Audit Provisions and Contingent Liabilities under AS 29

The Audit of Provisions and Contingent Liabilities refers to the process by which an auditor examines and verifies a company’s recognition, measurement, presentation, and disclosure of provisions and contingent liabilities in its financial statements. The audit ensures that these items are accurately recorded and disclosed in compliance with applicable accounting standards (such as AS 29) and legal frameworks (like the Companies Act, 2013), and that there are no material misstatements affecting the financial position of the entity.

Table of Contents

1. Introduction
2. Audit of Provisions & Contingent Liabilities
3. Reporting Requirements
4. Disclosure Requirements as per Schedule III (Division 1) of the Companies Act, 2013 and AS 29 “Provisions, Contingent Liabilities and Contingent Assets”

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1. Introduction

Accounting Standard AS 29 – ‘Provisions, Contingent Liabilities, and Contingent Assets defines provision as a liability which can be measured only by using a substantial degree of estimation.

Terms such as ‘provision for doubtful debtors’, ‘provision for impairment of investments’, etc. are commonly used and refer to the adjustments to the carrying value of assets. These should be distinguished from provisions as defined under AS 29.

As per paragraph 14 of AS 29, a provision should be recognised when –

(a) an enterprise has a present obligation as a result of a past event;

(b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and

(c) a reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision should be recognised.

Examples of provisions include –

• Provision for income tax
• Provision for warranties
• Provision for employee benefits such as gratuity, earned leave

AS 29 defines contingent liability as –

(a) a possible obligation that arises from past events and the existence of which will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise; 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) a reliable estimate of the amount of the obligation cannot be made.

Examples of contingent liabilities include –

• The outcome of a lawsuit
• The outcome of a government investigation

2. Audit of Provisions & Contingent Liabilities

In carrying out the audit of provisions and contingent liabilities, the objective of the auditor is to validate the following assertions –

• Existence

1. 1. To establish the existence of provisions as at the end of the year/period.
   2. That disclosed contingent liabilities are in fact contingent liabilities and not actual liabilities.

• Completeness

1. 1. Provisions that were required to be recorded have been recognised in the financial statements.
   2. All contingent liabilities have been disclosed.

• Valuation

1. 1. Provisions have been valued appropriately.
   2. Contingent Liabilities have been disclosed at proper amounts

• Presentation & Disclosure

1. 1. Provisions have been presented, classified and disclosed in the financial statements in accordance with the requirements of applicable financial reporting framework, that is, Companies Act, 2013 and applicable accounting standards.
   2. All contingent liabilities have been presented and disclosed in accordance with the requirements of applicable financial reporting framework.

2.1 Potential Risks of Material Misstatement

Some of the potential risks of material misstatement regarding provisions and contingent liabilities are –

1. Recorded provisions do not exist at the balance sheet date or are overstated. [For example, where the management may be motivated to understate profits, or these are in fact ‘hidden reserves’].
2. All provisions have not been presented in the financial statements or that provisions are understated. [for example, even though a company is liable to provide warranty on goods sold, no provision for warranty has been recorded].
3. Provisions are not presented at the appropriate amounts in the financial statements. [For example, discounting rates used for actuarial valuation of provision for gratuity are not appropriate].
4. Presentation and disclosure of provisions is not in accordance with the disclosure requirements of Schedule III to the Companies Act or disclosure requirements of applicable accounting standards. [For example, the entity has not disclosed the movement of provisions as required by paragraph 66 of AS 29].
5. Current Provisions have been classified as non-current provisions and vice versa.
6. Methods used to measure provisions are not appropriate or are ad hoc. [For example, an ad hoc provision is recorded for warranty without any basis as to how the amount was estimated].
7. Disclosed contingent liabilities are in fact crystallised liabilities. [To present a rosy picture of financial statements by not recording liabilities, for example when the company has lost a legal case and is required to record outflow for the claim].
8. All contingent liabilities/commitments have not been disclosed. [Many stakeholders such as investors, lenders also consider the possible impact of contingent liabilities crystallising (probable future cash outflows) in making decisions. Omission of disclosures of contingent liabilities will influence the decision of such stakeholders. For example, a pending lawsuit could result in a large damage pay out in the future. Non-disclosure of this contingent liability in the financial statements will be misrepresentation of financial statements].

Note – The above is not a comprehensive list of all possible risks of material misstatement. This is only a list of most common risks. The auditor should evaluate the potential risks of material misstatement based on the facts and circumstances of the entity being audited.

2.2 Audit Procedures – Provisions

• The auditor should obtain a list of all provisions and compare the same with the balances as per ledger.
• Details should be obtained for all the provision accounts that are reflected in the books of account of the entity that have opening and/or closing balance.
• The auditor should review the list of all the provision accounts that are reflected in the books of account of the entity and ensure that the provision is as required in the prevailing circumstances and that the same doesn’t appear to be a provision made without any objective/requirement/need as such. The auditor inspects the underlying agreements such as employment contracts or Human Resource Policies (to assess obligation for employee benefits such as unearned leaves), agreements with customers (to assess warranty obligations), other documents such as claims against the company.
• The auditor should review and analyze the opening balances of provisions and assess whether any of the provisions should be written back. (For example, the company had in the previous year recorded a provision for a dispute with a vendor which was settled during the year. In such case the balance of unutilized provision should be written back).
• The auditor should obtain the underlying working of the recorded provisions together with the basis for each recorded provision and verify the same for reasonableness and completeness.
• In respect of provisions that require significant accounting estimates, the auditor should evaluate the reasonableness of the estimate by reviewing and testing the process used by management to develop the estimate in accordance with the requirements of SA 540 “Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures” issued by the ICAI. The auditor may consider the following procedures –

1. 1. Identify the sources of information that management used informing the assumptions and consider whether such information is relevant, reliable and sufficient for the purpose.
   2. Consider using the work of a specialist regarding certain assumptions.
   3. Evaluate whether the assumptions are consistent with supporting information, previous discussions and historical data/experience.
   4. Corroborate findings of the above procedures to board minutes and other audit evidence
   5. Ensure that any discrepancies or inconsistencies are followed up with management, obtaining corroboration for any explanations received.

• Certain provisions such as those for defined benefit plan (example, gratuity) or other long term employee benefits (example earned leave) require the management to use experts such as an actuary. The auditor should obtain the actuarial valuation report (or such report that is relevant for the provision being audited). The auditor should verify the underlying assumptions (for example, discount rate) and data used by the management expert with the data shared by the management. The auditor should –

1. 1. Evaluate the appropriateness of the work of the management expert as audit evidence for the relevant assertion
      • Relevance and reasonableness of the expert’s findings and conclusions
      • Evaluating the relevance, completeness, and accuracy of the source data used by the expert.

• SA 500 “Audit Evidence” issued by the ICAI requires the auditor should evaluate the work of management expert.
• The auditor should check whether the company sells products which require warranties. This may be verified by reference to sales orders or product brochures. If the company is liable to provide warranty, the auditor needs to analyse and understand the terms & conditions of the warranty contracts. Warranty expense is to be recognised in the same period as revenue for the sold products if there is a probability that an expense will be incurred and if the company can estimate the amount of the expense.

The auditor should obtain the computation of the warranty claim provision amount and analyse the same with the prevalent the terms and conditions. The auditor should ensure that the computation is consistent with those in previous years except where there are changes in conditions.

• The auditor should compare the provisions at the year-end with those at the end of the previous year. The auditor should make corroborative enquiries regarding the following –

1. 1. Provisions recorded in previous year but not in the current year and vice-versa.
   2. Significant variations in the amounts of provisions as compared to previous year.

2.3 Audit Procedures – Contingent Liabilities (and commitments)

SA 501 “Audit Evidence – Specific Considerations for Selected Items” issued by the ICAI has provided specific guidance on obtaining audit evidence in respect of litigation and claims. While key procedures have been included here, the auditor should ensure compliance with the relevant paragraphs (including application guidance) of SA 501.

• The auditor should obtain a detailed schedule of contingent liabilities as at the balance sheet date.
• The auditor should inquire and obtain documents in respect of contingent liabilities which were existing in the previous year and do not exist as contingent liabilities as at the Balance Sheet date. (for example, the decision of lawsuit is in company’s favour and hence the contingency no longer exists. The auditor verifies this with the relevant documentation. Another case could be that the company may have recorded liability during the year based on the facts and circumstances).
• The auditor should examine the following documents to identify undisclosed contingent liabilities –

1. 1. Examine the minutes of meetings of the board of directors for discussion of potential or current lawsuits.
   2. The auditor should examine in detail the legal and professional expenses. The supporting documentation for legal expense transactions may reveal contingent liabilities.
   3. Sales and purchase contracts for possible liquidated damages, penalties etc.
   4. Listing of pending suits and plaints filed by third parties against the company.
   5. Orders/demand notices from tax authorities or details available on the income tax portal regarding status of demands.

• The auditor should verify that the following are included in the contingent liabilities –

1. 1. Arrears of dividend on Cumulative Preference Shares
   2. Where any commitments have been given by the company to the Government for subsidies received, the auditor should examine if there are any contingent or actual liabilities on account of non-fulfilment of the conditions imposed?
   3. Any guarantees given by the company on behalf of other companies.
   4. Any export commitments under various government schemes

• With respect to legal matters, the auditor should inquire with the legal counsel/department and obtain confirmation letters from the legal counsel/department on pending legal matters.

• If there is a pending litigation against the company that would have material effect on the financial statements, the auditor should obtain details for further decision.
• Paragraph 12 of SA 501 requires that –

“The auditor shall request management and, where appropriate, those charged with governance to provide written representations that all known actual or possible litigation and claims whose effects should be considered when preparing the financial statements have been disclosed to the auditor and appropriately accounted for and disclosed in accordance with the applicable financial reporting framework”.

• The auditor should obtain confirmations from company’s bankers for bills discounted, letters of credit, guarantees given etc.
• The auditor should enquire and verify if there are any commitments such as capital commitments.

3. Reporting Requirements

Rule 11 of the Companies (Audit and Auditors) Rules, 2014, requires the auditor to report on the following –

Rule 11(a) – Whether the company has disclosed the impact, if any, of pending litigations on its financial position in its financial statement;

Rule 11(b) – Whether the company has made provision, as required under any law or accounting standards, for material foreseeable losses, if any, on long term contracts including derivative contracts;

The relevant clause related to contingent liabilities (disputed demands) on which auditor is required to report under Companies (Auditor’s Report) Order, 2020 is –

(vii)(b) where statutory dues referred to in sub-clause (a) have not been deposited on account of any dispute, then the amount involved and the forum where dispute is pending shall be mentioned (a mere representation to the concerned department shall not be treated as a dispute).

4. Disclosure Requirements as per Schedule III (Division 1) of the Companies Act, 2013 and AS 29 “Provisions, Contingent Liabilities and Contingent Assets”

Schedule III

Disclosure requirements for provisions have been described in Paragraphs 6(E) and 6(H) of General Instructions of Schedule III for preparation of balance sheet.

Long-term provisions

The amounts shall be classified as –

• Provision for employee benefits.
• Others (specify nature)

Short-term provisions

The amounts shall be classified as –

•  Provision for employee benefits.
• Others (specify nature)

Disclosure requirements contingent liabilities have been described in Paragraph 6(T) of General Instructions of Schedule III for preparation of balance sheet.

Contingent liabilities and commitments (to the extent not provided for)

• Contingent liabilities shall be classified as –

1. 1. Claims against the company not acknowledged as debt;
   2. Guarantees;
   3. Other money for which the company is contingently liable

• Commitments shall be classified as –

1. 1. Estimated amount of contracts remaining to be executed on capital account and not provided for;