 Hello and welcome to this session. This is Professor Farhad and this session we would look at IAS 37 which covers provisions, contingent liabilities and contingent assets. This topic is covered in international accounting as well as the CPA exam and the ACCA exam as well. As always I would like to remind you to connect with me on LinkedIn. YouTube is where you would need to subscribe. I have over 1500 plus accounting, auditing and tax lectures. If you like my lectures, please like them, put them in the playlist, share them with the word. If they're benefiting you, it means they might benefit other people. So please share the wealth. This is my Instagram account. Please follow me on Instagram. This is my Facebook account. And this is my website on my website. If you'd like to support the channel, you could always donate. That's a greatly appreciated on my website. Also I have a limited time offer now from Becker, which will give you a thousand dollar off of the Becker bundle, the four parts CPA exam. Becker is the gold standard in CPA preparation for the CPA exam. I strongly suggest you go for it. The link is on my website if you're going to go for your CPA exam. Although you may not be studying now, you can have this as long as you need to. So if you're a college students, you can supplement your studies with Becker. Before we talk about AIS 37, we need to talk a little bit more about liabilities because AIS 37 provision and contingent liabilities are form of liabilities. So if we don't understand what liabilities are, we won't be able to understand what the provisions and the contingent liabilities are. So we're going to go back to AIS 1 in the presentation of financial statement. And the first thing we need to know liabilities, they could be current or non-current. So first we need to know what is a current liability? What's a non-current liabilities? Well, what is a current liability? Simply put, a current liability is a liability that it's expected to be settled in the normal operating cycle. What does that mean? It means within our operating cycle. And we're going to assume for the sake of illustration, our operating cycle is 12 months or one year. Okay? So as long as you're going to settle it, settle it means either pay it off, refinance it, defer it. You're going to settle the liability within 12 months. Okay? And you're holding primarily for trading purposes. It means the liability for operating your business. Expect to be settled within 12 months. Again, what really matters is your normal operating cycle. We assume it's 12 months. Or you cannot defer it more than 12 or does not have the right to defer it. You don't have to write to defer it more than 12 months. Again, when we say 12 months, really we mean the operating cycle. But we always assume that the operating cycle is 12 months. Now compared to US GAAP, they're very similar in terms of how we do with the fine liabilities, but they differ in few things. One is refinancing short-term debt. Okay? Refinancing short-term that may be classified as long-term is the refinancing is completed before the balance sheet date. This is IFRS. What does that mean? If you have a short-term debt, if you have a short-term loan, but it's going to be refinanced, you're going to replace this loan with a long-term loan. For that short-term loan to be considered long-term, you have to refinance it before the balance sheet date. This is IFRS. Under US GAAP, they're a little bit more flexible. Under US GAAP, you don't have to complete it by the balance sheet date. Under US GAAP, although this is not a US GAAP course, but just want to let you know, it differ. For example, if this December 31st is the balance sheet date, if the year end is here, and let's assume you're going to prepare your financial statement on March 1st. As long as you can take care of it, show that you have the ability or you actually refinance it or you have the ability, then you can classify the loan under US GAAP. Under IFRS, guess what? We have to refinance here in this period before the year end. So that's the difference. So here, GAAP, they have a little bit more flexibility as long as you can do it. Before you issue the financial statements, we can live with that. Amount payable on demand due to violation of debt covenant must be classified as current unless a waiver of at least 12 months is obtained from the lender by the balance sheet date. What does that mean? Under IFRS, if there's a violation of the debt, what is the violation of the debt? You took out a loan, the bank or the lender might impose conditions on you. Conditions such as your retained earning has to be maintained at a certain level. You cannot pay out dividend. You have to contain a certain amount of cash. Let's assume you took out a loan on November 1st and you borrowed a million dollars. Here comes December 31st as the year end. By December 31st, and this loan was for three years. So this is a long term loan. By December 31st, so it didn't take you very long, two months, you violated your debt covenant. You did something and your financial statements, maybe you paid out too much dividend. And as a result, the bank's heads, guess what? Now this loan, I need you to pay the whole loan back because you violated the debt covenant. Okay? Now under IFRS, unless you can get a waiver before December 31st, which is year end, you're assuming this is year end, you have to get the waiver here. You have to get the waiver here. And the waiver has to tell you, you have more than 12 months to take care of it. In other words, fix your retained earning, whatever you violated. Okay? Now under US GAAP, they're a little bit more flexible here. Let's assume you're going to issue your financial statement March 1st. You still have this time to get that waiver, to get that waiver. So they give you more time. Okay? So it may be, it might be, you have to obtain that waiver by the issuance of the annual report. Okay? We're assuming it's year end December 31st. So they give you a little bit more time. Bank overdraft are netted against cash if the overdraft from an integral part of the entity's cash management. Otherwise the bank overdraft is defined as a current liability. Well, under US GAAP, bank overdraft are always current liabilities. So this is basically kind of a comparison between the two. But let's talk about what we need to talk about AIS 37, which is provisioned contingent liabilities and contingent assets. In this session, I will not cover contingent asset. I'm going to break this AIS 37 into two parts. I will cover that in the next session. But what does it do? What does, what's the purpose of the IAS 37? It provide guidance for reporting liabilities and assets of uncertain timing, amount, or existence. What does that mean? It means we have a liability, but guess what? There's something about the liability we are missing. What is that something that's missing? When are we gonna pay at the timing? The amount, how much are we gonna pay? Or whether there's a liability or not. Okay? And those are basically, those are the provisions and the contingencies, which we'll talk about shortly. Also, it contain specific rules related to what's called a nervous contract, which I will talk about this in the next session, and restructuring cost. I will talk about this in the next session. Issues that deals with environmental cost, which is environmental liabilities, and disclosure. How much do we need to disclosure? So in this session, I will focus only on provisions and contingent liabilities kind of dirt the same in the same boat, because they talk about liabilities that are uncertain in terms of time, amount, or even existence. Okay? So IS-37 talks about provision, and basically those are liabilities, as we said, of an uncertain timing, amount, or existence. Now, but the question is, do we know what is a liability? Do we know the the definition of a liability? Basically, a liability is you have an obligation. This is what a liability is. You have an obligation, a present obligation to be more specific. You have a present obligation. That happens because of a past event. Give you an example. You borrowed money from the bank. You debited cash, credited notes payable for 100,000. That's something happened in the past. As a result, now you have 100,000 in notes payable. And in the future, you have to pay the liability. You have to sacrifice your asset. You have to sacrifice. Usually you pay it in cash. You have to sacrifice some economic benefit. Usually you pay your liabilities with cash. It doesn't have to. Sometimes you have to perform your service. I'm just making sure you understand where a liability is. So, this is what a liability is. Now, a provision, when would the provision should be recognized? So, it's a little bit different than the liability. It's a liability, but it has a little bit more characteristic to it. The entity has a present obligation, which again, we talked about the present obligation. It could be legal like you sign a loan or a constructive. It could be constructive means you accept that some responsibilities that made you have made the other part, you have a valid expectation for you to deliver. So, this is what constructive. So, a company accepts certain responsibilities, thus creating valid expectation. For example, if you honor a warranty, now you have a constructive liability because you have to deliver. You have to deliver in case something happened. You have to make the product hold for that customer in case it breaks down. You might have to replace it. Okay? Also, it is probable. Now, probable means more likely than not. And how do we define this? And we're talking about this is an international accounting. So, we're talking about IFRS. More likely than not is defined basically in the literature as 50% plus. So, there's more likely than not. There's more than 50% chance that you're going to have to pay something in the future. Then, that liability will have to be recognized. Recognized means recorded. So, first you have to have an obligation. Okay? Either constructive or legal. The probability of you paying, it has to be just more than 50%. Now, you as GAP is a little bit different. They want basically higher probability. And the third component is we have to have a reliable estimate. You have to know how much you are going to be paying or you can estimate how much you're going to be paying. Now, you might be saying what happen if the probability is that if it's probable less than 50%. Less than 50% means it's as far as IFRS, it's not likely than not you're not going to pay. Okay? We're going to talk about this. Well, but those are the three conditions. One, two, three, to have a provision, to record a provision. And what does it need to record the provision? Generally speaking, to debit either an expense or a loss most of the time and credit a liability. So, you have a provision, you have a provision, you have a liability and basically for to pay something, $10,000, you debit expense or a loss and you credit the liability. See, I'm going to be responsible for that. Why? Because there's a more than 50% chance I'm responsible for this and I can estimate this $10,000. Now, how do you know if you have a provision? Well, you ask yourself, can you avoid this obligation? If you cannot avoid the obligation, then you have an obligation. Okay? Now, those are provisions. What are contingent liabilities? Because I told you they're kind of the same thing. Okay? The possible obligation that arises from a past event whose existence will be confirmed by the occurrence or a non-occurrence of a future event. So basically, simply put, something happened in the past and we're waiting for the future to see if that if the liability will occur or not. The best the classic example is a lawsuit. Someone sues you. That's a contingent liability. Why? Because you might lose, depending on the outcome by the judge and the jury. Okay? Or contingent liability exists when you have a present obligation that is not recognized. You cannot recognize it. Why can't you not recognize it? Because it's not probable. How do we define probable less than 50% that an outflow of resources will require to be settled? Or you cannot measure the amount that you have to pay. So you do have you do have a liability. It exists. But here's the problem. There's less than 50% chance or there's more than 50% chance but you don't know the dollar amount. Why don't you why don't you know the dollar amount? Because the case is so unique and it all depends on the jury. The jury could award the plaint could award the plaint of a dollar or they could award them a million dollar. You really cannot make any estimate. Under those circumstances you have contingent liabilities. So basically provisions. Let me just show you this picture. Although I use this one. I teach US GAAP but this is basically I can use this for IFRS as well. So what's going to happen is you have to you have to you have to guess or the company will have to estimate or study their probability of losing if they are being sued the probability of losing. If usually let's start with remote. Remote means there's no chance or a very low chance. Okay. Basically we can ignore the situation. Okay. Now if it's under let me show you US GAAP first. Let me just explain US GAAP. Under US GAAP if there's remote chance you're going to lose you ignore the situation. If it's reasonably possible. Now US GAAP does not give you a percentage for reasonably possible but they say reasonably possible. Reasonably possible means it may or may not happen we're not really sure. What you need to do you need to do a footnote. Footnote means you need to disclose it. Disclosing means what means you tell the in the financial statement you tell us you're being sued by such and such party and here are the merits of the case. It's in in in a federal state whatever court it is in. It's going to take us three years to resolve this issue and just be aware of it. Okay. We disclose it. Now if it's probable now US GAAP says probable has to be like 70 to 98 percent like really there's a high chance you are going to lose. Okay. If you have if there's a high chance you are going to lose that's not enough. You accrue only if you know the dollar amount. So there's a it's a probable and you know the dollar amount. If probable plus the dollar amount then you accrue accrue means you would recognize. So this is US GAAP. Okay. Now I'm going to use a different color. If you don't know the dollar amount you just disclose. Now I'm going to use a different color to illustrate IFRS. IFRS simply put simply put if it's less than 50 percent let's assume the 50 percent level here if it's less than 50 percent. Okay. You can disclose basically you could put in the notes. Once it's more than 50 percent and and you can estimate then you would recognize. So notice the threshold is lower 50 plus and you know the dollar amount you will you would record. Okay. So it's anything less it's a contingent liability and you will disclose in the notes. Now the question becomes how do you measure how do you measure the dollar amount? What's the estimate? Because you're estimating. Well the best estimate okay it's how much it's going to cost you to settle it on the balance sheet date. That's the best estimate. Now how do you of course that's the best estimate. Now how do you do it? Well one way to do it is to do a probability weighted expected value. What does that mean? Let's assume there's a you know 10 chance you would lose 100,000. There's 20 chance you would lose 300,000 dollar. So on and so forth. So you'll add up all your percentage 100 percent and you will take 10 times 100,000. That's 10,000. 20 times 300,000. If my math is right it's 60,000 and you add up all the probabilities and that's the expected. Okay so this is the best value is the probability weighted expected value within a range of estimate. This is an estimate or the midpoint if all estimates are equally are equally likely. You know if you have two numbers it's either 50,000 or 100,000. Well let's slid the difference 75,000. Now also the provision must be discounted if you expect to be paying this three years from now you will discount it to the present value. And provisions must also be reviewed at the end of each accounting period and adjusted to reflect current best estimate. So if this is what you estimated now and next year there's more evidence to the case and now they're gonna up the settlement then guess what you're gonna have to change that as well. The best way to do this is just to look at an example to see how this all worked. A former employee of this company filed a lawsuit against the company in year one for age discrimination. December 31st the external legal council provided an opinion that it's 60 percent probable. There we go more than 50 percent that the company will be found liable which will result in a total payment between a million and 1.5 million and there's equally likely 50 chance a million 50 chance of 1.5 million. Because it's more likely than not here we go how why more likely than not 60 percent and we know the dollar amount and we know it's 50 percent a million 50 percent 1.5 million. Guess what now we have a liability of 1.25 1.25 million therefore we debit litigation laws we credit provision for litigation. Now under USGAP I'm telling you under USGAP we don't do this why under USGAP we don't do this because 60 percent is not high probability. Under USGAP we just disclose that we are being sued by this individual and that's the end. Now what happened when we actually paid this liability because eventually we're gonna have let's assume we paid it and let's assume we settled for one million dollar we settled for one million dollar therefore we have to credit cash a million if we settle for a million we have to debit this the provision for loss we have this is a liability we have to debit this provision for law for for laws for litigation laws which is a liability 1.25 million and now what we have to do we have to reverse litigation laws we have to basically credit reversal of litigation laws which is going to increase our income for year two when we pay it so this is year two when we pay it this is year one it's going to increase our income by 250,000. If you have any questions about this topic please email me if you happen to visit my website please consider donating if you're studying for your CPA exam or your certification study hard it's worth it. In the next session I will take a look at those topics which is part of IAS 37. Good luck.