NAS 37: Provisions, Contingent Liabilities

& Contingent Assets

NFRS 3: Business Combination

CA. Krishna Niraula

 NAS 37
Provisions
Provisions are liabilities of uncertain timing or amount. Liability is 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. An obligating event is an event that creates a legal or constructive obligation that results in an entity having no
realistic alternative to settling that obligation.
Recognition of Provisions
Provision should be recognized as a liability in the financial statements when the followings conditions are satisfied:
a. An entity has a present obligation (legal or constructive) as a result of past event; and
b. It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
c. A reliable estimate can be made of the amount of the obligation.
Unless these conditions are met, no provision can be recognized.
Present obligation and obligating events
A past event which leads to a present obligation is called as obligating event. For an event to be an obligating event, it is
necessary that the entity has no realistic alternative to settling that obligation created by the event.
The event leading to the obligation must be past, and must have occurred before the end of the reporting period when the
provision is first recognized. No provision is made for costs that may be incurred in the future but where no obligation yet
exists. An obligation can either be legal or constructive.
 NAS 37
a. Legal obligation: A legal obligation is one that derives from a contract, legislation or any other operation of law.
b. Constructive obligation: A constructive obligation is an obligation that derives from the actions of the entity where:
i. From an established pattern of past practice, published policies or a specific statement, the entity has indicated to other parties that
it will accept certain responsibilities; and
ii. As a result the entity has created a valid expectation in other parties that it will discharge those responsibilities.
Illustration X Limited is required to fit a smoke filters to its factories by 30th September 2018. The entity has not fitted the filters as on
31st December 2017 which is the reporting date of the entity. Give the treatment for the 31st December 2017. What will be the position
as on 31st December 2018 if the entity has not fitted the filers till date?
Hints: Obligating event, so provision for fines and penalties.
Illustration In which of the following circumstances might a provision be recognized?
a. On 31st December 2018 the board of the entity decided to close down a division. The closing date of the entity is 31st December.
Before 31st December 2018, the decision was not communicated to any of those affected and no other steps were taken to implement
the decision.
b. The board agreed a detailed closure plan on 20th December 2018 and details were given to customers and employees.
c. The entity is obliged to incur cleanup costs for environmental damage (that has already been caused).
d. The entity intends to carry out future expenditure to operate in a particular way in the future.
Solution a. No provision would be recognized as the decision has not been communicated. b. Provision should be made in the year 31st
December 2018. c. Provision should be made. d. No provision required. The cost can be avoided by operating in other manner.
 NAS 37
Measurement of provisions at initial recognition
The amount recognized as a provision is the best estimate of the expenditure required to settle the obligation at the end of the reporting
period. The estimate will be determined by the judgment of the entity’s management supplemented by the experience of similar
transactions.
Time value
Where the effect of the time value of money is material, a provision is measured at the present value of the expenditure expected to be
required to settle the obligation. The discount rate should be a pre-tax rate that reflects current market assessments of the time value of
the money.
Uncertainties
Uncertainties about the amount to be recognized as provision should be considered. Where the provision being measured involves a large
population of items, the amount is estimated by weighting all possible outcomes by their associated probabilities i.e. expected value.
Where the provision involves a single item, provision is made for the most likely outcome.
Future events
Future events which are reasonably expected to occur (e.g. new legislation, changes in technology) may affect the amount required to
settle the entity’s obligation and should be taken into accounts.
Reimbursements
Some or all of the expenditure needed to settle a provision may be expected to be recovered from a third party. If so, the reimbursement
should be recognized only when it is virtually certain that reimbursement will be received if the entity settles the obligation.
a. The reimbursement should be treated as a separate asset, and the amount recognized should not be greater that the provision itself.
b. The provision and the amount recognized for reimbursement may be netted off in statement of profit or loss.
 NAS 37
Illustration X Solar Power Ltd, a power company, has a present obligation to dismantle its plant after 35 years of useful life. X
Solar Power Ltd cannot cancel this obligation or transfer to third party. X Solar Power Ltd has estimated the total cost of
dismantling at Rs.5,000,000, the present value of which is Rs.3,000,000. Based on the facts and circumstances, X Solar Power Ltd
considers the risk factor of 5% i.e. the risk that the actual outflows would be more from the expected present value. How should X
Solar Power Ltd account for the obligation?
Answer: The obligation should be measured at the present value of future expected outflows i.e. at Rs.3,000,000. Further the
obligation should be adjusted for risk @ 5% i.e. 5% of Rs.3,000,000 = Rs.150,000. Therefore, the total amount of provision to be
made will be Rs.3,150,000.
Illustration A Ltd sells goods with a warranty under which customers are covered for the cost of repairs of any manufacturing
defect that becomes apparent within the first six months of purchase. The company’s past experience and future expectation
indicate the following pattern of likely repairs:
% of goods sold Defects Cost of repairs if all items suffered from these defects (Rs. million)
75 None Nil
20 Minor 1.0
5 Major 4.0
Required: What should be the amount of provision?
Solution
Amount of provision should be expected value of cost of repairs at Rs.400,000.
(75% of Nil + 20% of Rs.1,000,0000 + 5% of Rs.4,000,000)
 NAS 37
Measurement at subsequent reporting date
Provisions should be reviewed at the end of each reporting period and adjusted to reflect the current best estimate. If it is no
longer probable that a transfer of resources will be required to settle the obligation, the provision should be reversed.
Illustration A company was sued by a customer in the year ended 31st December 2014. Legal advice is that the customer is
virtually certain to win the case as several similar cases have been already been decided in the favor of the injured parties.
At 31st December 2014
The company’s lawyer was of the opinion that the cost of the settlement would be Rs.1,000,000.
At 31st December 2015
The claim has still not been settled. The lawyer now advises that the claim will probably be settled in customer’s favor at
Rs.1,200,000.
At 31st December 2016
The claim has still not been settled. The lawyer now advises that the claim will probably be settled in customer’s favor at
Rs.900,000.
At 31st December 2017
Was settled for Rs.950,000.
 NAS 37
Solution
At 31st December 2014: Provision should be made for Rs.1,000,000
Statement of profit/loss Dr. 1,000,000
To Provision for Claim 1,000,000
At 31st December 2015: Provision should be increased by Rs.200,000.
Statement of profit/loss Dr. 200,000
To Provision for Claim 200,000
At 31st December 2016: Provision should be decreased by Rs.300,000.
Provision for Claim Dr. 300,000
To Statement for Profit/loss 300,000
At 31st December 2017: Charge in statement of profit/loss would be Rs.50,000
Provision for Claim Dr. 900,000
Statement of Profit/Loss Dr. 50,000
To Bank 950,000
 NAS 37
Future operating losses Provisions shall not be recognized for future operating losses as they do not meet the definition of
liability or provisions.
Onerous contract If an entity has a contract that is onerous, the present obligation under the contract shall be recognized and
measured as provision.
A onerous contract is a contract entered into with another party under which the unavoidable costs of fulfilling the terms of
contract exceeds revenue to be received, directly or indirectly, and where the entity would have to compensate the other party if
it did not fulfill the terms of the contract.
Restructuring Restructuring is a program that is planned and is controlled by management and materially changes one of two
things:
a. The scope of business undertaken by the entity.
b. The manner in which that business is controlled.
The following are examples of restructuring:
a. Sale or termination of a line of business.
b. The closure of business locations in a country or region or the relocation of business activities from one country or region to
another.
c. changes in management structure e.g. the elimination of a layer of management.
d. fundamental reorganizations that have a material effect on the nature and focus of the entity’s operations.
 NAS 37
Obligation to restructure may be legal or constructive. A constructive obligation to restructure arises only when an entity:
a. has a detailed plan for restructuring; and
b. has raised a valid expectation in those affected that it will carry out the restructuring by starting to implement that plan or
announcing its main features to those affected by it.
No obligation arises for the sale of an operation until the entity is committed to the sale i.e. there is a binding sale agreement.
A restructuring provision shall include only the direct expenditures arising from the restructuring, which are those that are both:
a. necessarily entailed by the restructuring; and
b. not associated with the ongoing activities of the entity.
A restructuring provision does not include such costs as:
a. retaining or relocating continuing staff,
b. marketing, or
c. investment in new systems and distribution network.
 NAS 37
Contingent liabilities
Contingent liability is either:
a. A possible obligation arising from past events whose existence will be confirmed only by the occurrence of one or more
uncertain future events not wholly within the control of the entity; or
b. A present obligation that arises from the past events but is not recognized because:
i. it is not possible that an outflow of economic benefits will be required to settle the obligation; or
ii. the amount of obligation cannot be measured with sufficient reliability.
Recognition
An entity should not recognize a contingent liability. A contingent liability is disclosed unless the possibility of an outflow of
economic benefits is remote.
Disclosure
For each class of contingent liability an entity should disclose at the reporting date, all of the following:
a. the nature of the contingent liability
b. an estimate of the financial effect
c. an indication of the uncertainties relating to the amount or timing of any outflow.
d. the possibility of any reimbursement.
 NAS 37
Illustration
During 2017 A Ltd gives a guarantee of certain borrowings of B Ltd, whose financial condition at that time was sound. During 2018,
the financial condition of B Ltd deteriorates and at 30th June 2018, Pony Co files for protection from its creditors.
Required:
What accounting treatment is required?
a. at 31st December 2017?
b. at 31st December 2018?
Solution
31st December 2017
There is a present obligation as a result of a past obligating event (giving guarantee). However, no provision will be required as
there is no transfer of resources is probable in settling the obligation.
The guarantee should be disclosed as contingent liability.
31st December 2018
There is a present obligation as a result of a past obligating event (giving guarantee).
Provision should be made as it is probable that a transfer of resources will be required to settling the obligation.
 NAS 37
Contingent Assets A contingent asset is a possible asset arising from past events whose existence will only be confirmed by the
occurrence of one or more uncertain future events not wholly within the control of the entity.
Recognition An entity should not recognize a contingent asset because it could result in the recognition of profits that may never
be realized. However, where the realization of profits is virtually certain, then the related asset is not a contingent assets
and recognition is appropriate.
A contingent asset is disclosed where an inflow of economic benefits is probable.
Disclosure
The following should be disclosed:
a. a brief description of the nature of the contingent asset at the reporting date.
b. where practicable, an estimate of the financial effect.
 NAS 37
Illustration On 1st October 2015, Alpha completed the construction of a non-current asset with an estimated useful life of 20
years. The costs of construction were recognized in property, plant and equipment and depreciated appropriately. Alpha has a
legal obligation to restore the site on which non-current asset is located on 30th September 2035. The estimated cost of
restoration work at 30th September 2035 prices, is Rs.25 million. The directors of Alpha have made a provision of Rs.1.25 million
(1/20 × Rs.25 million) in the draft statement of financial position at 30th September 2016. An appropriate annual discount rate to
use in any relevant calculations is 6% and at this rate the present value of Rs.1 payable in 20 years is Re.0.312.
Solution The cost of restoration should not be charged to statement of profit/loss, it should be capitalized at present value as a
part of cost of property, plant and equipment i.e. at Rs.7,800 (25,000×0.312).
PPE Dr. 7,800
To Provision 7,800
Finance charge of Rs.468 (7,800 × 6%) should be considered on provision amount.
Finance cost (Statement of profit/loss) Dr. 468
To Provision 468
Statement of profit /loss (30th September 2016)
Finance charge 468
Statement of financial position (30th September 2016)
Non-current liabilities -Provision (7,800 + 468) 8,268
 Past QA NAS 37
1. Accounting treatment of contingency gains. (CAP Dec. 2009, 6a-2.5 Marks)
Answer Contingency gains are not recognized in financial statement since their recognition may result in the recognition of revenue which may never
be realized. However, when the realization of a gain is virtually certain, then such a gain is not a contingency and accounting for the same is
appropriate.
2. Recognition of contingent assets and liabilities (CAP Dec. 2015 Q6d; CAP Jun. 2013 Q6d– 2.Marks)
An entity shall not recognize a contingent liability.
1. A contingent liability is disclosed, unless the possibility of an outflow of resources embodying economic benefits is remote.
2. Where an entity is jointly and severally liable for an obligation, the part of the obligation that is expected to be met by other parties is treated as
a contingent liability. The entity recognizes a provision for the part of the obligation for which an outflow of resources embodying economic benefits
is probable, except in the extremely rare circumstances where no reliable estimate can be made.
3. Contingent liabilities may develop in a way not initially expected. Therefore, they are assessed continually to determine whether an outflow of
resources embodying economic benefits has become probable. If it becomes probable that an outflow of future economic benefits will be required
for an item previously dealt with as a contingent liability, a provision is recognized in the financial statements of the period in which the change in
probability occurs (except in the extremely rare circumstances where no reliable estimate can be made).
An entity shall not recognize a contingent asset.
1. Contingent assets usually arise from unplanned or other unexpected events that give rise to the possibility of an inflow of economic benefits to the
entity. An example is a claim that an entity is pursuing through legal processes, where the outcome is uncertain.
2. Contingent assets are not recognized in financial statements since this may result in the recognition of income that may never be realized.
However, when the realization of income is virtually certain, then the related asset is not a contingent asset and its recognition is appropriate. 3. A
contingent asset is disclosed, where an inflow of economic benefits is probable. 4. Contingent assets are 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 are recognized in the financial statements of the period in which the change occurs. If an inflow of economic
benefits has become probable, an entity discloses the contingent asset (see paragraph 89).
 Past QA NAS 37
3. Difference between provisions and contingent liabilities. (Jun. 2006, Q 7d- 3 Marks)
Answer: Provision is a liability of uncertain timing and amount. A provision shall be recognized when:
(i) An entity has a present obligation (legal or constructive) as a result of a past event
(ii) It is probable that any outflow of resources embodying economic benefits will be required to settle the obligation, and
(iii) A reliable estimate can be made of the amount of obligation
A contingent liability is:
(i) A possible obligation that arises from the past events and whose existence will be conformed only by the occurrence of or non-occurrence of
one or more uncertain future events not wholly within the control of the entity, or
(ii) A present obligation that arises from past events but is not recognized because:
a. It is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or
b. The amount of the obligation cannot be measured with sufficient reliability.
4. Difference between Provisions and other liabilities. (CAP Jun. 2014 Q6c- 2.5 Marks)
Answer Provision can be distinguished from other liabilities such as trade payable and accruals because there is uncertainty about the timing or
amount of future expenditure required in settlement. By contrast:
Trade payables are liabilities to pay for goods or services that have been received or supplied and have been invoiced or formally agreed with the
supplier; and
Accruals are liabilities to pay for goods or services that have been received or supplied but not have been paid, invoiced or formally agreed with
the supplier, including amounts due to employees. Although it is sometimes necessary to estimate the amount or timing of accruals, the
uncertainty is generally much less than for provision.
Accruals are often reported as part of trade and other payables, whereas provisions are reported separately.
 Past QA NAS 37
5. Alpha Ltd. has entered into a sale contract of Rs. 7 crores with Gamma Ltd. during 2072-73 financial years. The profit on this
transaction is Rs. 1 crore. The delivery of goods to take place during the first month of 2073-74 financial years. In case of failure of
Alpha Ltd. to deliver within the schedule, a compensation of Rs. 2 crores is to be paid to Gamma Ltd. Alpha Ltd. planned to
manufacture the goods during the last month of 2072-73 financial year. As on the reporting date (31.3.2073), the goods were not
manufactured and it was unlikely that Alpha Ltd. will be in a position to meet the contractual obligation. You are required to advise
Alpha Ltd. on requirement of provision for contingency in the financial statements for the year ended 31st Ashadh, 2073, in line with
provisions of Accounting Standards? (CAP Jun. 2017 Q5c-5 Marks)
Answer: NAS 37 “Provisions, Contingent Liabilities and Contingent Assets” provides that a provision shall be recognized when:
(a) an entity has a present obligation (legal or constructive) as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
(c) a reliable estimate can be made of the amount of the obligation.
If these conditions are not met, no provision shall be recognized. when an enterprise has a present obligation, as a result of past events,
that probably requires an outflow of resources and a reliable estimate can be made of the amount of obligation, a provision should be
recognized.
In the given case, Alpha Ltd. has present obligation to deliver the goods as a result of contract entered with the customer and it is more
likely than not that Alpha Ltd. will be required to settle the obligation on account of penalties. Therefore, Alpha Ltd. should provide for
the provision amounting Rs. 2 crores as per NAS 37.
 Past QA NAS 37
6. M/s Dalima Ltd. is in a dispute with the competitor company. The dispute is regarding the alleged infringement of copyrights. The
competitor has filed a suit in the court seeking damages of Rs. 325 lakhs. Directors are of the view that the claim can be successfully
resisted by the company. How the matter be dealt in the financial statements of the company in the light of NAS 37. Explain in brief giving
reasons for your answer. (CAP Jun. 2018 Q5b-5 Marks)
Answer As per NAS 37 "Provisions, Contingent liabilities and Contingent assets" a provision should be recognized when
a) an entity has a present obligation as a result of a past event.
b) it is probable that the outflow of resources embodying economic benefits will be required to settle the obligation and
c) a reliable estimate can be made of the amount of obligation.
If these conditions are not met, no provision should be recognized.
In the given situation, since the directors of the company are of the opinion that the claim can be successfully resisted by the company, therefore
there will be no outflow of resources. Hence no provision is required. The company can disclose the same as contingent liability by way of
following note.
Litigation is in the process against the company relating to dispute with the competitor who alleged that the company has infringed copyrights and
seeking damages of Rs. 325 lakhs. However the director are of the opinion that the claim can be successfully resisted by the company.
7. Contingent Liability (Jun 07 Q 5e)
Answer A possible obligation that arises from past events and the existence of which will be confirmed only by the occurrence or non-occurrence
of one or more uncertain future events not wholly within the control of the enterprise, or.
A present obligation that arises from past events but it is not recognized because
(a) It is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation, or
(b) A reliable estimate of the amount of the obligation cannot be made.
A contingent liability should not be recognized, but only disclosed. Also contingent liability should be periodically reviewed by the enterprise.
 Past QA NAS 37
8. Difference between Provisions and Reserves (Dec 07 Q 6c)
Answer:
A provision is a liability of uncertain timing or amount whereas he portion of earnings, receipts or other surplus of an enterprise whether
capital or revenues, apportioned by the management for a general or specific purpose is called reserve. Reserves are primarily of two
types: capital reserves and revenue reserves. Provision is the charge against the profit whereas reserve is the appropriation out of
profits.
NFRS 3 Business Combination
 NFRS 3 Business Combination
Business combinations
A business combination is a transaction or other event in which an acquirer obtains control of one or more business. A business is
integrated set of activities and asserts that is capable of being conducted and managed for the purpose of providing a return in the form
of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants.
Guidance /accounting treatment is discussed in two NFRS- (i) NFRS 3 Business Combinations and (ii) NFRS 10 Consolidated Financial
Statements. NFRS 3 is about initial accounting for a new investment, setting out the rules on the calculation of goodwill on acquisition
of investment. NFRS 10 explains the on-going rules related to procedure of preparation of consolidated financial statements.
Objectives of NFRS 3
The objective of this NFRS is to improve the relevance, reliability and comparability of the information that a reporting entity provides
in its financial statements about a business combination and its effects. To accomplish this, this NFRS establishes principles and
requirements for how the acquirer:
a. recognizes and measures in its financial statements the identifiable assets acquired, the liability assumed and any non-controlling
interest in the acquiree.
b. recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and
c. determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of
the business combination.
 NFRS 3 Business Combination
Recognition Principle
An acquirer must recognize (separately from goodwill), identifiable assets acquired, liabilities assumed and any non-controlling interest
in the acquiree as of the acquisition date, if they meet the definitions of assets and liabilities in the Framework for the Preparation and
Presentation of Financial Statements at the acquisition date. This might result in recognition of assets and liabilities not previously
recognized by the acquiree.
Intangible Assets
When a company acquires a subsidiary, it may identify intangible assets of the acquiree, which were not included in the financial
statements of the acquiree. If these assets are separately identifiable and can be measured reliably, they should be included in the
consolidated financial statement as intangible assets.
Re-structuring expenses An acquirer should not recognize any liability for the cost of restructuring a subsidiary or for any other costs
expected to be incurred as a result of the acquisition.
Reacquired rights
As a part of business combination, an acquirer may reacquire a right that it had previously granted to the acquiree to use one or more of
the acquirer’s recognized or unrecognized assets. A reacquired right is an identifiable intangible asset that the acquirer recognizes
separately from goodwill.
Contingent liabilities A contingent liability of acquiree which was not recognized in the financial statement of the acquiree, the
acquirer should recognize it at acquisition date even if it is not probable that an outflow of resources will be required to settle the
obligation.
Contingent assets should not be recognized.
 NFRS 3 Business Combination
Measurement Principle
The acquirer should measure all the identifiable assets and liabilities assumed at their acquisition date fair value.
Income tax As per NAS 12 Income Tax.
Employee Benefits As per NAS 19 Employees Benefits
Contingent liabilities At Fair value
Intangible assets At fair value
Purchase consideration (Cost of Investment)
Three type of consideration
- Immediate payment
- Deferred payment
- Contingent consideration
Immediate payment – at fair value at acquisition.
Deferred payment – at present value.
Contingent consideration – at fair value at date of acquisition
Contingent consideration after initial recognition
The fair value of contingent consideration should be reviewed at the end of each accounting period and any increase/ decrease should
be adjusted with retained earnings in the consolidated financial statements.
 NFRS 3 Business Combination
Acquisition related costs Acquisition related costs include advisory, legal, accounting fee and other expenses incurred for the
acquisition of shares. All the acquisition related costs should be expensed in the period in which they are incurred.
The costs to issue debt or equity The costs to issue debt or equity securities shall be recognized in accordance with NAS 32 and NFRS 9.
Non- controlling interest should be recognized at fair value at date of acquisition. Alternatively, it may be shown at proportionate share
by non-controlling interest in net assets of acquiree at the acquisition date.
Non-controlling interest at subsequent reporting date should be reported at fair value (proportionate assets) of noncontrolling
interest at acquisition date after adjusting with share of NCI in increase or decrease in net assets of acquiree after the date of
acquisition to reporting date.
Recognizing and measuring goodwill or gain from a bargain purchase
Goodwill The acquirer shall recognize goodwill as of the acquisition date as the excess of (a) over (b) below:
(a) the aggregate of:
i. the consideration transferred (sum of all three type)
ii. value of non-controlling interest at acquisition date
iii. in a business combination achieved in stages, the acquisition date fair value of the acquirer’s previously held equity interest in the
acquiree.
(b) the net assets of the acquiree as on the acquisition date.
The excess is goodwill. The amount of goodwill should be separately recognized (separately from assets and liabilities). This goodwill on
acquisition should not be amortized. However the goodwill is subject to impairment loss as per NAS 27.
 NFRS 3 Business Combination
Goodwill at subsequent reporting date
Recognized at goodwill at date of acquisition adjusted with impairment loss if any.
Gain from a Bargain Purchase
It results in gain if (b) is excess over (a). The acquirer shall recognize the resulting gain in profit
or loss on the acquisition date.