IAS 37 – PROVISION, CONTINGENT ASSET AND CONTINGENT LIABILTIES

This Standard sets out the required accounting treatment and disclosures for provisions, contingent
liabilities and contingent assets. These are linked by their commonality as areas that require judgment at
the end of an accounting period. In all three cases, the correct treatment in terms of making accounting
adjustments or making disclosure (or ignoring altogether) comes down to careful examination of the
definitions therein. This Standard becomes operative for annual financial statements covering periods
beginning on or after 1 July 1999. Earlier application is encouraged.

DEFINITIONS
Provision: This is a liability of uncertain timing and amount
Liability: This is a present obligation of an entity arising from past events.
Contingent Liability: This is a possible obligation that arises from past events and whose existence will
be confirmed by the occurrence or non-occurrence of one or more uncertain future events not wholly
within the control of the entity.
It can also be defined as 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.

Contingent asset: This is a possible asset 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.
Onerous contract: This is a contract in which the unavoidable costs of meeting the obligations under the
contract exceed the economic benefits expected to be received under it.
Restructuring: This is a programme that is planned and controlled by management, and materially
changes either:
(a) the scope of a business undertaken by an entity; or
(b) the manner in which that business is conducted
Obligating event: This is an event that gives rise to a present obligation. This Standard sets out the
following guidance on the identification of obligating events, the salient features of which include:

• A present obligation exists where the entity has no realistic alternative but to make the transfer
of economic benefits; or
• A present obligation may take the form of a legal obligation if, and only if, settlement of the
obligation can be enforced by the law; or
• A present obligation may take the form of a constructive obligation.

Constructive obligation: This is an obligation that derives from an entity’s actions where:

• The entity has indicated to other parties (by a pattern of past practice, published
policies or a current statement) that it will accept certain responsibilities; and
• As a result, the entity has created in the other parties a valid expectation it will
discharge those responsibilities.

Provisions and Other Liabilities

As defined above provisions are liabilities with uncertain timing and amount. Therefore, Provisions can
be distinguished from other liabilities such as trade payables and accruals because there is uncertainty
about the timing or amount of the future expenditure required in settlement. By contrast:

a) trade payables are liabilities to pay for goods or services that have been received or supplied and
have been invoiced or formally agreed with the supplier; and
b) accruals are liabilities to pay for goods or services that have been received or supplied but have
not been paid, invoiced or formally agreed with the supplier, including amounts due to
employees (for example, amounts relating to accrued vacation pay). Although it is sometimes
necessary to estimate the amount or timing of accruals, the uncertainty is generally much less
than for provisions.
Accruals are often reported as part of trade and other payables, whereas provisions are reported
separately.
RECOGNITION OF PROVISION

IAS 37 stipulates the criteria for provisions which must be met for a provision to be recognised so that
companies are prevented from manipulating profits. According to IAS 37, three criteria are required to
be met before a provision can be recognised. These are:

1. There needs to be a present obligation from a past event

2. There needs to be a reliable estimate, and
3. There needs to be a probable outflow of resources embodying economic benefits (eg
cash)

If all the above criteria are met then provision is recognized in the financial statement as either Current
or Non-Current Liability.

DR: P/L (Expense)

CR: SOFP (Liabilty)

Measurement of Provision

One of the important criteria for recognising provision is the ability to reliably estimate the amount that
will be paid to settle the obligation. The use of estimates is an essential part of the preparation of
financial statements and does not undermine their reliability. This is especially true in the case of
provisions, which by their nature are more uncertain than most other items in the statement of financial
position. Except in extremely rare cases, an entity will be able to determine a range of possible outcomes
and can therefore make an estimate of the obligation that is sufficiently reliable to use in recognising a
provision.

Therefore, the amount recognised as a provision shall be the best estimate of the expenditure required
to settle the present obligation at the end of the reporting period. The best estimate of the expenditure
required to settle the present obligation is the amount that an entity would rationally pay to settle the
obligation at the end of the reporting period or to transfer it to a third party at that time. The best
estimate according the standard could be either:

1. The Most likely Amount: This is used when provision is measured for a single obligation
Illustrative Example

XYZ Ltd has received legal advice that the most likely outcome of the court case from the employee is
that they will lose the case and have to pay $10m. The legal team think there is an 80% chance of this.
They believe there is a 10% chance of having to pay $12m, and a 10% chance of paying nothing.

What amount will be the provision?

In this case, XYZ Ltd would provide $10m, being the most likely outcome. It is not uncommon for
candidates to incorrectly take the $12m, thinking that the worst-case scenario should be provided for.
Other candidates may calculate an expected value based on the various probabilities which also would
not be appropriate in these circumstances.

2. Expected Value: This is use if the provision being measured involves a large number of items,
such as a warranty provision for repairing goods, the expected value should be calculated using
the probability of all possible outcomes.

Illustrative Example

Ever_Jay plc gives a year’s warranty with all goods sold during the year. Past experience shows that Rey
Co needs to do no repairs on 85% of the goods. On average, 10% need minor repairs, and 5% need major
repairs Ever_Jay plc manufacturing manager has calculated that if minor repairs were needed on all
goods, it would cost $100,000 and major repairs on all goods would cost $1m.

What amount will be the provision?

Here, the provision would be measured at $60k. The expected cost of minor repairs would be $10k (10%
of $100k) and the expected costs of major repairs is $50k (5% of $1m). This is because there will not be a
one-off payment, so Rey Co should calculate the estimate of all likely repairs.

OTHER SPECIFIC GUIDANCE ON PROVISIONS.

Time Value of Money: If the time value of money is material (generally if the potential outflow is payable
in one year or more), the provision should be discounted to present value initially. Subsequently, the
discount on this provision would be unwound over time, to record the provision at the actual amount
payable. The unwinding of this discount would be recorded in the statement of profit or loss as a finance
cost. The rate to use is a pre-tax rate (or rates) that reflect(s) current market assessments of the time
value of money and the risks specific to the liability.
Reimbursement: Where some or all of the expenditure required to settle a provision is expected to be
reimbursed by another party, the reimbursement shall be recognised when, and only when, it is virtually
certain that reimbursement will be received if the entity settles the obligation. The reimbursement shall
be treated as a separate asset. The amount recognised for the reimbursement shall not exceed the
amount of the provision.

In the statement of comprehensive income, the expense relating to a provision may be presented net of
the amount recognised for a reimbursement.

Restructuring Cost: Restructuring costs associated with reorganising divisions provide two issues. The
first is to assess whether an obligation exists at the reporting date. The key here is whether the
restructuring has been announced to the affected employees. If the employees have been informed,
then an obligation exists and a provision must be made. If the employees have not been informed, then
the company could change its mind. In this case, there is no present obligation to incur the costs
associated with this.

The second issue for consideration is which costs should be included within the provision. These costs
should exclude any costs associated with any continuing activities. Therefore, any provision should only
include items such as redundancy costs and closure costs. Ongoing costs such as the costs of relocating
staff should be excluded from the provision and should instead be expensed as they are incurred.

Onerous Contract: Onerous contracts are those in which the costs of meeting the contract will exceed
any benefits which will flow to the entity from the contract. As soon as an entity is aware that a contract
is onerous, the full loss should be provided for as a liability in the statement of financial position.

Future Operating Losses: Future operating losses do not meet the criteria for a provision, as there is no
obligation to make these losses. Therefore, they cannot be included in the financial statements.

Decommissioning Cost Associated to an Asset: Where an entity creates an obligation for future costs
due to the construction of a non-current asset. In this case, the provision should be included within the
original cost of the asset, as this is directly attributable to the construction of that asset.

Recognising contingent liabilities or contingent assets

According to IAS 37 both Contingent liabilities and contingent assets are not recognised in the financial
statements. In some circumstances, information about the existence of a contingent asset or a
contingent liability should be disclosed in the notes to the financial statements.
 ➢ Contingent liabilities should be disclosed unless the possibility of any outflow in settlement is
remote (the meaning of ‘remote’ is not defined in IAS 37)
➢ Contingent assets should be disclosed only if an inflow in settlement is probable. ’Probable’ is
defined by IAS 37 as ‘more likely than not’. (And if an inflow is certain, the item is an actual asset
that should be recognised in the statement of financial position.)

Disclosure Requirement

IAS 37 requires the following disclosures about provisions in notes to the financial statements. For each
class of provision, the following should be disclosed:

I. the opening and closing balances and movements in the provision during the year;
II. a brief description of:
• the nature of the obligation;
• the expected timing of any settlement; and
• an indication of the uncertainties surrounding the amount and timing of any
settlement

Where disclosure of a contingent liability or a contingent asset is appropriate, the following disclosures
are required:

I. A brief description of the nature of the contingent liability/asset

II. For contingent liabilities, the possibility of any reimbursement
III. Where practicable:
• an estimate of its financial effect
• an indication of the uncertainties