AFA Formative assessment

AFA Formative assessment

Question:

Discuss, with the reference IAS 37: Provisions, Contingent Liabilities and Contingent Assets and the relevant literature, how the managerial judgments on the recognition of the provision affects the usefulness of the information.

Your Task:

Use the following marking criteria to give a mark to each of the answers on the next page.

Marking Criteria:

References

Overall information regarding the IAS 37

Positive implications of the application of the IAS 37 for Provision, contingent assets, contingent liabilities

Negative implications of the application of the IAS 37 for Provision, contingent assets, contingent liabilities

Linking the positives and negatives with the qualitative characteristics of the accounting information

Answer 1:

A provision is a liability of uncertain timing or amount, meaning that it is subjective to management's judgment regarding the recognition of timing and the estimation of the amount. Following IAS 37, the amount recognized as a provision should be the best estimate of the expenditure required to settle existing obligations at the end of the reporting period. “ Management achieves the best estimate of provision through similar transaction experience or expert reports from third parties”. [IAS 37.36] When managers exercise the discretion to provide best estimates and judgments, the presentation and disclosure of provisions give a higher informational value to the financial statements and investors can use this figure to assess the operating performance of the entity. The finding of Peek (2004) suggests that allowing less discretion in provisions has potential benefits as it reduces the likelihood of earnings management. However, we have to admit that IAS 37 gives tremendous discretion to managers (Schneider, Michelon, & Maier, 2017) leading to an incentive to manipulate financial statements. In practice, managers may abuse the discretion given by the standards for adverse motivations and thus manipulate the information to create a favorable view of the financial statement. The recognition and disclosure of provisions require an explanation of probabilities, key assumptions, and estimates, as well as estimation uncertainties (Suer, 2014). These uncertainties can be exploited by companies trying to smooth income to achieve the outcomes they believe various stakeholders may want.

For example, when the chief accountant found that profits for the year had exceeded the expected targets, he may want to make some provision for potential future expenses. Using the provision as an income smoothing tool, the profit for this year is reduced by recognizing a provision. In the following year, the chief accountant then reverses the profit back which is effectively an attempt to transfer exceeded profit from one year to the next. Clearly, the information presented on the statements is not true and fair and does not have the quality of reliability and relevance which is detrimental to the users of the financial statements, and gives them a false impression of the performance of the company and thus influences decision-making. Previous research has revealed that provisions are one of the main tools of earnings management and one of the most discretionary accruals - managers use their discretion under IAS 37 to meet or exceed earnings targets, as Suer (2014) argued by. In general, it is difficult to measure the impact of managerial discretion on accounting information, and managers’ discretion on provisions as a problem still need to be addressed.

Answer 2:

IAS 37 describes and stipulates the accountability, divulgation and distribution of provisions, contingent assets and contingent liabilities. Provisions – A provision is a liability that has an unknown timing or number. The responsibility may be either a lawful or a positive duty. A constructive responsibility derives from the entity's acts, which demonstrate to everyone that it will assume those obligations and, as a result, has generated a presumption that certain responsibilities will be met. If it is likely that an outflow of cash or other economic capital would be needed to settle the provision, the agency recognizes a provision. The object is viewed as a contingent liability if an outflow is not anticipated. The measurement of a provision is the amount that an individual rationally would pay to resolve or pass it to a third party at the conclusion of the reporting period. The measurement of a provision takes into account risks and uncertainty. The value of a provision is discounted to its current value.

Contingent Liabilities – Contingent liabilities are potential commitments whose presence would be verified by unforeseeable future circumstances outside the entity's influence. One instance is litigation against an organization when it is unclear if the organization has committed a misdeed and when settlements are not likely to be necessary. Contingent liabilities have no provisions in respect to which it is clear that the company may be subject to an existing duty whereby, even if the number or time limit is unknown, was most likely to contribute to cash outflow or other economic capital. In the declaration of financial status a contingent liability is not recognized. That being said, a contingent liability is reported throughout the notes, unless the probability of an outflow of economic capital is minimal. Contingent Assets – Contingent assets are potential assets that are validated by an incidence or failure of uncertainty of future events not entirely under the entity's influence. Contingent assets are not recognized nor revealed if an influx of benefits is more probable than not. If the influx of benefits is almost assured, though, the declaration of financial status acknowledges an asset, since the asset is no longer regarded as contingent.