Provisions, contingent liabilities and litigation

The gap between a provision and a mere contingent liability is exactly the gap between recognizing an expense today and only mentioning a risk in the notes, so the probable/possible distinction and the reliability of the estimate directly control the income statement; because litigation and regulatory exposures are qualitatively sensitive and often actively contested, this is also an area where management's incentive to understate probability and auditors' skepticism can pull in different directions, making legal counsel's independent input central to a defensible conclusion.

Does a present legal or constructive obligation exist from a past event (filed lawsuit, regulatory notice, or public commitment), supported by documented legal counsel assessment? Is an outflow of resources probable, more likely than not, rather than merely possible, and can a reliable estimate be made even if only as a range or expected value? Has the provision or contingent liability classification been reassessed at this reporting date as the matter has progressed, rather than left at its initial assessment?

1. Confirm a present legal or constructive obligation exists as a result of a past event (a filed lawsuit, a regulatory notice, a public commitment creating a valid expectation).
2. Assess whether an outflow of economic resources is probable, meaning more likely than not, rather than merely possible; obtain and document legal counsel's assessment for each material matter.
3. If probable and a reliable estimate can be made, recognize a provision at the best estimate of the expenditure required to settle the obligation at the reporting date.
4. If an outflow is only possible (not probable), or probable but no reliable estimate can be made, disclose as a contingent liability instead of recognizing a provision.
5. Where disclosure itself would be seriously prejudicial to the bank's position in an ongoing dispute, this narrow exemption from detailed disclosure may apply, but the general nature of the dispute must still be indicated.
6. Reassess the provision and the probable/possible classification at each reporting date as legal proceedings progress; do not treat the initial assessment as fixed for the life of the case.

Measure the provision at the best estimate of the expenditure required to settle the obligation, using an expected value approach (probability-weighted outcomes) where a range of possible outcomes exists with no single most likely amount, or the single most likely outcome where one outcome is clearly more probable than the others; discount to present value where the effect of the time value of money is material for long-dated obligations (e.g., a multi-year regulatory remediation program), using a pre-tax discount rate reflecting current market assessments.

Disclose: (1) a reconciliation of provisions by class from opening to closing balance (additional provisions, amounts used, unused amounts reversed, unwinding of discount); (2) the nature of the obligation and expected timing of resulting outflows; (3) major assumptions made about future events; (4) for contingent liabilities, a brief description of the nature of the dispute and, unless impracticable, an estimate of its financial effect and uncertainties relating to the amount or timing; (5) if the seriously prejudicial exemption is used, that fact and the general nature of the dispute, without detail that would prejudice the bank's position.

• Recognizing a provision for a merely possible (not probable) litigation outcome, overstating liabilities and expenses
• failing to update the provision estimate as a case progresses through legal stages (settlement negotiations, adverse rulings, appeals)
• disclosing overly generic litigation language ('
• various claims arise in the ordinary course of business'
• ) that does not convey the bank'
• s actual assessment of likely outcomes for material matters
• using the seriously-prejudicial exemption too broadly to avoid disclosure that is merely unfavorable rather than genuinely prejudicial to the bank'
• s legal position
• not distinguishing regulatory conduct-risk provisions (often estimated using statistical/actuarial techniques) from single-case litigation provisions in the reconciliation.