case 12-3

Topics: Balance sheet, Financial statements, Generally Accepted Accounting Principles Pages: 6 (1843 words) Published: January 14, 2014
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 20x1. 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 20x1 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...
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