An Analysis of Contingent Liabilities and Assets - Essay Example

It will first examine the link between uncertain transactions and mainstream accounting, will review the rules pertaining to the recognition of contingent assets and liabilities and examine the similarities and differences with US accounting standards.Purpose of IAS 37 A provision is a charge against profits for the purpose of offsetting liability or loss (Hanif, 2005). From this definition, there are three possible reasons why these provisions would be made: 1. For liabilities and changes like provision for income tax. 2. For valuation adjustments for fixed assets like the provision for income tax. 3. For valuation adjustments for current assets like the provision for bad and uncertain debts (Hanif, 2005).

Contingent liabilities and their position in financial accounting have a strong connection with recognition (Robinson, 2008). Recognition is the process of incorporating items that meet the definition of elements in financial statements (asset, liabilities, equity, income and expenses) into the balance sheet or income statement (Robinson, 2008). The fundamental requirement for recognition is probability and measured reliability (Arboleda & Bessis, 2011). In other words, for a transaction to become an element in a financial statement, it must have a high chance of being carried out.

It should also be measured reliably. Porter and Norton (2010) explain that recognition occurs when an economic event is recognised by words (e.g. cash, numbers, amount), can be measured by attribute (i.e. historical cost concept) and by unit (i.e. currency). Although some items are easy to recognise, such as cash and bank balances, other provisions are not so easy to recognise and can be carried into the financial statement. These provisions are liabilities of uncertain timing or amount (Alexander et al., 2007), i.e. they do not fit the orthodox criteria for recognition.

A contingent liability is a present obligation that involves a possible outflow, which has no reliable estimate (Alexander et al., 2007). A contingent asset, on the other hand, is an asset whose economic benefit depends solely on future events outside the control of the company (Investopedia, 2012). IAS 37 is meant to ensure that the proper recognition criteria and measurements are applied to provisions made for contingent assets and liabilities (Ernst & Young, 2011). It encourages significant disclosure in financial statements in relation to nature, timing and amounts (Ernst & Young, 2011).

The IAS makes a distinction between provisions and contingent liabilities. In other words, not all contingent liabilities need a corresponding provision to be created for them. Contingent liabilities are not recognised as liabilities because they are only possible and confirmation of payments occurs only after action is taken by an external entity. Second, they are present obligations that either do not meet recognition standards or no reliable estimation system exists for them. As such, it would be wrong and potentially fraudulent to recognise them.

In the Deloitte textbook (2012), three examples are given to clarify the different types of liabilities in relation to contingent liabilities/assets. When goods are received and invoices are issued for them, they can be recognised as trade payables or debtors because there is no degree of uncertainty. They are assets. If goods are received