Provisions, Contingent Assets & Liabilities - IAS - 37

•Syllabus

5. Other Reporting
 IAS 10 Events after the Reporting Period
 IAS 37 Provisions, Contingent Liabilities and Contingent Assets

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 Provision
A provision is a liability of uncertain timing or amount, meaning that there is
some question over either how much will be paid or when this will be paid.

Example: Provision for Bad Debts, Provision for Taxation

Before IAS 37, these uncertainties may have been exploited by companies trying
to ‘smooth profits’ in order to achieve results that various stakeholders wanted.

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 Criteria for Provision
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 (eg cash)

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1. Present obligation from a past event

This rule has two parts, first the type of obligation, and second, the requirement
for it to arise from a past event (ie something must already have happened to
create the obligation).

(a) Type of obligation

Obligation could be a legal one, arising from a court case or some kind of
contractual arrangement.

Alternatively, obligation could be constructive. This is where a company

establishes an expectation through an established course of past practice.

(b) Past event

The obligation needs to have arisen from a past event, rather than simply
something which may or may not arise in the future.
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 EXAMPLE

Rey Co has a published environmental policy. In this, Rey Co explains that they
always replant trees to counterbalance the environmental damage created by
their operations. Rey Co has a consistent history of honouring this policy. During
20X8, Rey Co opened a new factory, leading to some environmental damage.
Rey Co estimates that the associated tree planting and environmental clear up
costs will be $400,000.

 Even if the country that Rey Co operates in has no legal regulations forcing
them to replant trees, Rey Co will have a constructive obligation because it has
created an expectation from its publications, practice and history.

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 PROVISION:

IAS defines Provision as a liability which can be

measured only by using estimation.
RECOGNITION CRITERIA

PROVISION = + + +
Ability
Present obligation Outflow to
from Is measure
past event probable

Provisions are discounted to if effect is material.

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 Legal & Constructive Obligations
Legal obligation is one which derives either from:
 Terms of a contract
 Legislation; or
 Other operation of law

 Constructive obligation derives from an entity’s actions where:

 By established pattern of past practice, published policies, the entity has indicated
to other parties that it will accept certain responsibilities.

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PPR Analysis

Probable > 50% Chance of occurrence Provision

Possible <50% Chance of occurrence Contingent Liability

Remote Almost 0% Disclose CL or forget

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 CONTINGENT LIABILITY:

a) Possible obligation that arises from past event and existence of which will be confirmed only by
occurrence of one or more uncertain future events not wholly within control of enterprise
or

b) A present obligation that arises from past events but is not recognized because:
i) A reliable estimate of the amount of the obligation cannot be made.
ii) It is not probable that an outflow of resources (e.g. cash) will be required to settle obligation

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 Disclosures

For each class of provision, an entity shall disclose:

 (a) the carrying amount at the beginning and end of the period;

 (b) additional provisions made in the period

 (c) amounts used (i.e. incurred and charged against the provision) during the period;

 (d) unused amounts reversed during period; and

 (e) the increase during the period in the discounted amount arising from the passage
of time and the effect of any change in the discount rate.

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 CONTINGENT LIABILITY:

Future
Dependent
Possible event
upon a
obligation not
Contingent Liability = from past + +event
contingent
within
event control

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 CONTINGENT LIABILITIES (CL)

 An enterprise should not recognise a CL.

 A CL is disclosed, unless possibility of an outflow of resources is remote.

 Where an enterprise is jointly & severally liable for an obligation,

 The part of obligation that is expected to be met by other parties is treated as a CL.
 The remainder, being entity's share is recognised as provision, exception=no reliable estimate.

 Conduct a continuous review of CL.

Characteristics of an item that was originally reckoned as a CL may change over time. In turn, this
may lead to recognition of a provision, in line with recognition criteria.

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 CONTINGENT ASSET:

A possible asset arises from past events and existence of which is

dependent upon a contingent event.

Possible Dependent Future

Contingent = + asset
+ upon a event not
Asset from past contingent within
event event control

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 CONTINGENT ASSETS (CA)

 An enterprise should not recognise a CA. CA are not disclosed in financial statements.

 CAs usually arise from unexpected events that give rise to possibility of an inflow of economic
benefits.

 When realisation of income is virtually certain, then related asset is not a CA & its recognition is
appropriate.

 CAs are assessed continually & if it has become virtually certain that an inflow of economic
benefits will arise, the asset & the related income are recognised in F/Ss of period in which change
occurs.

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Accounting Treatment of Contingent Assets & Liabilities

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 DECISION TREE
Start

Present obligation as a result of an Possible

No Obligation ?
obligating event ?
No
Yes
Yes
Probable Remote ?
No Yes
outflow ?
Yes No

Reliable Disclose
No (rare)
estimate ? contingent
Do nothing
Yes
liability

Provide

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 EXAMPLES

WARRANTIES:
A manufacturer gives warranties at the time of sale to purchasers of its
product. Under terms of contract for sale manufacturer undertakes to
make good, repair or replacement, manufacturing defects that become
apparent within three years from the date of sale.
The obligating event is the sale of the product with a warranty

 Conclusion - A provision is recognized for the best estimate of the costs

of making good under the warranty products sold before the balance
sheet date

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 EXAMPLES

 REFUND POLICY:
A retail store has a policy of refunding purchases by dissatisfied customers, even
though it is under no legal obligation to do so. Its policy of making refunds is
generally known.

 The obligating event is the sale of the product.

 An outflow of resources in settlement - Probable, a proportion of goods are returned

for refund.

 Conclusion - A provision is recognized for the best estimate of the costs of refunds.

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 IAS-37 ILLUSTRATIVELY

Extract of the B.H.E.L Annual Report 2007-08

 Claims by / against the Company

(i) Claims for liquidated damages against the Company are recognized
(provided) in accounts based on management’s assessment of the
probable outcome with reference to the available information
supplemented by experience of similar transactions.

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 BHEL ANNUAL REPORT 2007-08

 Provision for Warranties

(i) For construction contracts entered into on or after 01.04.2003:

Provision for contractual obligation is maintained at 2.5% of contract value on completion of trial
operation.

(ii) For all other contracts:

Provision for contractual obligations in respect of contracts under warranty at the year end is
maintained at 2.5% of the value of contract. In the case of contracts for supply of more than a single
product 2.5% of the value of each completed product is provided.

(iii) Warranty claims/ expenses on rectification work are accounted for against natural heads as and
when incurred and changed to provisions in the year end.

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 Example

 Expected Values

 An entity sells goods with a warranty covering customers for the cost of repairs of any defects
that are discovered within the first two months after purchase. Past experience suggests that
88% of the goods sold will have no defects, 7% will have minor defects and 5% will have
major defects. If minor defects were detected in all products sold, the cost of repairs would be
Rs 24,000; if major defects were detected in all products sold, the cost would be Rs 200,000.

 Example 6
 A company requires a provision of Rs. 100,000 at the end of year 5. The discount rate is 8%.
 Required: You are required to calculate the amount of provision for each year.

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 Example

 On 14 June 20X5 a decision was made by the board of an entity to close down a
division. The decision was not communicated at that time to any of those affected and
no other steps were taken to implement the decision by the year end of 30 June
20X5. The division was closed in September 20X5.

 Should a provision be made at 30 June 20X5 for the cost of closing down the
division?

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