Hello,

I am currently writing an essay regarding the tax treatment of provisions* and contingent liabilities in various countries across the world

I would appreciate it if someone answers the following question:

Do the tax authorities in the US allow the deduction of expenses incurred following the recognition of a provision or a contingent liability?

*A provision is a liability that is of uncertain timing or amount, to be settled by the transfer of economic benefits

For instance, suppose a firm faces a lawsuit. The firm is expecting to pay 1000 pounds with a probability of 80%. As a result, the firm recognizes both a liability and an expense in its financial statement. Can the firm deduct this expense from its income for tax purposes?

Another example is taken from IAS 37 ( I understand that IAS 37 is irrelevant for US companies-it's just an example)
Firm sells goods with a warranty under which customers are covered for the cost of repairs of any manufacturing defects that become apparent within the first six months after purchase. If minor defects were detected in all products sold, repair costs of 1 million would result. If major defects were detected in all products sold, repair costs of 4 million would result. The Firm’s past experience and future expectations indicate that, for the coming year, 75 per cent of the goods sold will have no defects, 20 per cent of the goods sold will have minor defects and 5 per cent of the goods sold will have major defects. In accordance with paragraph 24, an entity assesses the probability of an outflow for the warranty obligations as a whole.

The expected value of the cost of repairs is (the exact number does not matter)
(75% of nil) + (20% of 1m) + (5% of 4m) = 400,000

Can 400,000 be deducted from the firm income for taxation?

In addition, please refer me to a formal source (a law or a court ruling) regarding this issue.

Thanks in advance,
Michael

#1;I guess it depends. The firm, the entity , should be entitled to a deduction as soon as it meets the all-events test (the fact of the liability is fixed and the amount is determinable).Section 461(h) and § 1.461-1(a)(2)(i) provide that, under the accrual method of accounting, a liability is incurred, and is generally taken into account for federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. Section 461(h)(2)(A)(i) provides that, if the liability of the firm arises out of the providing of services to the taxpayer by another person, economic performance occurs as that person provides the services. Generally, in a transaction where one taxpayer is accruing a liability to pay another taxpayer, the last event necessary to establish the fact of liability under the all events test of § 1.461-1(a)(2)(i) is the same event that fixes the right to receive income under the all events test of § 1.451-1(a).In the case of a lawsuit there usually are no services to be performed and economic performance need not be considered.

#2;Basically, as we know, compared to variables such as useful lives of assets for depreciation purposes or collectability of accounts receivable, warranty costs can be wildly accurately unpredictable. After all a major failure in the production process may require a complete / partial recall of a product line which can be enormously expensive. Estimating warranty expense cannot possibly be an exact science because with continuing product innovation past warranty cost experience with established products will not necessarily be a good guide for estimating warranty expense associated with a new untested product. Technically, warranty expense is a contingent liability. Contingencies are possible economic events that may or may not occur in the future, as mentioned above: Provisions for warranties are governed by IAS 37 PROVISIONS, “QUOTE,” CONTINGENT LIABILITIES AND CONTINGENT ASSETS The key definitions are:
Provision: A liability of uncertain timing or amount.
Liability:
* Present obligation as a result of past events
* Settlement is expected to result in an outflow of resources (payment)
Contingent liability:
* a possible obligation depending on whether some uncertain future event occurs, or
* a present obligation but payment is not probable or the amount cannot be measured reliably . When a manufacturer gives a warranty, it satisfies the criteria for a liability - there is a legal obligation and settlement is expected to result in an outflow of resources (whether by payment to repair the defect or by using up of spare parts maintained for this purpose), so that's why a warranty is a provision and not merely a contingent liability. From history, the manufacturer would know that there will definitely be some claims for repairs or rectification, andas you said, the firm has to use either historical data or industry data as the best estimate (e.g. 2% of sales) for the provision.

Measurement of Provisions ;The amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date, that is, the amount that an enterprise would rationally pay to settle the obligation at the balance sheet date or to transfer it to a third party. [IAS 37.36] This means:

* Provisions for one-off events (restructuring, environmental clean-up, settlement of a lawsuit) are measured at the most likely amount. [IAS 37.40]
* Provisions for large populations of events (warranties, customer refunds) are measured at a probability-weighted expected value. [IAS 37.39]
* Both measurements are at discounted present value using a pre-tax discount rate that reflects the current market assessments of the time value of money and the risks specific to the liability. [IAS 37.45 and 37.47]
In reaching its best estimate, the enterprise should take into account the risks and uncertainties that surround the underlying events. Expected cash outflows should be discounted to their present values, where the effect of the time value of money is material. [IAS 37.42]

If you are governed by US GAAP, SFAS 5 Accounting for Contingencies is the authoritative pronouncement.

4. Examples of loss contingencies include:
a. Collectibility of receivables.
b. Obligations related to product warranties and product defects. Accrual of Loss Contingencies
8. An estimated loss from a loss contingency (as defined in paragraph 1) shall be accrued by a charge to income if both of the following conditions are met:
a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
b. The amount of loss can be reasonably estimated.

Under both IAS and SFAS, a warranty provision has to be created as the event is hardly remote. History will tell the management that never a year goes by when there is NO claim for repair under the warranty given and it is industry practice to make the provision. If warranties are allowed to be treated as merely contingent liabilities, I'm sure lots of companies will only be too happy to not take up the provision.

Source:

http://www.iasplus.com/standard/ias37.ht...
FAS 5 (as issued)

Hello,
First of all, thanks a lot for the detailed answer!

After I had posted this thread, I continued looking for an answer. During the search, I came across the following statement from United States v. Hughes Properties, Inc.[476 U.S. 593 (1986)]:

"The "all events" test prescribed by the Treasury Regulations requires that before an expense can be regarded as "incurred" for federal income tax purposes, a liability must be fixed and absolute"

Since a provision is an uncertain liability, it is not, by definition "fixed and absolute".

In addition, here is a quote for Internal Revenue Manual 4.43.1.12 (regarding retail industry) :
"For financial reporting purposes, GAAP requires the reflection of contingent obligations as expenses on financial statements. For tax reporting purposes, however, no deduction is allowed for liabilities that might never occur. The contingency element is a very strict consideration in assessing whether the liability is fixed for tax reporting purposes. Consequently, a liability does not accrue for tax purposes as long as it remains contingent."

Do the above mentioned quotes lead to the conclusion that a provision cannot be deducted from the taxable income, since it is not certain by 100%? (Even if it's possible to give fairly good estimation)

#1;good info.


#2;I guess so. I guess you can ocntact the IRS for more info in detail.

Thanks a lot, I appreciate all the help!