Provisions and Contingencies

Scenario 1

Fact:
Energy Inc. (Energy, or the Company), which operates in the oil industry, is a U.S. subsidiary of a U.K. entity that prepares its financial statements in accordance with IFRS and U.S. GAAP. A draft law in a country where Energy operates in, which requires a cleanup of land already contaminated, will possibly be enacted shortly after the year-end.

Issues:
Should Energy recognize a provision, (i) in reporting under IFRSs, and (ii) in accordance with U.S. GAAP?

Analysis:
(i) Under IFRSs, Energy should recognize a provision for the cleanup costs in its 20×1. IAS 37-14 states a provision shall be recognized if “(a) an entity has a present obligation, (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.” When it is not clear if there is a present obligation, IAS 37-15 also defines a present obligation as obligation that “more or likely than not is risen by a past event after taking accounting of all available evidence”.

Moreover, IAS 37-22 also specifically provides that “where details of a proposed new law have yet to be finalized, an obligation arises only when the legislation is virtually certain to be enacted as drafted”. As it is virtually certain that the law will be enacted shortly after year-end, it is highly possible the Company will be required to clean up the contamination. The amount of obligation is also estimable, as the Company has cleaned up contaminations in other countries in which it operates. As a result, Energy should recognize a provision.

(ii) Under U.S. GAAP, Energy should recognize a loss for the cleanup costs in its 20×1 financial statements. ASC 450-20-25-2 provides that “an estimated loss from a loss contingency shall be accrued by a charge to income if (a) information available before the financial statements are issued indicates it is probable that a liability had been incurred at the date of financial statements and (b) the amount of loss can be reasonably estimated”.

If the draft law is enacted, Energy will be required to clean up the land that was contaminated by the Company’s operations. In addition, it is virtually certain that the law will be enacted shortly after the year-end. Therefore, it is probable that Energy has incurred a liability because the draft law will likely be enacted. Also, the amount of cleanup cost can easily be estimated as the Company has cleaned up its contamination in other countries in which it operates. As a result, a provision should be recognized.

Scenario 2

Fact:
FuelSource Co (FuelSource or the Company), which operates in the oil industry, is a U.S. subsidiary of a U.K. entity that prepares its financial statements in accordance with IFRS and U.S. GAAP. The Company operates in Dirty Country where it has no environmental legislation that requires cleanup of contamination. However, FuelSource and its U.K. parent have a widely published environmental policy to clean up all contamination and have a record of honoring the policy.

Issues:
Should FuelSource recognize a provision, (i) in reporting under IFRSs, and (ii) in accordance with U.S. GAAP?

Analysis:
(i) Under IFRS, FuelSource should recognize a provision for its cleanup cost. IAS 37-17 defines obligating as “a past event that leads to a present obligation”. IAS 37-17(b) further explains that “in the case of a constructive obligation, where the event (which may be an action of the entity) creates valid expectations in other parties that the entity will discharge the obligation”. As FuelSource and its U.K. parent tend to honor
their widely published environmental policy to clean up all contamination, it creates expectations in other parties that their operation in Dirty Country will follow their global policy as they always did in the other countries.

The environmental policy creates a constructive obligation as a result of their record of honoring the policy even though legal obligation does not exist in this case. Since FuelSource has a constructive obligation as a result of a past event and an estimable cleanup cost will be required to settle the obligation, it meets all of the requirements to recognize a provision under IAS 37-14. Therefore, FuelSource should recognize a provision under IFRS.

(ii) Under U.S. GAAP, FuelSource should not recognize a loss in its financial statement, and is not required to disclose the potential obligation of the cleanup cost. ASC 410-30-25-1 requires “the accrual of a liability arisen by environmental obligation if both (a) it is probable that an asset has been impaired or a liability has been incurred; and (b) the amount of the loss can be reasonably estimated, are met”.

To determine the probability of an environmental remediation liability, ASC 410-30-25-4 further explains that “two elements need to be met: (a) litigation has commenced or a claim or an assessment has been asserted or, commencement of litigation or assertion of a claim or an assessment is probable; (b) it is probable that the outcome of such litigation, claim, or assessment will be unfavorable”. However, in this case, the Company has no legal obligation to clean up the contamination in Dirty Country as there is no such environmental legislation that requires to do so. Moreover, cleanup of contamination in other country outside of United States is not required by any of the Federal laws or Codification.

It is remote that there will be any litigation; claim or assessment asserted that FuelSource would be responsible for participating in a remediation. Therefore, it fails both of the criterions under ASC 410-30-25-4 and recognition of a provision is not required. ASC 450-20-50-6 states that “disclosure is not required of a loss contingency involving an unasserted claim or assessment if there has been no manifestation by a potential claimant of an awareness of a possible claim or assessment”. As there is no law or regulation that requires a cleanup in Dirty Country, disclosure is not required by the Codification.

Scenario 3

Fact:
A number of changes to the income tax system are introduced by the government and Energy, or the Company, will have to retrain its administrative and sales workforce to ensure compliance with new system. No retraining has taken place as or the balance sheet date.

Issues:
Should Energy recognize a provision for the expected costs to retrain the staff (i) under IFRSs and (ii) in accordance with U.S. GAAP?

Analysis:
(i) Under IFRS, Energy should not recognize a provision for the expected costs to retrain the staff. IAS 37-14(a) specifically requires “a provision shall be recognized only when an entity has a present obligation as a result of a past event”. As no obligation was imposed by the government to provide the training to its staff or the obligation is not owed to any third party, the liability should only be recognized as it occurs (when the retraining takes place).

Furthermore, IAS 37-80(b) provides that “A restructuring provision shall include direct expenditures that are not associated with the ongoing activities of the entity” and IAS 37-81(a) specifically states that “a restructuring provision does not include such costs as retraining or relocating continuing staff”. As a result, no provision should be recognized, as the retraining of the staff does not arise any present obligation since the retraining has not taken place yet and it does not qualify as a restructuring expenditure. (ii) Under U.S. GAAP, Energy should not recognize a loss in its financial statement for the current year. ASC 450-20-25-2(a) provides that “An estimated loss shall be accrued if it is probable that an asset had been impaired or a liability had been incurred”.

As the changes of income tax did not impose any obligation on the Company by the government or company policy to provide retraining of the staff to ensure compliance with the system, the Company has no liability at the time of the change or before the year-end as the retraining has not taken place yet. ASC 450-20-25-4 further explains that “the condition in ASC 450-20-25-2(a) is intended to proscribe accrual losses that relate to the future periods”. As the retraining of staff would enhance the efficiency of future operation, it will become a liability to the Company as it occurs. Therefore, the retraining shall not be recognized as a loss for the current year.

Scenario 4

Fact:
FuelSource, or the Company, is required to install smoke filters in its factories by June 30, 20X2 under new legislation. FuelSource has not yet installed the smoke filters as of December 31, 20X1.

Issues:
Should FuelSource recognize a provision of December 31, 20X1 (i) under IFRSs and (ii) in accordance with U.S. GAAP?

Analysis:
(i) Under IFRS, FuelSource should not recognize a provision but disclose a contingent liability. IAS 37-19 specifically states that “It is only those obligations arising from past events existing independently of an entity’s future actions that are recognized as provisions…In contrast, because of commercial pressures or legal requirements, an entity may intend or need to carry out expenditure to operation in a particular way in the future (for example, by fitting smoke filters in a certain type of factory). Because the entity can avoid the future expenditure by its future actions, for example by changing its method of operation, it has no present obligation for that future expenditure and no provision is recognized”.

In this case, FuelSource should not recognize a provision as it has no present obligation at this point of time and installing smoke filters would allow the Company to avoid future expenditure. However, IAS 37-86 states that “unless the possibility of any outflow in settlement is remote, an entity shall disclose each class of contingent liability at the end of the reporting period a brief description of the nature of the contingent liability”. FuelSource will be required to disclose the information regarding of the contingent liability in its financial statement

(ii) Under U.S. GAAP, FuelSource should not recognize a loss in the financial statement for the current period. ASC 450-20-25-2 explains that “the purpose of the conditions described in (a) and (b) is to require accrual of losses when they are reasonably estimate and relate to the current or a prior period…even the losses that are reasonably estimable shall not be accrued if it is not probable that an asset has been impaired or a liability has been incurred at the date of an entity’s financial statements because those losses relate to a future period rather than the current or a prior period”.

Since the new legislation does not require the Company to install smoke filters until June 30, 20X2, which is after the balance sheet date, it has not yet incurred a liability to the Company as of December 31, 20X1. As a result, it fails the timing requirement under ASC 450-20-25-2 and FuelSource is not required to recognize a provision.