance’ is potentially misleading, since it really means that the entity is not insured at all and will settle claims from third parties from its own resources in the event that it is found to be liable. Accordingly, the recognition criteria in Section 21 should be applied, with a provision being justified only if there is a present obligation as a result of a past event; if it is probable that an outflow of resources will occur; and a reliable estimate can be determined. [FRS 102.21.4]. FRS 103 – Insurance Contracts – also clarifies that self-insurance is not insurance as there is no insurance contract because there is no agreement with another party. [FRS 103 Appendix II.19(c)].

Therefore, losses are recognised based on their actual incidence and any provisions that appear in the balance sheet should reflect only the amounts expected to be paid in respect of those incidents that have occurred by the end of the reporting period.

In certain circumstances, a provision will often be needed not simply for known incidents, but also for those which insurance companies call IBNR – Incurred But Not Reported – representing an estimate of claims that have occurred at the end of the reporting period but which have not yet been notified to the reporting entity. We believe that it is appropriate that provision for such expected claims is made.

4.9 Parent company guarantees given in connection with audit exemption

The Companies Act 2006 exempts some subsidiary companies from the requirement to be audited, subject to a number of conditions. One of the conditions requires that the parent company files with the registrar a statutory guarantee of all of the outstanding financial liabilities of the subsidiary at the end of the financial year for which the subsidiary seeks an exemption from audit. [s394A, s479A]. In our view, the statutory guarantee is not a contract. It therefore does not meet the definition of a financial guarantee contract within FRS 102 and should be accounted for under Section 21. If it is only a remote possibility that the guarantee will be called upon by the subsidiary's creditors, the parent does not recognise a provision nor disclose the guarantee in their separate financial statement. If it is possible (but not probable) that the guarantee will be called upon, the parent should disclose a contingent liability in their separate financial statements. If it is probable that the guarantee will be called upon, the parent must recognise a provision for the best estimate of the amount required to settle the obligation under the guarantee at the reporting date.

4.10 Recognition of provisions for vacant leasehold property

The most common example of an onerous contract in practice relates to leasehold property. From time to time entities may hold vacant leasehold property which they have substantially ceased to use for the purpose of their business and where sub-letting is either unlikely, or would be at a significantly reduced rental from that being paid by the entity. In these circumstances, the obligating event is the signing of the lease contract (a legal obligation) and when the lease becomes onerous, an outflow of resources embodying economic benefits is probable. Accordingly, a provision is recognised for the best estimate of the unavoidable lease payments.

Entities have to make systematic provision when such properties become vacant, and on a discounted basis where the effect is sufficiently material. Indeed, it is not just when the properties become vacant that provision would be required, but that provision should be made at the time the expected economic benefits of using the property fall short of the unavoidable costs under the lease. This may occur prior to an entity physically vacating a property. The recognition of onerous lease provisions for occupied leasehold property when the entity has no current intention of vacating the property is addressed in Chapter 27 at 6.2.1.B of EY International GAAP 2019. For vacant, or soon to be vacated, leasehold property consideration will need to be given to the point in time at which the lease becomes onerous and whether this may occur prior to the property being physically vacated. In our view, it may be appropriate to recognise an onerous lease provision prior to physically vacating a property if an entity has made a commitment to vacate from which it cannot realistically withdraw or if the unavoidable costs of meeting the obligations under the lease exceed the economic benefits expected to be received under that lease.

Nevertheless, where a provision is to be recognised a number of difficulties remain. The first is how the provision should be calculated. It is unlikely that the provision will simply be the net present value of the future rental obligation, because if a substantial period of the lease remains, the entity will probably be able either to agree a negotiated sum with the landlord to terminate the lease early, or to sub-lease the building at some point in the future. Hence, the entity will have to make a best estimate of its future cash flows taking all these factors into account.

Another issue that arises from this is whether the provision in the statement of financial position should be shown net of any cash flows that may arise from sub-leasing the property, or whether the provision must be shown gross, with a corresponding asset set up for expected cash flows from sub-leasing only if they meet the recognition criteria of being ‘virtually certain’ to be received. Whilst the expense relating to a provision can be shown in the income statement net of reimbursement, [FRS 102.21.9], the strict offset criteria (see 3.7.5 above) would suggest the latter to be required, as the entity would normally retain liability for the full lease payments if the sub-lessee defaulted. However, neither FRS 102 nor IAS 37 make explicit reference to this issue. It is common for entities to apply a net approach for such onerous contracts. Indeed, it could be argued that because an onerous contract provision relates to the excess of the unavoidable costs over the expected economic benefits, [FRS 102.21A.2], there is no corresponding asset to be recognised. In its 2005 exposure draft of proposed amendments to IAS 37, the IASB confirmed that if an onerous contract is an operating lease, the unavoidable cost of the contract is the remaining lease commitment reduced by the estimated rentals that the entity could reasonably obtain, regardless of whether or not the entity intends to enter into a sublease.2 Given the consistent principles of Section 21 and IAS 37 regarding the measurement of provisions, we would also expect this to be the case for entities reporting under FRS 102.

In the past, some entities may have maintained that no provision is required for vacant properties, because if the property leases are looked at on a portfolio basis, the overall economic benefits from properties exceed the overall costs. However, this argument is not sustainable under FRS 102, as the definition of an onerous contract refers specifically to costs and economic benefits under the contract. [FRS 102 Appendix I].

It is more difficult to apply the definition of onerous contracts to the lease on a head office which is not generating revenue specifically. If the definition were applied too literally, one might end up concluding that all head office leases should be provided against because no specific economic benefits are expected under them. It would be more sensible to conclude that the entity as a whole obtains economic benefits from its head office, which is consistent with the way in which corporate assets are allocated to other cash generating units for the purposes of impairment testing (see Chapter 24 at 4.6.7). However, this does not alter the fact that if circumstances change and the head office becomes vacant, or the unavoidable costs of meeting the obligations under the head office lease come to exceed the economic benefits expected to be received, a provision should then be made in respect of the lease.

IAS 37 requires that any impairment loss that has occurred in respect of assets dedicated to an onerous contract is recognised before establishing a provision for the onerous contract. [IAS 37.69]. For example, any leasehold improvements that have been capitalised should be written off before provision is made for excess future rental costs.

5 SUMMARY OF GAAP DIFFERENCES

FRS 102 IFRS
Scope – Provisions, contingent liabilities and contingent assets covered by another Section / Standard Section 21 does not apply to provisions, contingent liabilities and contingent assets covered by another section of FRS 102.
However, where those other sections contain no specific requirements to deal with contracts that have become onerous, Section 21 applies to those contracts. This will include, for example, onerous leases, and loss making revenue contracts other than construction contracts. The recognition of provisions for loss making construction contracts is addressed by Section 23. 		In contrast to FRS 102, where a provision, contingent liability or contingent asset is covered by another Standard and that Standard contained no specific requirements to deal with onerous contracts, there is no general requirement that IAS 37 be applied to those contracts. However, IAS 37 applies specifically to certain onerous leases and to contracts with customers that are, or have become, onerous.
Scope – Financial guarantee contracts Financial guarantee contracts are in scope of Section 21 unless:
  • the entity has chosen to apply IAS 39 or IFRS 9 to its financial instruments; or
  • the entity has elected under FRS 103 to continue the application of insurance contract accounting.
 Financial guarantee contracts are out of scope of IAS 37. They are accounted for as financial instruments unless the entity has elected under IFRS 4 or IFRS 17 to continue the application of insurance contract accounting.
Disclosure –Provisions Included within the disclosure requirements for provisions is a requirement to disclose the expected amount of payments resulting from an obligation.
There is no requirement to disclose:
Major assumptions concerning future events that may affect the amount required to settle an obligation; or
a separate line item in the reconciliation of opening and closing provision balances showing the increase during the period in the discounted amount arising from the passage of time and the effect of any change in discount rate. 		Included within the disclosure requirements for provisions are requirements to disclose:
Major assumptions concerning future events that may affect the amount required to settle an obligation where this is necessary to provide adequate information; and
a separate line item in the reconciliation of opening and closing provision balances showing the increase during the period in the discounted amount arising from the passage of time and the effect of any change in discount rate.
There is no requirement to disclose the expected amount of payments resulting from an obligation.
Disclosure when information is seriously prejudicial Section 21 includes much more fulsome disclosure requirements in the case where information is considered seriously prejudicial than is required under IFRS. The disclosure requirements are set out in 3.10.5 above and significantly reduce the usefulness of the seriously prejudicial exemption under Section 21 compared to IFRS. Under the seriously prejudicial exemption in IAS 37, entities must disclose the general nature of the dispute, together with the fact that, and the reason why, the information otherwise required by the standard has not been disclosed.
Disclosure – Financial guarantee contracts An entity must disclose the nature and business purpose of any financial guarantee contracts in scope of Section 21, regardless of whether a provision is required.
In addition, to the extent a provision is recognised for financial guarantee contracts, or a contingent liability disclosed, the general provision / contingent liability disclosures within Section 21 are also required. 		There is no specific requirement for entities to disclose the nature and business purpose of any financial guarantee contracts it has issued. Financial guarantee contracts are in scope of the disclosure requirement of IFRS 7(if the issuer has elected to apply IFRS 9 or IAS 39 to the contracts), or IFRS 4 / IFRS 17, not IAS 37.

References

  1. 1   Discounting in Financial Reporting, ASB, April 1997.
  2. 2   Exposure Draft of Proposed Amendments to IAS 37 Provisions, Contingent Liabilities and Contingent Assets (IAS 37 ED) and IAS 19 – Employee Benefits (IAS 19 ED), IASB, June 2005, para. 58.
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