HKAS 37 Provisions,

Contingent Liabilities and

Contingent assets

Wiley text (Intermediate Accounting

IFRS edition): Chapter 13
Wiley text (Applying IFRS): Chapter 5

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 Contents
1. Introduction
2. Provisions
3. Contingent liabilities
4. Contingent assets

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1. Objective & Scope

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 1. Objective
• The objective of HKAS 37 is to ensure
that appropriate recognition criteria and
measurement bases are applied to
provisions, contingent liabilities and
contingent assets and that sufficient
information is disclosed in the notes to
the financial statements to enable users
to understand their nature, timing and
amount.

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 1. Scope
• all entities in accounting for provisions,
contingent liabilities and contingent
assets, except:
– those resulting from executory contracts,
except where the contract is onerous; and
– those covered by another Standard.
• not apply to financial instruments
(including guarantees) that are within the
scope of HKFRS 9 Financial Instruments.

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2. Provisions

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 2.1 Definition
• A provision is a liability of uncertain
timing or amount.

• A liability is a present obligation of the

enterprise arising from past events, the
settlement of which is expected to result
in an outflow from the enterprise of
resources embodying economic
benefits.

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 2.1 Definitions
• Creditors (trade payables) and accrued
expenses are not considered as “provisions”.

• The term "Provision" is also used in the

context of items such as depreciation and
doubtful debts
– these are contra accounts or adjustments to the
carrying amounts of assets;
– are NOT really provisions and do not fall into the
definition in HKAS 37

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 2.2 Recognition of provisions

Recognized when all of the 3 conditions are met:

a) An enterprise has a present obligation (legal
or constructive) as a result of a past event;

b) It is probable that an outflow of resources

embodying benefits will be required to settle
the obligation; and

c) A reliable estimate can be made of the amount

of the obligation.

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2.2(a) Present obligations as a result of a past event

• This condition: prevent recognition of future losses

and expenditure

An obligating event is an event that creates a legal or

constructive obligation that results in an enterprise
having no realistic alternative to settling that obligation.

 i.e. a past event that leads to a present obligation.

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2.2(a) Present obligations as a result of a past event

A legal obligation is an obligation that derives from:

a. a contract (through its explicit or implicit
terms);
b. legislation; or
c. other operation of law.

A constructive obligation is an obligation that derives

from an enterprise's actions where:
a. by an established pattern of past practice, published
policies or a sufficiently specific current statement, the
enterprise has indicated to other parties that it will
accept certain responsibilities; and
b. as a result, the enterprise has created a valid
expectation on the part of those other parties that it
will discharge those responsibilities.
e.g. a retailer offering a 14 days money back guarantee if the11
customer is not completely satisfied with the product.
2.2(b) Outflow of resources embodying economic benefits

 An outflow of resources is regarded as

probable if the event is ‘more likely than not to
occur’.

 I.e. the probability that the event will occur is

greater than the probability that it will not
(>50%).

 Where it is not probable that a present

obligation exists, an enterprise should
disclose contingent liability, unless the
possibility of an outflow of resources
embodying economic benefits is remote.
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2.2(c)Reliable estimate can be made

An enterprise :
 Make an estimate that is sufficiently reliable to
use in recognizing a provision

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 Accounting treatment for
provisions
• The provision will be recognized as a
liability:
Dr Expenses
Cr Provision for such item

Example: Warranties
Dr Warranties expense XXX
Cr Provision for warranties
XXX
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 2.3 Measurement of provisions

• The amount recognized as a provision

should be the best estimate of the
expenditure required to settle the
present obligation

• Assess the risk and uncertainties

• Sometimes require to discount the

provisions into present value

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 2.3 Measurement of provisions
Change in provisions
• Review at each reporting date and adjust
to reflect the current best estimate

Use of provisions (i.e. Dr. provision)

• Use only for expenditures for which the
provision was originally recognized

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 2.3 Measurement of provisions
Reimbursements from third parties:
• Where some or all of the expenditure required settling a
provision is expected to be reimbursed by another party,
the reimbursement shall be recognized 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 recognized 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 recognized for a reimbursement.
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 Example 1 – warranties
• ABC Ltd gives warranties at the time of sales to customers of
its Product X. Under the terms of the sales contract, ABC Ltd
undertakes to repair or replace product X for its
manufacturing defects within one year from the date of sale.
According to past experience and future expectation, the
claims for repair or replacement are as follows:

• Repair: 3% of the quantity sold

• Replacement: 1% of the quantity sold

• During the year ended 31 December Year 1, the company has

sold 100,000 units of product X. The costs of repairing and
replacing a Product X are $10 and $90 respectively. Goods
returned as faulty have no resale value.

Required:
Discuss the accounting treatment for the case. Journalize
the appropriate entry where applicable.
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 Example 1 - Answers
Present obligation as a result of a past
obligating event –The obligating event is the sale
of the product with a warranty, which gives rise
to a legal obligation.

An outflow of resources embodying economic

benefits in settlement - Probable for the
warranties as a whole.

A reliable estimate can be made: the best

estimate of provision should be:
100,000 x 3% x $10 + 100,000 x 1% x $90 = $120,000

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 Example 1 - answers

Journal entries:
Dr Warranty expenses 120,000
Cr Provision for warranty expenses 120,000

Conclusion: A provision of $120,000 is recognized

for the costs of making good under the warranty
products sold before the end of the reporting period
because all the conditions for provision recognition
are met.

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 Example 2 – Refunds policy

A retail store is well known for its policy to refund

the money paid by its dissatisfied customers. In
fact, it is not an obligation under the law.

Required:
•Discuss the accounting treatment for the case.
Journalize the appropriate entry where applicable.

(Adapted from HKAS 37 p.19-24)

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 Example 2 – Answers
Present obligation as a result of a past obligating event –
The obligating event is the sale of the product, which
gives rise to a constructive obligation because the
conduct of the store has created a valid expectation on the
part of its customers that the store will refund purchases.

An outflow of resources embodying economic benefits in

settlement - Probable, a proportion of goods are returned
for refund.

A reliable estimate can be made – Assumed.

Conclusion: A provision is recognized for the best

estimate of the costs of refunds.

Journal entries:
Dr Refund expenses xxx
Cr Provision for refund expenses xxx 22
2.4 Application of the recognition
and measurement rules
2.4.1 Future operating losses
• Provisions shall not be recognized.
• It does not meet the definition of a
liability and general recognition criteria
for a provision.

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2.4 Application of the recognition
and measurement rules
2.4.2 Onerous contracts
• A contract in which the unavoidable costs
of meeting the obligations under the
contract exceed the economic benefits
expected to be received under it.
• If an entity has a contract that is
onerous, the present obligation under the
contract shall be recognized and
measured as a provision.

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 Example 3a – An onerous contract
(Adapted from HKAS 37 p.19-24)

Four Ltd operates profitably from a factory

that it has leased under operating lease.
During December Year 1 the company
relocates its operation to a new factory in
Tai Po. The lease on the old factory
continues for the next four years, it cannot
be cancelled and the factory cannot be re-
let to another user.
Required: Explain whether a provision
should be made for Four Ltd.
Note:
An onerous contract is a contract in which the unavoidable costs
of meeting obligations under the contract exceed the economic
benefits expected to be received under it. 25
 Example 3a – Answers
Present obligation as a result of a past obligating
event – The obligating event is the signing of the
lease contract, which gives rise to a legal
obligation.

An outflow of resources embodying economic

benefits in settlement – When the lease becomes
onerous, an outflow of resources embodying
economic benefits is probable.

Reliable estimate: assumed

Conclusion: A provision is recognized for the best26

estimate of the unavoidable lease payments.
Example 3b (Adapted from HKAS 37 p.19-24)

• Same fact as example 3a except that the

old factory can be used as a temporary
godown generating a low level of
income.

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 Example 3b – Answers
Present obligation as a result of a past obligating
event – The obligating event is the signing of the lease
contract, which gives rise to a legal obligation.

An outflow of resources embodying economic

benefits in settlement – When the lease becomes
onerous, an outflow of resources embodying
economic benefits is probable.

Reliable estimate: assumed

Conclusion: A provision is recognized for the best

estimate of net amount of the unavoidable lease costs.
i.e. the unavoidable lease payments less the probable
net revenue expected from the godown operations. 28
2.4 Application of the recognition
and measurement rules
2.4.3 Restructuring costs
• A restructuring is a programme that is planned and
controlled by management and would materially
change either the scope of a business undertaken
by an enterprise or the manner in which that
business is conducted.
– E.g. sale or termination of a line of business; the
closure of business locations in a country or
region; the relocation of business activities from
one country or region to another or changes in
management structure

• Restructuring costs – recognised as a provision

only when the enterprise has (i) present obligation
as a result of past event; (ii) probable that an
outflow of resources embodying benefits will be
required to settle the obligation & (iii) a reliable 29
estimate can be made.
 2.5 Disclosure of Provision
For each class of provision, an enterprise should disclose:

a) the carrying amount at the beginning and end

of the period;
b) additional provisions made in the period,
including increases to existing provisions;
c) amounts used (i.e. incurred and charged
against the provision) during the period;
d) unused amounts reversed during the period;
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. Comparative information is not30
required;
 2.5 Disclosure of Provision

f) a brief description of the nature of the

obligation and the expected timing of may
resulting outflows of economic benefits;
g) an indication of the uncertainties about the
amount or timing of those outflows, where
necessary to provide adequate information, an
enterprise should disclose the major
assumptions made concerning future events;
and
h) the amount of any expected reimbursement,
stating the amount of any asset that has been
recognized for that expected reimbursement.
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3. Contingent liability

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 3.1 Definitions
A contingent liability is
a) a possible obligation 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 enterprise;
or

b) a present obligation that arises from past events but

is not recognized (unrecognized present obligation):
because:
i. it is not probable that an outflow of resources
embodying economic benefits will be required to
settle the obligation;
ii. or the amount of the obligation cannot be
measured with sufficient reliability.
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 Example 4 – A Court Case
(Adapted from HKAS 37 p.19-24)

After a party in Year 1, ten people died, possibly as a result

of food poisoning from food provided sold by a restaurant.
Legal proceedings are started seeking damages from the
restaurant.

Up to the date of authorization of the financial statements

for the year to 31 December Year 1 for issue, the
restaurant’s lawyers advise that it is probable that the
restaurant will not be found liable.

However, when the restaurant prepares the financial

statements for the year to 31 December Year 2, its lawyers
advise that, owing to developments in the case, it is
probable that the restaurant will be found liable.

Required: Explain whether a provision should be made for

the restaurant at end of (a) Year 1 and (b) Year 2.
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 Example 4(a) - Answers
At 31 December Year 1
Present obligation as a result of a past obligation
event - Given the evidence that it is probable that the
restaurant will not be found liable when the financial
statements were approved, there is no obligation as a
result of past events.

An outflow of resources embodying economic

benefits in settlement - At 31 December Year 1, it is not
probable that an outflow of resources embodying
economic benefits will be required to settle the
obligation.

Conclusion: No provision is recognized because no

outflow of resources is probable at 31 December Year 1.
The matter is disclosed as a contingent liability unless
the probability of any outflow is regarded as remote.
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 Example 4(b) – Answers
At 31 December Year 2
Present obligation as a result of a past obligating
event - there is a present obligation

An outflow of resources embodying economic

benefits in settlement - At 31 December Year 2, it
is probable that an outflow of resources
embodying economic benefits will be required to
settle the obligation.

A reliable estimate can be made – Assumed.

Conclusion: A provision is recognized for the

best estimate of the amount to settle the
obligation. 36
3.2 Recognition - Contingent liabilities

• An enterprise should not recognize the

contingent liability.

• A contingent liability is disclosed (i.e. no

journal entries but disclose it in the
notes to financial statements) unless the
possibility of an outflow of resources
embodying economic benefits is remote.

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 3.3 Disclosure of Contingent Liability

Unless the possibility of any outflow is

remote, need to disclose:

• The nature of the contingent liability and;

where applicable
• An estimate of its financial effect;
• An indication of the uncertainties relating
to the amount or timing of any outflow;
• The possibility of any reimbursement.

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3.4 Provisions Vs Contingent liabilities
(HKAS 37, appendix B)

Start

Present
No Possible No
obligation as
obligatio
a result of
n?
past event?
Yes Yes
Probable No Outflow of Yes
outflow of resource -
resources? remote?
Yes
No
Reliable No (rare)
estimate?
Yes
Provision is Disclose contingent 39
Do nothing
required liability
4. Contingent asset

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 4.1 Definition
• A contingent asset 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 control of the entity.

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 4.2-3 Recognition & Disclosure
• An enterprise should not recognize a contingent
asset.
• Contingent assets are not recognized in financial
statements since this may result in the recognition
of income that may never be realized.

• Usually no disclosure is required for contingent

asset;

• But where an inflow of economic benefits is

probable, a contingent asset is disclosed. (para 35
of HKAS 37)

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4.3 Disclosure – contingent asset

If the inflow of economic benefits is

probable, an entity shall disclose:
• A brief description of the nature of the
contingent assets at the end of the
reporting period, and
• Where practicable, an estimate of their
financial effect.

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 Example 5
“An example of a contingent asset would be
possible receipt of damages arising from a
court case which at the end of the reporting
period, has been decided in favour of the entity.
The hearing to determine damages, however,
will be held after the reporting period.

The outcome of the hearing to determine

damages is outside the control of the entity but
the receipt of damages is probable because the
case has been decided in the entity’s favour.

(Quoted from Picker, Clark, Dunn, Kolitz, Livne, Loftus, Van der Tas,
Applying IFRS Standards 4E p.111)

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 Example 5
The assets from the case meet the definition of
the contingent asset because it is possible
that the entity will receive the damages and
the hearing is outside its control.

The contingent asset is disclosed because it is

probable that the damages will flow to the
entity.”

(Quoted from Picker, Clark, Dunn, Kolitz, Livne, Loftus, Van der Tas, Applying
IFRS Standards 4E p.111)

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Contingent Assets – summary

Where, as a result of past events, there is a possible asset

whose existence will be confirmed only by the occurrence or
non-occurrence of one or more uncertain future events not only
within the control of the enterprise, and
the inflow of the inflow of the inflow is not
economic benefits economic benefits is probable,
is virtually certain probable, but not
virtually certain,
the asset is not no asset is no asset is
contingent. recognized; and recognized; and
disclosures are no disclosure is
required. required.

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