Insights

Tips for analysing contingent liabilities using a framework incorporating accounting and common law principles.

A critical component within many solvency reports is the treatment of contingent liabilities and the effect these liabilities have on the company’s solvency. It is an uncontentious proposition that when preparing a solvency report, financial accounts should be compared to source documents, and if there are discrepancies, the records should be adjusted to reflect the actual position. Regard should also be had to the applicable accounting standards.

When assessing whether a potential contingent liability should be included for the purpose of assessing solvency, an analysis should have regard to:

• The framework published by the Australian Accounting Standards Board (AASB),2 particularly AASB 137 Provisions, Contingent Liabilities and Contingent Assets (AASB 137, or the Standard).
• Case law which assists in the interpretation of the AASB 137 framework and solvency analysis more generally.

DEFINITIONS
For the purpose of this article (and the analysis generally) it is critical to apply standard definitions. We have, where possible, relied on the definitions contained in paragraph 10 of AASB 137 (our defined terms added in square brackets). Including:

A provision is a liability of uncertain timing or amount.

A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

An obligating event is an event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation.

A legal obligation is an obligation that derives from:
a) a contract (through its explicit or implicit terms);
b) legislation; or
c) other operation of law. [Legal Obligation]

A contingent liability is:
a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity;
or
b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability.

Neither the AASB standards nor case law in respect of Contingent Liabilities include a definition of the term ‘remote’. The matter is further complicated by the range of terminology used in case law to describe probability. The following standard definitions of ‘remote’ are relevant for this analysis:

Read More…