14 Provisions and contingencies

Need to know

Provisions

A provision is a known yet imprecise liability, i.e. we know it exists but we may not know exactly when it will have to be paid or how much will be paid.

A provision has to be made when each of the following occurs:

• ■There is a present obligation (i.e. a duty to make a future payment) resulting from a past event – see the Nice to know section below for more detail.
• ■It is probable that there will be a future cost (or outflow of resources).
• ■The amount of the obligation can be reliably estimated.

Contingent liabilities

In contrast, a ‘contingent’ liability arises when there is uncertainty over one or more of the above (hence the use of the term ‘contingent’). Typically, the uncertainties are around:

• ■the likelihood of the obligation (where it is possible but not probable) and
• ■the reliability.

Contingent liabilities become actual liabilities only if one or more uncertain events actually happen. It is prudent to make shareholders aware of the possible liabilities that may crystallise rather than ignore them.

In these situations, the company should disclose the presence of a ‘contingent’ liability, however, unlike a provision, the financial impact of the liability should not be recognised in the financial statements.

Why is this important?

Provisions are recognised as a cost to a business. They reduce both profit and net assets and adversely impact key performance measures (see Chapter 23 Profitability performance measures and Chapter 26 Long-term solvency performance measures) including:

• ■net profit margin
• ■return on capital employment
• ■gearing.

Provisions are challenging, as firstly they must be identified and secondly, they require judgement to assess their value. This emphasises the important point that financial statements contain estimates based on management judgement and should be interpreted in this context (see Chapter 20 External financial audit).

In contrast, other liabilities are usually easier to identify and assess. For example, creditors are certain, as they relate to supplier invoices (see Chapter 12 Debtors and creditors) and accruals should be traceable to a specific transaction (see Chapter 13 Prepayments and accruals).

Liabilities: the big picture

It can be helpful to visualise provisions and contingent liabilities along a continuum of liabilities.

When is this important?

At the end of each reporting period a company should consider if any provisions need to be made and existing provisions should be reviewed to see if they should be increased, reduced or removed.

In practice

Some examples of infamous provisions are:

• ■Hyundai’s engine recall. In the financial year ending 31 December 2020, Hyundai made a provision of Won 5 trillion (~£3 billion) to reflect potential warranty claims in relation to the recall of its Theta II and other engines.
• ■Volkswagen’s diesel emissions scandal. In 2020, Volkswagen disclosed cumulative fines and settlements to date of €31 billion.¹ Since the scandal broke in 2015, Volkswagen has made provisions for these costs as soon as they were foreseen. A provision for further costs remains at the time of publication.
• ■BP’s Deepwater Horizon disaster. In 2020, the New Orleans Advocate reported that BP and its partners have spent $71 billion to date on the disaster.² Since the 2010 oil well incident in the Gulf of Mexico, BP has made provisions for these costs as soon as they were foreseen. A provision for further costs as well as contingent liabilities still remained in BP’s 2020 annual accounts.

Other examples of provisions are:

• ■Dilapidations
  • ■If a business rents property, it may face dilapidations (exit costs) at the end of its lease. Typically, this involves putting a property back into its original, pre-let state.
  • ■Accounting rules allow companies to make a provision at the start of a lease, for the dilapidations cost which will arise at the end of a lease.
• ■Onerous contracts
  • ■If a company which rents property must relocate before the end of the lease term, it will still be committed to the lease. If it is unable to re-let the property, it may become an onerous lease.
  • ■In this case the company could make a provision for future lease rentals and exit costs for properties which are no longer occupied but have remaining lease terms. See the Where to spot in company accounts section below to Greggs plc’s provision for onerous contracts.
• ■Restructuring
  • ■If, prior to the year end, a company has decided to close part of its business, relocate or fundamentally reorganise its operations it may be necessary to make a provision.
  • ■Companies should only make restructuring provisions where a formal plan has been publicly communicated to stakeholders.
• ■Legal obligations
  • ■Legal obligations will often result in provisions. For example, if a company has issued a service warranty with the sale of a product. The company has a legal obligation to fulfill the warranty and should provide for the warranty costs at the time of the sale.
• ■Constructive obligations
  • ■A well-known and established refund policy (for example those offered by retailers such as Marks & Spencer and John Lewis) is an example of a constructive obligation. A breach of this policy, even where there is no legal or contractual obligation, may cause damage to the company’s reputation and have a commercial impact. Therefore, a provision should be made for estimated refunds.

Nice to know

Contingent liabilities

Typical examples of contingent liabilities are provisions which are either improbable or cannot be reliably estimated. These will often include legal claims and product warranties which are unlikely to be exercised. There may be a degree of subjectivity and judgement whether a potential liability is:

• ■improbable and disclosed as contingent, or
• ■probable and becomes a provision with a quantitative impact on the financial accounts.

An example of a contingency liability can be found in the 2019 Financial Statements (filed in February 2021) of Uber London Ltd, part of the Uber Group. The note to the accounts explains that Uber is ‘involved in a dialog with HMRC, which is seeking to classify the Uber group as a transportation provider in the UK. Being classified as a transportation provider would result in a VAT (20%) on gross bookings or on the service fee that the company charges drivers both retroactively and prospectively. The Uber group believes that the position of the HMRC and the regulators in similar disputes and audits is without merit and is defending itself vigorously’.

Optional detail

Single obligation

For a single obligation a provision is made for the full future obligation.

For example, ABC Ltd has calculated there is a 60% probability of receiving a £25,000 fine from a legal proceeding. It should nevertheless make a provision for the full £25,000 fine.

Multiple obligations

Where a business has multiple probable obligations, its provision can be based on the probability of the outcome.

For example, XYZ Ltd offers a money back guarantee on £10 million worth of its sales. It knows from experience that 5% of customers will take up the guarantee. It should make a provision for £500,000 (being 5% of £10 million).

Contingent assets

The converse to a contingent liability is a contingent asset.

A contingent asset arises where there is an uncertain asset resulting from a past event which will only be confirmed by the occurrence or non-occurrence of one or more uncertain future events, not wholly within the control of the company.

As with a contingent liability, a contingent asset should not be recognised in the financial statements. Instead, it should be disclosed in the notes to the accounts if the inflow of economic benefits is probable, unless it is virtually certain in which case it should be recognised.

Contingent assets should be continually assessed to see if they become more certain and if their financial benefit can be reliably estimated.

Typical examples are insurance and legal claims.

It is worth noting that in accounting there is a principle of ‘no netting off’. For example, under an insurance claim a company is required to account for the cost once incurred and only disclose the potential recovery as a contingent asset, which may arise sometime later.

Bad debt provisions

It is common for companies to make provisions against bad debts (see Chapter 12 Debtors and creditors).

The accounting treatment for bad debt provisions is, however, different to the other provisions outlined in this chapter. Bad debt provisions are deducted from the total debtor balance and are treated therefore as a reduction in asset values.

Reflect and embed your understanding

• 1Why do accountants and auditors spend significant time working on provisions?
• 2Why should a business be prudent when assessing a provision?
• 3Reflect on the systems and procedures that need to be in place to identify and assess the value of provisions. For an example organisation, consider the (adequacy of) the systems in place. Are there additional procedures that you might recommend?
• 4What effect, if any, would you expect to a listed company’s share price following an announcement that is making a substantial provision?

For the authors’ reflections on these questions please go to financebook.co.uk

Where to spot in company accounts

Accounting policies

A company’s treatment of provisions will be found in its accounting policy notes.

Provisions note

The provisions note should provide details of each provision (or provision category for multiple provisions).

It should be clear how the provision has changed during the financial year, i.e. any utilisation, additions or releases

Contingent liabilities

Contingent liabilities should not be recognised in the financial statements, but may require disclosure in the notes. For each contingent liability, unless extremely unlikely (i.e. the probability is so small that it can be ignored), the company should disclose a brief description and, where practicable.

• ■an estimate of the financial effect
• ■an indication of the uncertainties and
• ■the possibility of any reimbursement.

Extract from Greggs plc 2020 annual report and accounts

Greggs plc’s provision policy is as follows:

Greggs plc’s provisions note is shown below:

(Appendix pp. 457, 479)

There are no contingent liabilities disclosed by Greggs plc in its 2020 annual report.

Consolidate and apply

To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 397.

Watch out for in practice

• →New provisions made by a company and the reason behind them. Do they relate to normal business practice, for example onerous leases or are they an indication of a larger long-term problem?
• →Changes to existing provisions, including provisions that have been released and the reasons why.
• →The size of provisions in total.
• →Year-on-year movement in provisions, as these can have a significant impact on profit.
• →Provisions as a percentage of total liabilities and year-on-year changes in this percentage.
• →Any contingent liabilities and what they relate to. For example, losing a large legal claim could result in a risk of insolvency (see Chapter 25 Insolvency and going concern risk).

1reuters.com/article/us-volkswagen-results-diesel-idUSKBN2141JB

2nola.com/news/business/article_ca773cc0-80f4-11ea-8fbe-ffa77e5297bd.html