“Do Provisions on Company Balance Sheets Adequately Reflect the Reality of the Liabilities Facing Some Businesses?”

Topics: International Financial Reporting Standards, Balance sheet, Financial statements Pages: 7 (2267 words) Published: October 26, 2010
The accounting standard that deals with the issue of Provisions, Contingent Liabilities and Contingent Assts is IAS 37. According to Flower and Ebbers (2002), companies use provision for ‘big bath’ provision and smooth profits to boost profit growth, but a provision is an estimated liability. This essay will first investigate the problems associated before the introduction of IAS 37 and why provisions were necessary, followed by the discussion of the introduction of IAS 37 and its main rules. Also, there will be a few examples of how companies established their provisions. Finally, the essay will be concluded to state if provision on company balance sheets adequately reflects the reality of the liabilities facing some businesses. The use of provision accounting prior to the introduction of IAS 37 Before the issue of IAS 37, managers and creative accountants used provisions to manipulate the earnings and financial performance of the company. Therefore, managers increased the profits in an unsuccessful year, to prevent the possibilities of shareholders sacking management staff due to their lack of performance (Flower and Ebbers 2002). They did this by making large one-off provisions in years where a high level of essential profits were generated and then obtained some of the money back when profits were lower then expected to smooth profits and boost profit growth (Trapp, 1997). Some companies were creating ‘big bath provision’ to smooth profits, which is based on manager’s objectives. Companies who use ‘big bath’ provision plead to get support from the theory of prudence; therefore it was argued that it was prudent to immediately make a huge provision (Elliott & Elliott, 2006). As a result, companies were ‘smoothing the trend of the reported profits, the trend was raising the profits as opposed to fluctuating profits. This will give an impression of quality earnings and may contribute to supporting a higher share price.’ (Houillon, 1999) According to Lewis and Pendrill (2004) ‘big bath’ accounting was employed to create a healthy growth in profits by acquisition of a new subsidiary or in reorganization. Hence why, provisions were made to smooth profits without any practical assurance that the provision would actually be required in subsequent periods. Sutton (2004, P314) ‘describes a favourite ploy of firms embarking on a restructuring was to bring forward future operating costs and include them in restructuring provision’. Therefore entities have been using restructuring provision to manipulate their income so it can boost profit growth. This is done by recording large one off provisions which includes future liabilities, combined with large asset write-downs, which results in firms having smaller profits in the year of restructuring but larger ones in the later years. According to Sutton (2004) this is often employed by new management which have been appointed and acquirer firm to depress the net assets at the time of takeover and thereby boosting its post-acquisition profits. Introduction of IAS 37

According to the IASB the above section was considered that the information which was being reported to the shareholders was misleading, so the inefficient performance was hidden by the mangers (Flowers and Ebbers, 2002), which lead resources to be misallocated, to boost and smooth profits by manipulating the financial figures. Therefore, IAS 37 Provisions, Contingent Liabilities and Contingent Assets was introduced by the IASB in 1998 (Rees, 2006), to overcome the popularity of provision. The main objective of the standard was to ‘ensure that appropriate recognition criteria and measurement bases are applied and the sufficient information is disclosed in the notes to enable users to understand their nature, timing and amount’ (Alexander, Britton and Jorissen, 2007 P346). If the provision were recognised and measured in accordance to IAS 37, it can be added to the financial statements but the standards requires...
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