5 Liabilities and Provisions
5.1 One of the areas of major difficulty in financial reporting has been in respect of the accounting policies to be adopted in respect of the recognition of liabilities: there have been infamous cases in the past in which accountants have been exceedingly creative in recognising liabilities at the point of acquisition of a new subsidiary. This has then enabled profits to be conjured from thin air in the post-acquisition period. This can be explained most simply by an example: Bildeston Enterprises Limited acquires the entire share capital of Nayland Trading Limited for consideration of £1 million. At acquisition the net assets of Nayland Trading Limited are shown as £900,000. This therefore indicates goodwill of £100,000. However the directors of Bildeston Enterprises Limited decide that there is a need to provide for redundancy and restructuring costs in Nayland Trading Limited of £500,000, as they have plans to reshape the way that the business is operated. Ignoring the tax effects, a provision for this amount is included in the opening balance sheet. This leads to the goodwill increasing from £100,000 to £600,000 as the net assets have been reduced from £900,000 to £400,000 by the deduction of the restructuring provision. In the two years following acquisition these provisions are then released as credits to the profit and loss account, creating profits in the consolidated financial statements. Neither Bildeston Enterprises Limited nor Nayland Trading Limited make any real profits in these two years; however, the consolidated profit is shown as £250,000 before tax in each of those two years as a result of the “big bath” provisions being credited to the profit and loss account. Bildeston Enterprises Limited, buoyed by its success, seeks its next acquisition..... and so the story continued. 5.2 This major problem was addressed in two ways: firstly the conceptual framework of UK GAAP now has a definition of a liability as an obligation to transfer economic benefits as a result of past transactions or events. The fundamental point here is that the obligation has to exist at the year end: it is not sufficient for the directors of Bildeston Enterprises Limited to produce detailed costed plans for any restructuring: the obligation only exists if they communicate the planned redundancies in detail to the employees. (The obligation can be either a legal or a constructive one.) 5.3 Secondly, the conceptual framework was then further developed with FRS 12, issued in September 1998. This Standard deals with provisions, contingent liabilities and contingent assets. It explores the way in which an obligation may first appear on the horizon as a potential or contingent liability. As more evidence is gathered it is then appropriate to make a provision for a possible cost; finally the provision is made more precise and is hardened into a specific liability. 5.4 A contingent liability is recorded as a note in the financial statements, but there is no charge to the profit and loss account and therefore no provision on the balance sheet; a provision is made once it is more likely than not that a cost will arise and this is the first time that the event results in a charge against profits; once the certainties harden, the amount then owing to the third party can be stated with certainty. At this point, the amount is moved from one place on the balance sheet to another - from provisions to liabilities.
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