IAS 37
Provisions,
Contingent Liabilities and Contingent
Assets
Definitions
A provision
is a liability
of uncertain timing or amount.
A 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
Definitions
What about:
Provision for depreciation, doubtful debts,
impairments.???
Above are adjustments to carrying values of assets
and are not addressed in IAS37.
Distinction – Provisions v Other liabilities
A provision is a liability of uncertain amount or timings
Trade payables are liabilities to pay for goods or services that
have been received or supplied and have been invoiced or
formally agreed with the supplier
Accruals are liabilities to pay for goods or services that have
been received or supplied but have not been paid, invoiced or
formally agreed with the supplier, including amounts due to
employees
Accruals are often reported as part of trade and other payables
Provisions are reported separately
Distinction – Provisions v Other liabilities
The IAS distinguishes provisions from other liabilities
such as trade payables and accruals. This is on the
basis that for a provision there is uncertainty about the
timing or amount of the future expenditure.
While uncertainty is clearly present in the case of certain
accruals the uncertainty is generally much less than for
provisions
Recognition
A provision shall be recognized when all the
following three conditions are met.
Condition 1: An entity has a present
obligation (legal or constructive) as a result of
a past event
Condition 2: It is probable that an outflow of
resources embodying economic benefits will
be required to settle the obligation
Condition 3: a reliable estimate can be made
of the amount of the obligation
Recognition – Condition 1
An entity has,
as a result of a past event,
a present obligation (legal or constructive).
Recognition – Condition 1
Past Event
The past event is known as obligating event
An obligating event is an event that creates a
legal or constructive obligation that results in
an entity having no realistic alternative to
settling that obligation
When no realistic alternative exists:
When settlement can be enforced by law; or
When the event creates valid expectations.
Recognition – Condition 1
Present obligation could be of two types: legal or constructive
A legal obligation is an obligation that derives from
A contract (through its explicit or implicit terms)
Legislation; or
Other operation of law
Examples:
A constructive obligation is an obligation that derives from an
entities actions where:
By an established pattern of past practice, published policies or a
sufficiently specific current statement, the entity has indicated to
other parties that it will accept certain responsibilities; and
As a result, the entity has created a valid expectation on the part
of those other parties that it will discharge those responsibilities
Examples:
Recognition – Condition 2
Probable outflow of resources embodying
economic benefits
Probable means more likely than not
Recognition – Condition 3
Reliable estimate
Best estimate
Consider
Risks and uncertainties
Present Value
Future Events
Ignore
Expected disposal of assets
Reimbursements
Measurement – General Rules
Best estimate
Risks and uncertainties
Present Value
Future Events
Expected disposal of assets
Reimbursements
Measurement – Best Estimate
The amount recognized as a provision shall
be the best estimate of the expenditure
required to settle the present obligation at the
end of the reporting period
The best estimate of the expenditure required
to settle the present obligation is the amount
that an entity would rationally pay to settle the
obligation at the end of the reporting period or
to transfer it to a third party at that time
Measurement – Best Estimate
If large population of items, best
estimate reflects probability weighting of
all possible outcomes.
If single obligation, best estimate is the
adjusted individual most likely outcome
Measurement – Risks and uncertainties
The risks and uncertainties that inevitably surround
many events and circumstances shall be taken into
account in reaching the best estimate of a provision
A risk adjustment may increase the amount at which
a liability is measured
Caution is needed in making judgements under
conditions of uncertainty, so that income or assets
are not overstated and expenses or liabilities are not
understated
Uncertainty does not justify the creation of excessive
provisions or a deliberate overstatement of liabilities
Measurement – Present Value
Where the effect of time value of money is
material, the amount of a provision shall be the
present value of the expenditures expected to
be required to settle the obligation
For example
DF PV
Year 1 40,000 x 0.909
Year 2 50,000 0.826
Measurement –
Expected disposal of assets
Gains from expected disposal of assets shall
not be taken into account in measuring a
provision
Measurement - Reimbursements
The reimbursements shall be recognized
when, and only when, it is virtually certain
that reimbursements will be received if the
entity settles the obligation
The reimbursement shall be treated as a
separate asset
The amount recognized for the
reimbursements shall not exceed the amount
of the provision
Changes in provision
Provisions shall be reviewed at the end of
each reporting period and adjusted to reflect
the current best estimate
If it is no longer probable that an outflow of
resources embodying economic benefits will
be required to settle the obligation, reverse
the provision
If there is no longer uncertainty about timing
and amount, the provision becomes a liability
Use of provisions
A provision shall be used only for
expenditures for which the provision was
originally recognized.
Why do we need IAS 37
To prevent entities from using provisions for
creative accounting
Future losses(not allowed)
Restructuring (allowed with conditions)
Future repairs and maintenance(not allowed)
Entities would create provision in years of profit and
release the provision in years of losses (profit
smoothing) or just bring changes to profit levels
Provisions for restructuring
IAS 37 defines a restructuring as:
A programme that is planned and is controlled by management and
materially changes either:
The scope of a business undertaken by an entity, or
The manner in which that business is conducted .
Examples
The sale or termination of a line of business
The closure of business locations in a country or region or the
relocation of business activities from one country region to another
Changes in management structure, for example, the elimination of a
layer of management
Fundamental reorganisations that have a material effect on the
nature and focus of the entity's operations
Provisions for restructuring
A provision can only be recognized for restructuring if:
An entity must have a detailed formal plan for the restructuring.
It must have raised a valid expectation in those affected
(employees)
A mere management decision is not normally sufficient. Management
decisions may sometimes trigger off recognition, but only if earlier
events such as negotiations with employee representatives and other
interested parties have been concluded subject only to management
approval.
Provisions for restructuring
Costs to be included within a restructuring provision
direct expenditures:
Necessarily entailed by the restructuring
Not associated with the ongoing activities of the entity
The following costs should specifically not be included within a
restructuring provision.
Retraining or relocating continuing staff
Marketing
Investment in new systems and distribution networks
Discussion 1 - Warranties
A manufacturer gives warranties at the time
of sale to purchasers of its product. Under the
terms of the contract for sale the
manufacturer undertakes to make good, by
repair or replacement, manufacturing defects
that become apparent within three years from
the date of sale. On past experience, it is
probable (ie more likely than not) that there
will be some claims under the warranties.
D1 – Warranties – Solution
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
Conclusion:
A provision is recognized for the best estimate of the costs
of making good under the warranty products sold before
the end of the reporting period
Warranty
Parker Co sells goods with a warranty under which customers
are covered for the cost of repairs of any manufacturing
defect that becomes apparent within the first six months of
purchase. The company's past experience and future
expectations indicate the following pattern of likely repairs.
% of goods sold Defects Cost of repairs
$m
75 None
20 Minor 1.0
5 Major 4.0
What is the expected cost of repairs ?
(75% x NIL) + (20% x 1.0) + (5% x 4.0) = $400,000
Discussion 2 – Contaminated land –
legislation virtually certain to be enacted
An entity in the oil industry causes contamination
but cleans up only when required to do so under the
laws of the particular country in which it operates.
One country in which it operates has had no
legislation requiring cleaning up, and the entity has
been contaminating land in that country for several
years. At 31st March 2009 it is virtually certain that a
draft law requiring clean-up of land already
contaminated will be enacted shortly after the year-
end.
D2 – Contaminated land – legislation
virtually certain to be enacted - Solution
Present obligation as a result of a past obligating
event:
The obligating event is the contamination of the land
because of the virtual certainty of legislation requiring
clean-up
An outflow of resources embodying economic
benefits in settlement:
Probable
Conclusion:
A provision is recognized for the best estimate of the costs
of the clean-up.
Discussion 3 – Contaminated land and
constructive obligation
An entity in the oil industry causes
contamination and operates in a country
where there is no environment legislation.
However, the entity has a widely published
environmental policy in which it undertakes to
clean up all contamination that it causes. The
entity has a record of honouring this
published policy.
D3 – Contaminated land and constructive
obligation
Present obligation as a result of a past obligating
event:
The obligating event is the contamination of the land, which
gives rise to a constructive obligation because the conduct
of the entity has created a valid expectation on the part of
those effected by it that the entity will clean up
contamination.
An outflow of resources embodying economic
benefits in settlement:
Probable
Conclusion:
A provision is recognized for the best estimate of the costs
of the clean-up.
Discussion 4 – Refunds 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.
D 4 – Refunds Policy
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
Conclusion:
A provision is recognized for the best estimate of the costs
of refunds
Discussion 5 – A court case
After a wedding in 2007, ten people died, possibly
as a result of food poisoning from products sold by
the entity. Legal proceedings are started seeking
damages from the entity but it disputes liability. Up
to the date of authorisation of the financial
statements for the year to 31.03.2008 for issue, the
entity’s lawyers advise that it is probable that the
entity will not be found liable. However, when the
entity prepares the financial statements for the year
to 31.03.2009, its lawyers advise that, owing to
developments in the case, it is probable that the
entity will be found liable.
D 5 – A court case – At 31.03.2008
Present obligation as a result of a past
obligating event:
On the basis of the evidence available when the
financial statements were approved, there is no
obligation as a result of past events.
Conclusion:
No provision is recognised.
The matter is disclosed as a contingent liability
unless the probability of any outflow is regarded
as remote
D 5 – A court case – At 31.03.2009
Present obligation as a result of a past
obligating event:
On the basis of the evidence available, there is a
present obligation.
An outflow of resources embodying economic
benefits in settlement:
Probable.
Conclusion:
A provision is recognised for the best estimate of
the amount to settle the obligation.
Disclosures
For each class of provision, an entity shall disclose:
the carrying amount at the beginning and end of the period;
additional provisions made in the period, including
increases to existing provisions;
amounts used (ie incurred and charged against the
provision) during the period ;
unused amounts reversed during the period ; and
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.
Disclosures - contd
An entity shall also disclose the following for each
class of provision:
a brief description of the nature of the obligation and the
expected timing of any resulting outflows of economic
benefits;
an indication of the uncertainties about the amount or
timing of those outflows. Where necessary to provide
adequate information, an entity shall disclose the major
assumptions made concerning future events; and
the amount of any expected reimbursement, stating the
amount of any asset that has been recognised for that
expected reimbursement.
Onerous contracts
An onerous contract is a contract where the
unavoidable costs of meeting the obligations under
the contract exceed the expected economic benefit:
Contingent Liabilities
Contingent Liabilities
Definition
A contingent liability is
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 entity;
or
A present obligation that arises from past events but is not
recognized because:
It is not probable that an outflow of resources embodying
economic benefits will be required to settle the obligation;
or
The amount of obligation cannot be measured with sufficient
reliability
Provisions v Contingent Liabilities
Both are uncertain in timing or amount
Contingent liability is dependant on
occurrence or non-occurrence of one / more
uncertain future events not in control of entity
Recognition
An entity shall not recognize a contingent
liability
Disclosures
Unless the possibility of any outflow in settlement is
remote,
an entity shall disclose for each class of contingent
liability at the end of the reporting period
a brief description of the nature of the contingent
liability and, where practicable:
an estimate of its financial effect;
an indication of the uncertainties relating to the amount or
timing of any outflow; and
the possibility of any reimbursement.
Contingent Assets
Contingent Assets
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 the control of
the entity
Recognition
An entity shall not recognize a contingent
asset
Disclosures
Where an 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.
It is important that disclosures for contingent assets
avoid giving misleading indications of the likelihood
of income arising.
