Workbook on IAS 37 Provisions
Background
Provisions are used to provide for future liabilities that are uncertain. Provisions are sometimes mis-used for ‘profit smoothing’ by inflating provisions to reduce profits in good years, then releasing those provisions to increase profits in the bad years.
Provisions for reorganisation have also been misused particularly those arising through mergers.
IAS 37 is a short standard, but its intention is to limit provisions to the specific underlying liabilities.
Contingent liabilities, such as guarantees and warrantees, do not appear on balance sheets, but need to be noted in financial statements to enable users to have a complete picture of the undertaking’s financial position.
Contingent assets are uncertain cash inflows that may be received. IAS 37 defines them, and prescribes their reporting treatment.
Scope
IAS 37 should be applied by all undertakings in accounting for provisions, contingent liabilities and contingent assets, except:
i those resulting from financial instruments, that are carried at fair value;
ii those arising in insurance undertakings from contracts with policyholders (IFRS 4); and
iii those covered by another Standard.
Where another Standard deals with a specific type of provision, contingent liability or contingent asset, an undertaking applies that Standard instead of IAS 37.
For example, certain types of provisions are also addressed in Standards on:
i construction contracts see IAS 11 Construction Contracts;
ii income taxes see IAS 12 Income Taxes;
iii leases see IFRS 16 Leases (although onerous operating leases are covered by IAS 37);
iv staff benefits: see IAS 19 Staff Benefits;
(v) insurance contracts (see IFRS 4 Insurance Contracts). However, IAS 37 applies to provisions, contingent liabilities and contingentassets of an insurer, other than those arising from its contractual obligations and rights under insurance contracts within the scope of IFRS 4; and
(vi) contingent consideration of an acquirer in a business combination (see IFRS 3 Business Combinations).
Some amounts treated as provisions may relate to the recognition of revenue, covered in IAS 18, for example where a bank gives guarantees in exchange for a fee.
The term ‘provision’ is also used for items such as depreciation, impairment of assets and doubtful debts: these are adjustments to the carrying amounts of assets, and are not addressed in IAS 37.
IAS 37 applies to provisions for restructuring including discontinuing operations. Discontinuing operations are covered by IFRS 5.
IAS 37 applies to:
- financial instruments and guarantees that are not carried at fair value.
- provisions, contingent liabilities and contingent assets of insurance undertakings other than those arising from contracts with policyholders.
Provisions and Other Liabilities
Provisions can be distinguished from other liabilities such as trade payables and accruals because there is uncertainty about the timing or amount of the expenditure. By contrast:
i trade payables are liabilities to pay for goods or services that have been received, and have been invoiced by the supplier; and
ii accruals are liabilities to pay for goods or services that have been received but have not been paid, 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 much less than for provisions.
Accruals are often reported as part of trade and other payables, whereas provisions are reported separately.
| EXAMPLE – Provisions versus accruals and other liabilities Issue Provisions are liabilities of uncertain timing or amount. Accruals, in contrast, 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. The following table identifies the types of liabilities that are usually presented as provisions and those that are presented as other liabilities. |
| Nature of the obligation | Provision | Other liabilities | Comments |
| Warranties given for goods or services sold | X | ||
| Refunds given for goods sold | X | ||
| Discounts given for customer loyalty schemes, such as frequent flyer programmes | X | ||
| Payments for damages connected with legal cases that are probable. | X | ||
| Dilapidations payable at the end of an operating lease | X | ||
| Interest payments | X | Accrual - the service has been received and the timing and amount of payment is known. | |
| Holiday pay earned by employees | X | Short-term compensated absences are recognised in accordance with IAS 19. | |
| Property rentals | X | Accrual - the service has been received and the timing and amount of payment is known. | |
| Ordinary dividend declared before year-end | X | Recognise as a current financial liability |
| EXAMPLE –Recognition of liability for purchase orders Issue A liability qualifies for recognition when there is a present obligation and there is the probability of an outflow of resources embodying economic benefits to settle that obligation. Should management recognise a liability following the placement of an order for goods or services? Background The management of Bank P has placed two separate orders for 100 units each of components A and B. Both types of component are specific to P’s processes and are not widely used by other entities. The terms of both of the contracts are such that once the goods are manufactured, the manufacturer will notify P, which must arrange for the goods to be collected from the supplier’s premises. P is obliged to accept the goods once it has been notified that the goods have been manufactured, or pay a substantial penalty if P’s management decide to cancel the contract. At the balance sheet date, the supplier has manufactured all 100 of the units of A. The supplier has notified P that the components are ready for collection but P has not yet arranged for collection. None of the units of B have been manufactured. Bank P’s management expects to take delivery of all components of A and B that have been ordered. Solution Yes, a liability for the purchase of component A should be recognised. No liability should be recognised in respect of the purchase of component B. |
Provisions – when and how they should be recorded
A provision should be recorded only when:
i an undertaking has a present obligation, legal or constructive, as a result of a past event;
ii it is probable that a payment will be required to settle the obligation; and
iii a reliable estimate can be made of the amount of the obligation.
A constructive obligation is an obligation where:
i by past practice, policies or statements, the undertaking has indicated that it will accept certain responsibilities; and
ii. as a result, the undertaking has created an expectation that it will discharge those responsibilities.
EXAMPLE – constructive obligation
You have a written policy to meet the highest standards of health and safety, even if this is more than the law requires. This is a constructive obligation.
In a lawsuit, it may not be clear if an undertaking has a present obligation.
If money is likely to be owed, there is a present obligation. If it cannot be quantified, a contingent liability is recorded. If the possibility of a penalty is remote, nothing is recorded.
The amount recorded as a provision should be the best estimate of the expenditure required to settle the obligation at the balance sheet date, or to transfer it to a third party at that time.
| EXAMPLE – cost of transfer of a liability to a third party You will have a liability for trademark infringements from a court case that is still in progress at the balance sheet date. Nobody knows how much you will have to pay. An insurance company offers to settle your case for $10 million. This amount can be used as your provision, if no better estimate is available. |
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| I/B | DR | CR |
| Trademark infringements | I | 10m |
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| Provision | B |
| 10m |
| Recording provision |
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PROVISION – Measurement
In measuring a provision:
i take risks and uncertainties into account. However, uncertainty does not justify the creation of excessive provisions, nor a deliberate overstatement of liabilities;
ii discount the provisions, where the impact of the time value of money is material, using a pre-tax discount rate. Where discounting is used, the increase in the provision due to the passage of time is recorded as an interest expense.
iii take future events, such as changes in the law and technology, into account, where there is evidence that they will occur; and
iv do not take gains from the disposal of assets into account, even if the expected disposal is closely linked to the event giving rise to the provision.
Provisions should be reviewed at each balance sheet date, and adjusted to reflect the current best estimate.
If it is no longer probable that payment will be required to settle the obligation, the provision should be reversed.
| EXAMPLE – provisions no longer required You have made a $1 million provision for redundancies. You then purchase another firm which has vacancies that your staff would like to fill. You reverse the $1 million provision. |
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| I/B | DR | CR |
| Redundancy costs | I |
| 1m |
| Provision | B | 1m |
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| Reversing provision |
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A provision should be used only for expenditures for which the provision was originally recorded.
Setting expenditures against an unrelated provision would conceal the impact of two different events.
| EXAMPLE – provisions to be used only for original purpose You have a provision for $4 million for trademark infringements, which you no longer need. You decide to reorganise the group and need a provision for $3 million. This should be a separate provision, and you should not use the surplus trademark infringements provision for reorganisation. |
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| I/B | DR | CR |
| Reorganisation costs | I | 3m |
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| Provision | B |
| 3m |
| Recording provision |
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| Trademark infringements | I |
| 4m |
| Provision | B | 4m |
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| Reversing provision |
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Specific cases of provisions are provided with interpretations by the IASB:
IFRIC Interpretation 1: Changes in Existing Decommissioning, Restoration and Similar Liabilities
IFRIC Interpretation 5: Rights to Interests arising from Decommissioning, Restoration and Environmental Rehabilitation Funds
IFRIC Interpretation 6: Liabilities arising from Participating in a Specific Market—Waste Electrical and Electronic Equipment
Provisions – Specific applications: Future Operating Losses
Provisions should not be recorded for future operating losses. Future operating losses do not meet the definition of a liability, and the criteria set out for provisions.
Anticipation of future operating losses is an indication that certain assets may be impaired under IAS 36 Impairment of Assets.
Please see also Onerous Contracts in the Annex.
Restructuring
A restructuring is a programme that is planned and controlled by management, and significantly changes either the scope of a business or the manner in which that business is conducted.
| EXAMPLE – reduced scope of a business Your business encompasses head office and branches. You decide to dispose of the branches at a net cost of $10m. This reduces the scope of your business. |
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| I/B | DR | CR |
| Restructuring costs | I | 10m |
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| Provision | B |
| 10m |
| Recording provision |
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| EXAMPLE – change of manner in which business is conducted You own and manage a network of branches. You sell the ownership of the property of the branches to property investors but continue to manage them through management contracts with the new owners. Restructuring costs of 1 mln are incurred in legal costs of selling the branches.
This changes the manner in which business is conducted. |
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| I/B | DR | CR |
| Restructuring costs | I | 1m |
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| Provision | B |
| 1m |
| Recording provision |
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The following are examples of events that may fall under the definition of restructuring:
i sale, or termination, of a line of business;
ii the closure of business locations in a country or region, or the relocation of business activities from one country or region to another;
iii changes in management structure; and
iv fundamental reorganisations that have a material impact on the nature and focus of operations.
A provision for restructuring costs is recorded only when the criteria for provisions met.
A constructive obligation to restructure arises only when an undertaking:
1. has a detailed formal plan for the restructuring identifying at least:
i the business, or part of a business concerned;
ii the principal locations affected;
iii the location, function, and approximate number of employees who will be compensated for terminating their services;
iv the expenditures that will be undertaken;
v when the plan will be implemented;
2 has raised a expectation that it will carry out the restructuring, by starting to implement that plan, or announcing its main features.
Evidence that an undertaking has started to implement a restructuring plan would be provided:
- by dismantling buildings or plant,
- selling assets, or by
- the announcement of the main features of the plan.
An announcement of a detailed plan constitutes a constructive obligation to restructure, only if it gives rise to expectations that the undertaking will carry out the restructuring.
Its implementation needs to be planned to begin as soon as possible, and to be completed in a timeframe that makes significant changes to the plan unlikely.
If it is expected that there will be a long delay before the restructuring begins, or that the restructuring will take an unreasonably long time, the timeframe allows for opportunities to change plans.
A management decision to restructure, taken before the balance sheet date, does not give rise to a constructive obligation at the balance sheet date, unless the undertaking has, before the balance sheet date:
i started to implement the restructuring plan; or
ii announced the main features of the plan that the undertaking will carry out.
In some cases, an undertaking starts to implement a restructuring plan, or announces its main features to those affected, only after the balance sheet date.
EXAMPLE – constructive obligation
In December, your board decided to close your book distribution division.
In January, the plans were announced to the staff concerned.
No provision should be made in the December accounts, as no start had been made at the balance sheet date, nor had any announcement been made. Disclosure may be required under IAS 10 Events After the Balance Sheet Date.
Although a constructive obligation is not created solely by a management decision, an obligation may result from other earlier events together with such a decision.
EXAMPLE – constructive obligation
Negotiations with staff representatives for termination payments may have been concluded, subject only to board approval. Only when approval has been obtained and communicated to the other parties, is there a constructive obligation to restructure.
No obligation arises for the sale of an operation until there is a binding agreement to the sale.
Even when an undertaking has taken a decision to sell an operation and announced that decision publicly, it cannot be committed to the sale until a purchaser has been identified and there is a binding agreement.
When the sale of an operation is envisaged as part of a restructuring, the assets of the operation are reviewed for impairment under IAS 36, Impairment of Assets.
A restructuring provision should include only the direct expenditures arising from the restructuring, which are those that are both necessitated by the restructuring and not associated with the ongoing activities of the undertaking.
A restructuring provision does not include such costs as:
i retraining, or relocating continuing staff;
ii marketing; or
iii investment in new systems and distribution networks.
| EXAMPLE – restructuring provision Your credit card business is losing money. You reorganise it, making redundancies at a cost of $12 million.
You also spend $2 million on retraining, $3 million on new equipment, and will suffer another $1 million of trading losses before the business breaks even.
The restructuring provision will be limited to the $12 million.
The costs of retraining, new equipment and the future trading losses must be expensed when incurred. |
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| I/B | DR | CR |
| Restructuring costs | I | 12m |
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| Provision | B |
| 12m |
| Recording provision |
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The other expenditures relate to the future of the business, and are not liabilities at the balance sheet date.
Such expenditures are recorded on the same basis as if they arose independently of a restructuring.
Identifiable future operating losses up to the date of a restructuring are not included in a provision, unless they relate to an onerous contract.
Gains on the expected disposal of assets are not taken into account in measuring a restructuring provision, even if the sale of assets is envisaged as part of the restructuring.
| EXAMPLE -Recognition of a liability for expenditure that is contingent on a future event Issue An obligating event is one that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation. Should management recognise a liability for expenditure that depends on future events? Background A bank intends to alter the terms and conditions of employment at one branch so that overtime will be paid at one-and-a-half times the normal rate, rather than twice the normal rate, as in the past. The bank intends to compensate staff in advance with a one-off payment and has put this offer to the union. No agreement has been reached with the union at year-end. The bank is likely to switch overtime work to other branch if the union does not accept the offer. Solution No, there is no liability at year-end because there is no constructive or legal obligation to pay the one-off payment. Management has commenced negotiations with unions but as yet no agreement has been reached that would raise a valid expectation with staff. The entity could avoid the payment by using the staff at other plants to carry out overtime. |
IFRS 3 Business Combinations has rules determining the use of provisions when one undertaking buys another.
| EXAMPLE – Costs to be included in a restructuring provision Issue A restructuring provision should include only the direct expenditures arising from the restructuring, being those that are both: i) necessarily entailed by the restructuring; and ii) not associated with the bank’s ongoing activities. The following table distinguishes between costs that should be included and excluded from a restructuring provision. |
| Description of costs | Included | Excluded | Reason for exclusion |
| Voluntary redundancies | X | ||
| Compulsory redundancies, if the target for voluntary redundancies are not met | X | ||
| Lease cancellation fees for a building which will no longer be used | X | ||
| Relocation of employees and equipment from a building (to be closed) to a building which will continue to be used | X | Costs associated with ongoing activities | |
| Retraining of remaining employees | X | Costs associated with ongoing activities | |
| Recruitment costs for a new manager | X | Costs associated with ongoing activities | |
| Marketing costs to develop new corporate image | X | Costs associated with ongoing activities | |
| Investments in a new distribution network | X | Costs associated with ongoing activities | |
| Future identifiable operating losses up to date of a restructuring | X | Costs associated with ongoing activities | |
| Impairment write-down of certain property, plant and equipment | X | The impairment provision should be assessed in accordance with IAS 36 and offset against the asset | |
| Rental costs under the lease contract for the period after the criteria in IAS 37 were met but before operation ceased | X | Operations is continued to be used | |
| Incremental increase in those costs related to claims for injuries and illnesses for staff who will be terminated, occurring prior to satisfying the criteria in IAS 37. | X | ||
| Costs to be incurred in respect of claims for injuries and illnesses occurring while the restructuring is being implemented | X | Costs associated with ongoing activities | |
| Consulting fees to identify future corporate strategies and organisational structures | X | Costs associated with ongoing activities | |
| Costs of relocating inventory and equipment that will be used at another location | X | Costs associated with ongoing activities |
Recognition of Provisions
A provision should be recorded when:
i an undertaking has a present obligation: legal, or constructive;
ii it is probable that payment will be required;
iii an estimate can be made of the obligation.
If these conditions are not met, no provision should be recorded.
Present Obligation
It will normally be clear whether a past event has given rise to a present obligation.
In a lawsuit, it may be disputed either whether events have occurred, or whether those events result in a present obligation. An undertaking determines whether a present obligation exists, at the balance sheet date, by taking account of all evidence, including the opinion of experts.
The evidence includes any extra evidence provided by events after the balance sheet date. On the basis of such evidence:
i where it is likely that a present obligation exists at the balance sheet date, the undertaking records a provision if the criteria are met;
ii where it is likely that no present obligation exists, at the balance sheet date, the undertaking discloses a contingent liability, unless the possibility of payment is remote.
| EXAMPLE -Mandatory renovation in an operating lease Issue A provision should be recognised when: i) an entity has a present obligation as a result of a past event; ii) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and iii) a reliable estimate can be made of the amount of the obligation. Should management recognise a provision for expenditure to be made to restore leased property to its original condition at the end of the lease term? Background Bank T, leases several branches for a period of 10 years with options to extend the lease contracts. The lease contracts specify that T has the obligation to restore the branches to the original condition at the end of the lease terms, even if the lease is terminated early. The restoration to the original condition means that T will have to repair all damages and put back any alteration made to the premises. If management of Bank T does not restore the branches, it will have to pay a penalty calculated as a reasonable amount required by third parties to restore the stores to their original condition. Management of T is not sure whether it will extend the lease contract after 10 years. Solution Management of T should recognise a provision when damage occurs to the branch, or when an alteration is made to the premises. That is the moment when the obligation arises, because the repairs are due. There is no present obligation at inception of the lease to make any expenditure, independent of management’s future actions. There is a probability that management will have to make expenditure regarding the restoration for any normal damages that may occur, but the expenditure is not due at the moment of entering the lease agreement. |
Past Event
An event that leads to an obligation to pay money is called an obligating event. For an obligating event, the undertaking must have no alternative to settling the obligation. This is the case only:
i where the settlement can be enforced by law; or
ii in the case of a constructive obligation, where the event creates expectations that the undertaking will pay.
Financial statements deal with the financial position at the end of a reporting period, and not its possible position in the future. No provision is recorded for costs that need to be incurred to operate in the future. The only liabilities recorded are those that exist at the balance sheet date.
| EXAMPLE - liabilities that exist at the balance sheet date You have been sued for $25 million for uncompetitive behaviour, and you believe that you will have to pay this amount in full. You will also have to pay $10 million to retrain staff, and buy new machines, to avoid incurring further legal action. Only the $25 million should be included in your provision, as the $10 million relates to future operating costs. |
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| I/B | DR | CR |
| Uncompetitive behaviour | I | 25m |
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| Provision | B |
| 25m |
| Recording provision |
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Only those obligations arising from past events, existing independently of an undertaking’s future actions (i.e. the future conduct of its business) are recorded as provisions.
EXAMPLE - obligation arising from past events
You buy a competitor, and plan to open 24 more branches. No provision is made for these new branches, as there is no obligation arising from past events.
Examples of such obligations are penalties, or clean-up costs, for environmental damage, both of which would lead to payment, regardless of the future actions of the undertaking (see Annex).
Future operating expenditure is not an obligation. It should be accounted for in future periods.
| EXAMPLE - no present obligation for future expenditure You have been told that new regulations will require you to install a sprinkler system in your office, in the next period.
You should record the expenditure when it is incurred, not make a provision in advance. |
| EXAMPLE -Recognition of liability for future maintenance costs
Issue A liability is defined as a bank’s present obligation arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. A past event that leads to a present obligation is called an obligating event. An obligating event creates a legal or constructive obligation. Should management recognise a liability for future maintenance costs? Background Management is planning a maintenance programme at one of the entity’s older offices in a years’ time. The cost is estimated at 100,000. Solution No, there is no obligating event. The intention to incur maintenance expenditure does not create a constructive or legal obligation. No liability should be recognised. |
It is not necessary, however, to know the identity of the party to whom the obligation is owed - the obligation may be to the general public.
Where the provision being measured involves a large population of items, the obligation is their ‘expected value’.
The provision will be different, depending on the probability of loss. Where there is a range of possible outcomes, and each point in that range is as likely as any other, the mid-point of the range is used.
Where a single obligation is being measured, the most likely outcome may be the best estimate of the liability.
The provision is measured before tax.
Where no reliable estimate can be made, a liability exists that cannot be recorded. That liability is disclosed as a contingent liability.
Risks and Uncertainties
Risks and uncertainties should be taken into account in making the estimate of a provision.
Risk describes variability of outcome. A risk adjustment may increase the amount at which a liability is measured. Caution is needed, so that income or assets is not overstated, and expenses or liabilities are not understated.
Uncertainty does not justify the creation of excessive provisions, nor a deliberate overstatement of liabilities.
Present Value
Where the effect of the time value of money is material the provision should be discounted using a pre-tax rate discount rate should that reflects current market assessments.
| EXAMPLE - Accretion of discount Issue The carrying amount of a provision recognised on a discounted basis increases in each period to reflect the passage of time. The increase should be recognised as a borrowing cost. How should management calculate the amount of borrowing costs recognised on the unwinding of a discount? Background T has litigation pending. Legal advice is that T will lose the case, and costs of 1,200 in two years’ time are estimated. The liability is recognised on a discounted basis. The appropriate discount rate is 4.5 %. Solution |
| Management should initially recognise a provision for 1,099, being the present value of 1,200 discounted at 4.5% for two years. At the end of year 1, the provision will increase to 1,148 as management discounts the cash outflow of 1,200 for one year instead of two. The increment of 49 should be recognised as a borrowing cost in the income statement. Similarly in year 2, the provision will increase by 52 to equal the amount due. |
| EXAMPLE - Change in discount rate Issue Provisions should be reviewed at each balance sheet date and adjusted to reflect the best estimate. Where discounting is used, a provision's carrying amount increases in each period to reflect the passage of time. This increase is recognised as a borrowing cost. How should management calculate the borrowing cost when the discount rate changes from one period to the next? Background A bank has an obligation to a third party for 1,000. The obligation is due at the end of year 5. The nominal risk-free pre-tax rate is 4.5%. At the end of year 3, the discount rate changed to 4%. Solution At the beginning of year 0, management should recognise an obligation of 802, which is the present value of 1,000 due at the end of year 5, discounted by 4.5%. At the end of year 3 the obligation that is recognised at 916 needs to increase to 925 to take account of the change in the discount rate The difference of 9 should be recognised in the income statement as a borrowing cost. |
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | ||
| Original discount rate | 4.50% | 802 | 839 | 876 | 916 | 957 | 1,000 |
| Revised discount rate | 4.00% | 925 | 962 | 1,000 | |||
| Original borrowing costs | 37 | 37 | 40 | 41 | 43 | ||
| Adjustment to provision | 9 | -4 | -5 | ||||
| Revised borrowing costs | 37 | 37 | 49 | 37 | 38 |
Future Events
Future events that may affect the amount of an obligation should be reflected in the amount of a provision, where there is evidence that they will occur.
It is appropriate to include expected cost reductions associated with increased experience.
An undertaking does not anticipate the development of a completely new technology unless it is supported by objective evidence.
The effect of possible legislation is taken into consideration in measuring an existing obligation, when the legislation is virtually certain to be enacted.
Expected Disposal of Assets
Gains on the expected disposal of assets are not taken into account in measuring a provision.
Gains on expected disposals of assets are recorded as specified by the Standard dealing with the assets concerned.
Contingent Liabilities
A contingent liability is:
i a possible obligation that arises from past events, and whose existence will be confirmed by the occurrence, or non-occurrence, of uncertain future events;
EXAMPLE - Uncertainty
You have given a performance guarantee, relating to your agent, that services will be successfully supplied to his client, for one year.
Whilst you hope that there will be no claim against you, there is a risk that your agent will not perform satisfactorily, and a claim will be made.
You will not know until either a claim is made or a year has elapsed. This will create a contingent liability based on the risk assessment.
or
ii a present obligation that arises from past events, but is not recorded because:
i it is not probable that payment will be required to settle the obligation; or
ii the amount of the obligation cannot be measured.
EXAMPLE - Uncertainty
You are being sued for $30 million for damages that it is claimed were caused by your work on a client’s stock exchange listing. You dispute the claim. It is unclear whether or not you will be liable. If you are found liable, it is unlikely that you would have to pay the claim in full.
The uncertainties make the claim a contingent liability.
You should not record a contingent liability in the balance sheet. You should disclose a contingent liability in the notes. If the possibility of payment is remote, no disclosure is necessary.
EXAMPLE - possibility of payment is remote
Every year for the last 5 years, the government has said that it will levy a ‘windfall’ tax on banks. It has yet to do so. Unless the government takes further steps to enact the tax collection, no contingent liability should be recorded, based on the anticipation that the government is unlikely to act.
Relationship between Provisions and Contingent Liabilities
All provisions are contingent, as they are uncertain in timing or amount.
Here, the term ‘contingent’ is used for liabilities, and assets, that are not recorded in the balance sheet, as their existence will be confirmed only by the occurrence or non-occurrence of uncertain future events.
In addition, the term ‘contingent liability’ is used for liabilities that do not meet the recognition criteria.
IAS 37 distinguishes between:
i provisions - which are recorded as liabilities because they are present obligations, and it is probable that payment will be made to settle them
ii contingent liabilities - which are not recorded on the balance sheet as liabilities, as they are either:
i possible obligations, as it has yet to be confirmed whether there is an obligation; or
ii obligations that do not meet the criteria in IAS 37 as either it is not probable that payment will be required, or an estimate of the obligation cannot be made.
Contingent liabilities are assessed continually to determine whether settlement has become probable. If it becomes probable that payment will be required for an item previously dealt with as a contingent liability, a provision is recorded in the financial statements of the period in which the change in probability occurs.
EXAMPLE contingent liability which becomes a provision
You are being sued for $40 million for uncompetitive behaviour. In 2XX8, you recognise a contingent liability, as you believe that the there is only a remote chance that you will have to pay.
In 2XX9, the court decides the case against you, and the $40 million is changed to a provision.
Joint and Several Liability
Where an undertaking is jointly, and severally, liable for an obligation, the part of the obligation that will be met by other parties is treated as a contingent liability. The undertaking records a provision for the obligation net of contributions by others for which payment is probable.
EXAMPLE – joint and several liability
You and your partners are jointly and severally liable for $50 million of damages resulting from work involved in a client’s stock exchange listing. The case has been brought against you, but your partners will reimburse you for $30 million.
You make a provision for $20 million, and a contingent liability for $30 million.
The contingent liability recognises that your partners may not pay, and you will be liable for the total claim.
The other party may either reimburse amounts paid by the undertaking, or pay the amounts directly.
In most cases, the undertaking will remain liable for the whole of the amount, so that the undertaking would have to pay the full amount, if the third party failed to pay.
A provision is recorded for the full amount of the liability, and a separate asset for the reimbursement is recorded when it is virtually certain that reimbursement will be received.
The undertaking may not be liable for the costs in question, if the third party fails to pay. In such a case, the undertaking has no liability for those costs, and they are not included in the provision.
Contingent Assets
Contingent assets arise from unplanned events that give rise to the possibility of an inflow of benefits. A contingent asset is disclosed where an inflow of benefits is probable.
An example is a claim being pursued through legal processes, where the outcome is uncertain but likely to be in your favour.
Contingent assets are recorded off balance sheet as the income that may never be realised.
EXAMPLE – contingent asset
You have made a claim for $50 million compensation against your insurance company. The claim has gone to court. Similar claims against the same company have also gone to court, and then been paid.
Treat this as a contingent asset.
When the realisation of income is virtually certain, the related asset is not a contingent asset, and income should be recorded.
| EXAMPLE – compensation treated as income Your claim for $50 million compensation against your insurance company has been successful. The company has asked for a month to pay, but you do not believe there is any serious risk of a bad debt. Treat this as income. |
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| I/B | DR | CR |
| Accounts receivable | B | 50m |
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| Other income | I |
| 50m |
| Recognition of income |
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Reimbursements
Reimbursement of the expenditure required to settle a provision may arise from insurance contracts, indemnity clauses, or suppliers’ warranties. An undertaking should:
i record a reimbursement only when it is virtually certain that reimbursement will be made. The amount recorded for the reimbursement should not exceed the amount of the provision;
| EXAMPLE –reimbursement -1 In 2XX5, the local government informs you that a new road will be built in 2XX7. This will cause the destruction of your head office. Assets of $5 million will have to be written off. By the end of 2XX5, no compensation has been agreed. In 2XX5, a provision should be made. In 2XX6, the government agreed to pay $4 million in compensation. The compensation should be recognised in 2XX6. |
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| I/B | DR | CR |
| Asset sequestration | I | 5m |
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| Provision | B |
| 5m |
| Recording provision in 2XX5 |
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| Accounts receivable | B | 4m |
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| Compensation | I |
| 4m |
| Recording compensation in 2XX6 |
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and
- record the reimbursement as a separate asset. In the income statement, the expense relating to a provision may be presented net of the amount recorded for a reimbursement.
| EXAMPLE –reimbursement -2 In 2XX5, the local government informs you that a new road will be built in 2XX7. This will cause the destruction of your head office. Assets of $5 million will have to be written off. By the end of 2XX5, the government agreed to pay $4 million in compensation. In 2XX5, a provision and the compensation should be recorded. The income statement should reflect the provision, net of compensation of $1 million. |
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| I/B | DR | CR |
| Asset sequestration Net | I | 1m |
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| Provision | B |
| 5m |
| Accounts receivable | B | 4m |
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| Recording provision and compensation in 2XX5 |
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| EXAMPLE –Potential insurance recovery Issue 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 the entity’s control. Contingent assets are disclosed where an inflow of economic benefits is probable. When should management recognise income for a potential insurance recovery? Background A fire destroyed T’s branch. T is insured for the replacement cost of the fixed assets and business interruption. However, the potential recovery from the insurance entity depends on the outcome of an investigation project that relates to the cause of the fire. Recent updates of the investigation report show that it is more likely than not that T’s insurance claim will be successful. Solution The potential insurance recovery meets the definition of a contingent asset, and should be disclosed as such in T’s financial statements. Contingent assets are not recognised, since this may result in the recognition of income that may never be realised. When the realisation of income becomes virtually certain, then the related asset is not a contingent asset and its recognition is appropriate The existence of the insurance recovery will be confirmed by the outcome of the investigation project. The investigation project is an uncertain future event not wholly within T’s control. Currently it is probable (more likely than not) that the insurance recovery will result in an asset and inflow of economic benefits. However, the income can only be recognised once it is virtually certain that there will be an inflow of economic benefits. |
Disclosure
For each class of provision, an undertaking should disclose:
i the carrying amount at the beginning, and end, of the period;
ii additional provisions made in the period, including increases to existing provisions;
iii amounts used i.e. incurred, and charged against the provision during the period;
iv unused amounts reversed during the period; and
v 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 not required.
An undertaking should disclose the following, for each class (or each kind) of provision:
i a brief description of the nature of the obligation, and the expected timing of any resulting outflows of benefits;
ii an indication of the uncertainties about the amount or timing of those outflows and major assumptions made concerning future events; and
iii the amount of any expected reimbursement, stating the amount of any asset that has been recorded for that reimbursement.
Unless the possibility of settlement is remote, an undertaking should disclose, for each class of contingent liability, at the balance sheet date a brief description of the nature of the contingent liability and, where practicable:
i an estimate of its financial effect;
ii an indication of the uncertainties relating to the amount, or timing of any outflow; and
iii the possibility of any reimbursement.
In determining which provisions or contingent liabilities may be aggregated to form a class, it is necessary to consider whether the nature of the items is sufficiently similar for a single statement about them.
Thus, it may be appropriate to treat as a single class of provision amounts relating to warranties of different products, but it would not be appropriate to treat as a single class amounts relating to normal warranties, and amounts that are subject to legal proceedings.
Where a provision and a contingent liability arise from the same set of circumstances, an undertaking makes the disclosures in a way that shows the link between the provision and the contingent liability.
Where an inflow of benefits is probable, an undertaking should disclose a brief description of the nature of the contingent assets at the balance sheet date, and, where practicable, an estimate of their financial effect.
It is important that disclosures for contingent assets avoid giving misleading indications of the likelihood of income arising.
Where any of the information is not disclosed because it is not practicable to do so, that fact should be stated.
Disclosure of some or all of the information may prejudice seriously the position of the undertaking in a dispute with other parties on the subject matter of the provision, contingent liability or contingent asset. The example below may apply:
| EXAMPLE – Disclosure exemption Issue In extremely rare cases, disclosure of some or all of the information required by IAS 37 can be expected to prejudice seriously the position of the bank in a dispute with other parties on the subject matter of the provision. In such cases a bank need not disclose specific information, but should disclose the general nature of the dispute, together with the fact that the information has not been disclosed, and the reason why. How should management make such a disclosure in the financial statements? Background Bank M is in dispute with a competitor, which is alleging that M has infringed trademarks. The competitor is seeking damages of 100 million. Management recognises a provision for its best estimate of the obligation, but discloses none of the information required by IAS 37 relating to it. Solution Management should disclose the following in a note to the financial statements: Litigation is in process against the entity relating to a dispute with a competitor, which alleges that the entity has infringed trademarks and is seeking damages of 100 million. The information usually required by IAS 37 is not disclosed because the directors believe that to do so would seriously prejudice the outcome of the litigation. The directors are of the opinion that the bank can successfully resist the claim. |
Annex – IAS 37 rules for users
This annex provides examples of the application of IAS37
Onerous Contracts
If an undertaking has a contract that is onerous, the present obligation under the contract should be recorded and measured as a provision.
An onerous contract is one in which the unavoidable costs of meeting the obligations under the contract, exceed the benefits expected to be received under it.
IASB has recently amended IAS 37 specifically relating to onerous contracts, these are to be applied from Jan 1, 2022. Read our blog here to know more.
| EXAMPLE – onerous contract You provide electricity to commercial and domestic clients. The government has instructed you to cut domestic charges by 5% and fix the price for 2 years. This will cost you $20 million, as you cannot reduce the cost of your supplies. This is an onerous contract, and a provision should be made for the $20 million loss. |
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| I/B | DR | CR |
| Cost of sales-onerous contract | I | 20m |
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| Provision | B |
| 210m |
| Recording provision |
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When contracts can be cancelled without paying compensation there is no obligation.
| EXAMPLE –Definition of onerous contracts Issue An onerous contract is one in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits to be received under the contract. What are the circumstances that give rise to an onerous contract? Background a) Contract 1 An entity has a contract to purchase 1 million units of gas at 0.15 per unit, giving a contract price of 150,000. The current market price for a similar contract is 0.16 per unit, giving a price of 160,000. The gas will be used in generating electricity and the electricity will be sold at a profit. b) Contract 2 An entity has a contract to purchase 1 million units of gas at 0.23 per unit, giving a contract price of 230,000. The current market price for a similar contract is 0.16 per unit, giving a price of 160,000. The entity does not use the gas in its business but has a sales contract to sell it to a third party at 0.18 per unit. The entity would have to pay a penalty of 55,000 to exit the contract. Solution a) Contract 1 These circumstances do not indicate an onerous contract. The economic benefits from the contract include the benefits to the entity from using the gas in its business to produce electricity. The electricity is sold at a profit, therefore the contract is not onerous. b) Contract 2 These circumstances do indicate an onerous contract. The economic benefit (revenue) from the contract is 180,000 at a cost of 230,000. Management should recognise an onerous contract of 50,000, which is the lower of the cost of fulfilling the contract and the penalty cost of cancellation (55,000). |
Before a separate provision for an onerous contract is established, impairment losses on assets dedicated to that contract should be provided for per IAS 36.
| EXAMPLE – Impairment of assets dedicated to an onerous contract
Issue An entity must recognise any impairment loss that has occurred on assets dedicated to an onerous contract before a separate provision for the contract is established. Give an example of a separate provision for an onerous contract? Background A enters into a contract to provide B with high-quality monitors. The sales contract is entered on 30 November 20X2 and the delivery date is 1 March 20X3. The contract is for the sale of 100,000 monitors for an amount of 20,000,000. The manufacturing processes take approximately 2 months to complete the order. As the delivery of the monitor is critical to the operation of B, A is required to deliver the monitors on time. Any delay or cancellation will result in high penalty charges of approximately 25,000,000. At the end of the financial year, due to a shortage of certain components in manufacturing the monitor, the cost of manufacturing the 100,000 units has escalated to 210 per unit, which would result in a loss of 1,000,000 for the whole contract. At year-end, no production has commenced on this order and no materials have been bought specifically to fulfil this order. The manufacturing equipment that is dedicated to fulfilling this order has a carrying amount of 5,000,000. The recoverable amount of the equipment is estimated to be 4,200,000 after taking the above contract into consideration. Solution A should recognise an impairment charge of 800,000 on the manufacturing equipment used to fulfil the order, and a further 200,000 should be provided separately for an onerous contract. The unavoidable costs of meeting the obligations amounts to 21,000,000 (the cost to manufacture 100,000 monitors at 210 per unit), and that exceeds the benefits of 20,000,000 expected from the contract (the contracted amount). The unavoidable loss should be applied first to reduce the manufacturing equipment to its recoverable amount and the balance recognised as a provision for the onerous contract. |
| EXAMPLE – Recognition of unavoidable costs under an onerous contract Issue The unavoidable costs under a contract reflect the least net cost of exiting from the contract, which is the lower of the cost of fulfilling the contract and any compensation or penalties arising from a failure to fulfil it [IAS37R.68]. How should management measure a provision for an onerous contract? Background An entity leases a property from a third party. The lease is an operating lease and has a 10-year term and a rental of 50,000 a year. The total contract cost is therefore 500,000. The entity does not occupy the property, but has arranged a sublease at a rent of 30,000 a year for 10 years. The total revenue receivable from the sub-lessee is 300,000. The cost of continuing with the lease and sublease is 200,000 (500,000-300,000). The penalty for exiting the lease and the sublease is 150,000. However, management believes that exiting from the contract would harm the entity’s public image and has decided to continue with the lease and the sublease. Solution Management should recognise a provision for 150,000, which is the lower of the cost of exiting the leases (150,000) and the cost of continuing with the leases (200,000). Management’s decision to continue with the leases does not affect the amount that should be recognised. The provision should be discounted at the appropriate pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability for which future cash flow estimates have not been adjusted. |
| EXAMPLE -Past event that gives rise to a present obligation Issue A past event is deemed to give rise to a present obligation if, taking account of all available evidence, it is more likely than not that a present obligation exists at the balance sheet date. Rarely will the existence of a present obligation be unclear. A past event that leads to a present obligation is called an obligating event. An obligating event creates a legal or constructive obligation. When does a past event lead to a present obligation? Background An entity operates a coal mine. Its licensing agreement requires it to remove the machinery used for mining coal at the end of production and restore the land. 80% of the restoration costs relate to the removal of the machinery and 20% arise through mining the coal. The damage caused by mining the coal is assumed to be incurred in proportion to the volume of coal mined. At the balance sheet date the machinery has been built but no coal has been mined. Solution A liability should be recognised at the balance sheet date for the best estimate of the costs that relate to the removal of the machinery. The corresponding entry should be included as part of the cost of the machinery. The amount recognised should be the discounted amount. The 20% of costs that arise through the mining of coal should be recognised as a liability over the periods in which the coal is mined. The corresponding entry for this element will be to cost of sales because the damage is caused by current production. The construction of the machinery creates a legal obligation, under the terms of the licence, to remove the machinery and restore the land and is therefore an obligating event. At the balance sheet date, however, there is no obligation to rectify the damage that will be caused by mining the coal in future years.
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Similarly, a provision for the decommissioning costs of an oil installation, or a nuclear power station, to rectify damage already caused.
| EXAMPLE - Recognition of decommissioning and site restoration expenses Issue The cost of an item of property, plant and equipment should include the initial estimate of the costs of dismantling and removing the asset and restoring the site on which it is located [IAS16.16(c)(R.05) ]. How should management recognise the estimated cost of dismantling and removing the asset and restoring the site? Background An oil company has an obligation, at the date of installation, to decommission an oil rig at the end of its thirty-year life in accordance with the local legislative requirements. The decommissioning costs for the rig are estimated to be 140,000,000 with a net present value of 8,023,197, based on a discount rate of 10%. Solution Management should include 8,023,197, the net present value of the decommissioning cost, in the carrying amount of the oil rig at the time of its installation. A provision for 8,023,197 is created because the obligating event is the installation of the oilrig. The amount included in PPE will be depreciated with the rest of the cost of the oil rig in the usual way. The accretion of the discount after the initial recognition of the provision should be recognised as interest expense. The double entry required for the recognition of the asset and the liability will be: Dr PPE - plant and machinery 8,023,197 Cr Provision - decommissioning 8,023,197 |
Measurement
| EXAMPLE –warranty estimated costs An undertaking sells goods, with a warranty under which clients are covered for the cost of repairs of any manufacturing defects that become apparent within the first six months after purchase.
If minor defects were detected in all products sold, repair costs of $1 million would result. If major defects were detected in all products sold, repair costs of $4 million would result.
The undertaking’s past experience and future expectations indicate that, for the coming year, 75 per cent of the goods sold will have no defects, 20 per cent of the goods sold will have minor defects and 5 per cent of the goods sold will have major defects.
The undertaking assesses the probability the warranty obligations as a whole. The expected value of the cost of repairs is: 75% of nil + 20% of $1m + 5% of $4m = $400,000 |
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| I/B | DR | CR |
| Warranty costs | I | 400.000 |
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| Provision – product warranties | B |
| 400.000 |
| Recording provision |
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| EXAMPLE - Extended warranties that are insured Issue A provision should be recognised if the conditions set out below are met: i) an entity has a present obligation (legal or constructive) as a result of a past event; ii) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and iii) a reliable estimate can be made of the amount of the obligation. Should management recognise a provision for extended warranties that are underwritten by a third party? Background H manufactures DVD players. Management offers customers an extended warranty, which guarantees the performance of the product for three years. The customer pays a fee for the extended warranty. Management pays the fee to a third party insurer, which underwrites the risk. Solution Management should recognise a provision for its best estimate of the entity’s obligation under the extended warranty. The underwriting agreement does not negate the entity’s obligation to the customer. The customer has recourse to the entity for claims under the extended warranty. The entity, in turn, can claim against the insurance provider. Management cannot recognise an asset for the insurance claims, unless it is virtually certain that it will recover the funds from the insurer. Management should disclose a contingent asset in the notes to the financial statements if it believes that receipt of the insurance proceeds is probable but not virtually certain. To recognise a contingent asset, management would have to demonstrate that: the risk was covered in the insurance policy; it had a history of successful similar claims made on the insurers, and legal or other professional advice suggesting that the claim would be successful. The expense relating to a provision may be presented net of the amount recognised for a reimbursement in the income statement. |
Where a single obligation is being measured, the most likely outcome may be the best estimate of the liability.
| EXAMPLE - estimates An undertaking has to rectify a serious fault in a major plant, built for a client, The most-likely outcome may be for the repair to succeed at the first attempt, at a cost of $100,000, but a provision for a larger amount is made, if there is a significant chance that further attempts will be necessary. If it is probable that another visit, costing $40.000, will be needed, the total provision should be $140.000. |
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| I/B | DR | CR |
| Repair costs | I | 140.000 |
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| Provision | B |
| 140.000 |
| Recording provision |
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