IAS-37 Provisions, Contingent

Assets & Liabilities

Chapter 15
Lecture by: Rafaqat Hasnat
 What is a “Provision”?

Provision is a liability of an uncertain timing or amount

Liability is a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of
resources embodying economic benefits

Accounting for Provison (uncertainty): Dr- Provision Expense (Profit/Loss

Ac)
Cr- Provisions (SFP)
 Recognition Criteria of a Provision

Provision

Present obligation as a
result of past event
Probable transfer/outflow
Measure the amount
of resources to settle the
reliably
obligation

If any one of the conditions is not met, no provision may be recognized.

1. Present obligation as a result of past event

Obligations as a result of events already occurred during the year, giving

rise to potential outflow of economic resources:
1. Legal/Contractual obligation- breaking a law
2. Constructive obligation- Demonstrable pattern of past practices has established an
expectation to perform the task

An obligation; not only an intention

The obligation is not avoidable
 Examples
1. A property lease includes that the premises are repainted after every
five years and the future cost is estimated at $100,000. How should this
be treated in the statements?
• Wrong approach: Spread the cost over five years and charging $20,000 annually;
No obligation to incur this cost until the end of fifth year, as it can be avoided by
selling the lease to someone else.
• IAS 37 requires the full cost to be recognized in the fifth year

2. A retail store has a generally known policy of refunding purchases by

dissatisfied customers, even though it is under no legal obligation to do
so. Should a provision be made at year end?
• A constructive obligation that fulfils the recognition criteria
 2. A reliable estimate can be made

Provision relates to one event:

• Estimate should be measured using the most likely outcome.
• E.g.: potential liability from a court case.

Provision relates to numerous events:

• Estimate should be measured using expected values.
• E.g.: to make repairs on goods within a year of sale.
 Example

Expected value of cost of repairs = 7% × $24,000 + 5% × $200,000

= $11,680
 Example

Best estimate of the liability is the most likely outcome, NOT the worst-case scenario

A provision for $400,000 is recognised

 3. Probable outflow of economic resources

Probable: >50% chance of outflow occurring;

If the likelihood of event is not probable (possible):
• No provision should be made; A contingent liability is recorded

As per IAS 37 Probable is defined as ‘more likely than not to occur’.

 Contingent Liability & Contingent Asset
Contingent Liability
(‘might be” a liability)

Present Obligation but

Possible Obligation (<50% chance)
 Existence will be confirmed after
the occurrence of an uncertain
future event (not in entity’s control)
Possible transfer of resources
OR Amount can’t be measured reliably
 Not probable that outflow of
resources will be required to settle

Contingent asset: Potential asset arising form past events, and whose existence will be
confirmed by the occurrence of an uncertain future event (not in entity’s control)
“Might be” a receivable
Both are disclosed as a note to the accounts only, no entry in financial statements
 Accounting for Contingent Assets& Liabilities

Contingent Liabilities:
Should not be recognised in the statement of financial position itself
Should be disclosed in a note unless the possibility of a transfer of economic benefits is remote.

Contingent Assets:
Should not generally be recognised, but if the possibility of inflows of economic benefits is
probable, they should be disclosed.
If a gain is virtually certain, it falls within the definition of an asset and should be recognised as
such, not as a contingent asset.
 Summary
Probability of Occurrence

0%

>50%

100% Liability
 Example

• It is unlikely that the company has a present obligation, therefore, no provision .

• There is, however, a contingent liability.

• Unless the possibility of a transfer of economic benefits is remote, the financial statements
should disclose the contingent liability (nature, estimate of its financial effect, indication of the
uncertainties relating to the amount or timing of any outflow).
Specific Provision Scenarios
 1. Warranty Provisions

Sale is a past event which give rise to a legal or constructive obligation to

repair/replace faulty goods.
Seller analyse past experience to estimate:
• The number of claims- keeping in consideration the improvement in manufacturing
techniques
• Cost of each repair- Increase in complexity of technology increases cost
Provision = Expected number of repairs × Expected cost of each repair
Provision should be reviewed at the end of each accounting period in the light of
further experience
 2. Guarantees
In some instances (particularly in groups) one company will make a guarantee
to another to pay off a loan, etc. if the other company is unable to do so.

Recognise as a provision- If it is probable that the payment will have to be

made: (in case of fin. difficulties/non repayment by co.A)
Otherwise, disclose as contingent liability.(if proper payments are made
on timely basis by Co.A)
Co.A

Guarantee on behalf of Co. A Co. B

Bank
 3. Future operating losses

An entity determines that it is probable that a segment of its operations will

incur future operating losses for several years.

No provision will be created:

• There is no past event that obliges the entity to pay out resources
• Losses can be avoided by selling the inefficient asset or closing the division that’s
making losses
 4. Onerous Contracts
An onerous contract 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.
Onerous Lease
When leased premises have become surplus to requirements but the lessee cannot
find anyone to sublet the premises to.
Signing of the lease is the past event giving rise to the obligation
Initial recognition: A provison is recognized in the period in which lease becomes
onerous in SPL at the lower of:
• Present value of continuing under the contract (payments less income generated)
• Present value of exiting the contract (exit fee to terminate the lease)

Subsequent measurement: Provision will be increased by the unwinding of the

discount (recognised as a finance charge) and reduced by the lease payments made.
Example
 5. Environmental Provision

A provision will be made for future environmental costs if there is either a

legal or constructive obligation to carry out the work
This will be discounted to present value at a pretax market rate.
Example
Solution
Solution (Cont’d)
 6. Restructuring Provisions
A restructuring is a program that is planned and controlled by management, and
materially changes the scope/geographical location of business or the manner in which
business is conducted.
A provision may be made if:
• A detailed, formal and approved plan exists, and
• The plan has been announced to those affected.

The provision should:

• Include direct expenditure arising from restructuring (redundancies, write-downs on property)
• Exclude costs associated with ongoing activities
• Exclude costs associated with future conduct of the business (retraining, reallocation staff,
marketing, investment in new systems)
Example