IAS 37, Provisions, Contingent Liabilities,

and Contingent Assets

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In this session, we’ll be discussing IAS 37, which deals

with the accounting for provisions, contingent
liabilities, and contingent assets. The standard was
issued in 1998 with very few amendments since. An
exposure draft of amendments was published in June
2005, but the proposals were not finalized. The
standard is treated as a longer-term research project
considering targeted improvements and issues such as
the rate an entity uses to discount a provision.

51
Learning objectives
• Identify the existence of a
provision, contingent liability,
and a contingent asset.
• Identify when to recognize
and measure a provision.
• Recognize when a contingent
item should be disclosed.

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Learning objectives

 Identify the existence of a provision, contingent

liability and a contingent asset.
 Identify when to recognize and measure a
provision.
 Recognize when a contingent item should be
disclosed.

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IAS 37 — Uncertainties

Inflows
Transactions where there may
be questions regarding the
probability, timing, or amount
Outflows

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IAS 37: Uncertainties

IAS 37 tells us how to account for uncertainties, such as
transactions (inflows and outflows) in which there may be
questions regarding the probability, timing, or amount. For
example:

Inflows. A company may be expecting some income; for

example, a payment of damages from a successful court
case or a successful insurance claim however the exact
amount or timing of the income may be uncertain.

Outflows. A company may be expecting to make a

payment such as a redundancy payment or damages in an
unsuccessful court case. However, once again, there may
be questions over the probability of the payment arising,
the timing of the payment, or its amount.

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Scoped out of IAS 37

Financial instruments Non-onerous

IFRS 9 executory contracts

Insurance Items covered

Contracts IFRS 4/ by another standard
IFRS 17
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Scoped out of IAS 37

 IAS 37 does not apply to any liabilities or assets that are Financial instruments
(IFRS 9)
 Liabilities arising under non-onerous executory
contracts (those where both parties have
outstanding obligations to perform e.g., a sales
contract where buyer has yet to pay and seller has
yet to deliver the goods)
 Liabilities arising from insurance contracts (IFRS 4
and IFRS 17)
 Items covered by another IFRS such as pension
obligations and lease obligations

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IAS 37 provision — Recognition criteria

Recognize provision if

Legal or constructive Probable outflow

and

and
obligation as result of economic Reliable estimate
of past event benefits

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IAS 37 provision: Recognition criteria

According to IAS 37, a provision is recognized when the following three criteria are all met:
1. When the entity has a present obligation (legal or constructive) as a result of a past event.
2. When it is probable that an outflow of resources will be required to settle the obligation.
3. When a reliable estimate can be made of the amount.

It is important to look at these criteria in some more detail.

1. Present obligation

A mentioned in point 1 above, a present obligation can be a legal or a constructive obligation.

A legal obligation is perhaps the easiest to understand—this is when the law requires a company to do something; for example, an oil
company is required by local law to clean up any environmental damage that is caused by drilling or by oil spills.

A constructive obligation exists when there is no law stipulating that a company must do something, but when the company has created an
expectation that they will do something e.g., by publishing a statement on their website. To illustrate: a retailer offers a full, no questions
asked, refund for goods returned within six months of purchase. There is no legal requirement for them to do so, but the policy is published
on their website. Creating the expectation in this way gives rise to a constructive obligation.

2. Probable outflow

For a provision to be recognized, there must be a probable outflow of economic benefits, i.e., the payment must be “more likely than not,”
which is considered to be greater than a 50 percent chance.

Comparison to U.S. GAAP

This is one of the first major differences with U.S. GAAP, which uses the term probable to describe a situation in which the outcome is “likely
to occur.” While there is no quantitative measure of likelihood in U.S. GAAP, in practice it generally means ≥ 75% chance.

3. Reliable measurement

Finally, for a provision to be created, there must be a reliable measurement of the amount of the obligation.

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IAS 37 — Accounting for a provision

Double entry for a provision

Dr Profit or loss* X

Cr Provision for liability X

*Note: If provision is for decommissioning costs, the Dr entry is to PPE

as part of initial cost.
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IAS 37: Accounting for a provision

When a provision is created, the double entry is to Dr P/L and Cr
Provision (SOFP) although in some cases, the debit entry is
included within the cost of an asset. For example, if a provision is
created for the decommissioning costs of an item of PPE, the Dr
entry is made to PPE as part of the initial cost.

If any of the criteria we saw previously are not met, then a

provision cannot be recognized. A present obligation that is not
probable or does not have a reliable measurement is disclosed as
a contingent liability, unless it is remote and can therefore be
ignored). This is consistent with the recognition criteria for
liabilities from the conceptual framework, since recognition would
provide neither relevant information nor a faithful representation.

Conceptual framework: Recognition criteria

There is more on contingent liabilities later in the session.

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Discussion exercise — Provision recognition criteria
Scenario

• A company in the oil industry is involved in a major project to construct and drill
a new oil well off the coast of Northland. No local law exists regarding the clean-
up of environmental damage; however, the company has published an
environmental policy on its website.
— “We work hard to minimize the environmental impact of our operations. We
endeavor to rectify any environmental pollution relating to soil, ground water,
surface water, and sediment contamination that may occur as a result of our
projects”
• The clean-up costs relating to the recent activity are expected to reach £20m.

How should the company treat the costs?

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Discussion exercise: Provision recognition criteria

Consider an oil company involved in a major project to
construct and drill a new oil well. There is no local law
requiring the company to make good any environmental
damage as a result of its activities; however, in response to
recent press criticism and environmental pressure groups,
the company has published a policy on its website stating
that it will bear the costs of any clean-up needed.

There is a reliable estimate of the costs, which are

expected to reach £20m.

With reference to the criteria in IAS 37, should a provision

be recognized for the clean-up costs?

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Discussion exercise solution – Provision recognition criteria
• Recognize a provision for the clean-up costs as the obligation is
considered constructive, outflow is probable, and costs can be
estimated.

• £20m should be recognized at its present value.

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Discussion exercise solution

In this example, all three criteria are met and a
provision should be recognized for the costs of clean-
up. The company does have a present obligation.
Although there is no local law requiring any
environmental damage to be cleaned up, the company
has a constructive obligation, as its intention to clean
up has been published on its website.

There is also a reliable measurement of the cost.

The slide mentions that the provision of £20m should

be measured at its present value. It is worth
mentioning this to participants at this point, but there
will be more on measurement later.

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IAS 37 provision example — Deepwater Horizon and
application of IAS 37

• 2010: Major explosion resulting in destruction of rig and oil spill

• By 2015, still no reliable estimate of costs to BP
• In 2016, significant progress made and reliable estimate possible

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IAS 37 pro vision example - Deepwater Horizon and application of IAS

37
Before moving on, share with participants issues arising for oil
companies and the application of IAS 37.

Deepwater Horizon and BP

In 2010, an explosion on the Deepwater Horizon offshore oil rig

tragically killed 11 of the crew and resulted in the largest ever oil spill
in U.S. waters. The aftermath was of an unprecedented scale and
complexity.

What is interesting from an accounting point of view is that five years

later, BP’s 2015 financial statements disclosed that they were yet to
reach a reliable measurement of the costs needed to settle the various
cases brought as a result of the disaster. This changed in 2016 when a
reliable measurement became possible due to the settlements brought
about by the Plaintiff Steering Committee. The FS in 2016 shows the
creation of approximately US$65bn in provisions.
(https://www.bp.com/content/dam/bp/business-
sites/en/global/corporate/pdfs/investors/bp-annual-report-and-form-
20f-2016.pdf)

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Measurement of provisions

Multiple
obligations: Discount to
Probability- present value
weighted using pretax
expected discount rate
value
Single
obligation: Best Review at
estimate of each
most likely reporting
amount date

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Measurement of provisions
We have seen the importance of a reliable measurement in order to be able to recognize a
provision and touched upon one aspect of this in the answer to the discussion example, but there is
a little more detail to be covered.

Single obligations
When there is a single obligation to be settled (e.g., the costs of a single court case), the provision
should be the best estimate of the most likely amount to settle the obligation.

Large population of similar claims

In some situations, however, a company may have to establish the amount of a provision for a large
amount of similar claims (e.g., warranty provisions). In cases such as these, companies should use
the expected value method.

There will be a discussion example on this shortly.

Discounting
If the time value of money has a material effect, then the provision should be discounted to its
present value.

This is not the case under U.S. GAAP.

Review
The amount of any provisions should be reviewed at each reporting date and adjusted if necessary
to reflect current best estimate.

If payment is no longer probable, the provision should be reversed.

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Discussion exercise — Provision measurement
Scenario
• A company sells washing machines with a warranty.
• Customers are covered for the cost of repairs for the first 12 months following purchase.
• Company estimates that it would cost £5m if major defects were found in all products
sold; £2m if minor defects were found in all products sold.
• Based upon past experience, the following is expected:
— 65% of products will have no defects
— 30% will require minor repairs
— 5% will require major repairs

How should the provision be measured?

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Discussion exercise—Provision measurement

Before moving on, it will be useful to see how the expected value method works when a
company has multiple similar obligations.

In this example, a company sells washing machines with a 12-month warranty. This means
that the company guarantees to rectify any machine defects arising within the first 12
months following the sale.

The company has a present obligation to provide for the costs of repair but (unlike a single
court case, for example) there will be multiple similar obligations arising, so the provision
should be determined using an expected value approach. The company estimates that it
would cost £5m if major defects were found in all products sold and £2m if minor defects
were found in all products sold.

Based upon past experience, the following outcome is predicted for next year:

65 percent of machines sold will have no defects

30 percent will require minor repairs
5 percent will require major repairs

Using the figures given for the costs of repairs, give participants a few moments to work
out what the expected value of the warranty provision should be.

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Discussion exercise solution — Provision measurement

• Multiple similar obligations = expected value approach.

• Expected value of cost of repairs:

— 65% × £0m = 0
— 30% × £2m = 0.6
— 5% × £5m = 0.25

• Total provision = £850,000

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Discussion exercise solution

As mentioned earlier, the company should use the
expected value approach. This results in the following:

Sixty-five percent of machines will require no repair, so the

provision needed is 65 percent of zero; that is, zero.

Thirty percent of machines will require minor repairs. If all

machines were to require minor repairs, this would cost
£2m; 30 percent of £2m is £600,000.

Five percent of machines will require major repairs. If all

machines were to require major repairs, the cost would be
£5m, so weighting this for the 5 percent gives us an
equation of 5% × £5m, which is £250,000.

The total provision should be £600,000 + £250,000 =

£850,000.

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IAS 37 provisions — Specific coverage scenarios

Future Onerous Restructuring Decommissioning

operating contracts provisions costs
losses
Provide for Provide Recognize when
Do not present when formal obligation exists
provide obligation plan and
(least net valid
cost of expectation
exiting the
contract) Provide for
direct costs
only
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IAS 37 provisions: Specific coverage scenarios

IAS 37 covers some specific and common scenarios with regard to provisions and the application of the
recognition and measurement rules.

1. Future operating losses. In accordance with paragraph 63 of IAS 37, companies are not allowed to
recognize a provision for these.
Future operating losses do not meet the criteria for recognition of a provision as the company has no
present obligation to make operating losses—it could wind up its business instead.

Before the introduction of IAS 37, it was common for companies to create what were known as “big
bath” provisions by recognizing general provisions in years in which the company was profitable. These
provisions would then be released (credit to profit or loss) in years in which losses were made,
resulting in a “smoothing” of the company’s results. The introduction of IAS 37 has put a stop to this.

2. Onerous contracts

An onerous contract is one in which the unavoidable costs of meeting obligations under the contract
exceed the economic benefits expected to be received under it.

Contracts that are expected to be loss making that fall within the scope of IFRS 15 are examples of
onerous contracts. Some leases may also meet the definition of an onerous contract; however, IAS 37
is only applicable where a lease liability has not already been recognized. Under the new IFRS 16 rules,
a liability is recognized for more leases than previously and, as a result, fewer provisions for onerous
lease contracts can be expected.

If a company has a contract that is onerous, the present obligation under the contract is recognized
and measured as a provision. The present obligation is the least net cost of exiting the contract, so
either the costs to fulfill it or the penalties from failure to fulfill it – whichever is lower. Costs to fulfil a

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 contract include all incremental costs, such as direct labor and materials, and also an allocation of
other costs that are directly related to fulfilling contracts
IAS 37 [66]

3. Restructuring provisions

Restructuring includes events such as sale or termination of a line of business, closure or relocation of
business locations, changes in management structure, or fundamental reorganizations.

A provision for the costs of restructuring is only recognized when the recognition criteria are met. This
means that the company must have a constructive obligation to restructure.
IAS 37 [71]

A constructive obligation will arise when an entity has created an expectation that the restructuring
will go ahead; this will mean the entity should do the following:

 Have a detailed formal plan

 Announce the features of the plan to those affected by it.
Only the direct costs of restructuring can be provided for – any costs such as retraining relate to
the ongoing business and so cannot be provided for.

4. Decommissioning costs

In certain industries, companies will have an obligation to dismantle or decommission an asset at the
end of its useful life. This is common in the oil and gas and electricity industries, where environmental
damage that needs to be rectified can occur.

The existence of a present obligation requires the company to recognize a liability for such costs in
accordance with IAS 37. The cost is included as part of the initial cost of PPE at its present value.

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Contingencies and contingent liabilities

Contingent liability

• Possible rather than present

obligation • Disclose nature and financial
• Present obligation but: effect unless remote
— not probable, or
— no reliable measurement

Contingent asset • Disclose nature and financial

effect if probable inflow
• Possible asset • Recognize when virtually
certain

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Contingencies and contingent liabilities

The recognition criteria to make a provision are not met if:

- An obligation is possible rather than present, or

- A present obligation is either not considered probable of
payment or cannot be measured reliably.

In these cases, a company will disclose a contingent liability

(unless the outcome is remote, in which case it can be ignored).
The disclosure note should explain the nature and the financial
effect of the contingent liability.

Contingent assets
Assets are only recognized as such when they are virtually certain.
Where there is a probable inflow of economic benefits, a
contingent asset is disclosed in a note to the financial statements
detailing the nature and its financial effect. Where an inflow of
economic benefits is considered only possible or remote, a
contingent asset is ignored.

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Reimbursements
• Recognized when
virtually certain if related
to a provision
• Treated as separate
asset
• ≤ Amount of provision
• Can present amounts in
SPL net

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Reimbursements
Sometimes the expenditure required to settle a provision will be reimbursed by a third party. For example, a
company may lose a court case but may be reimbursed by the insurer.

Any reimbursements should be recognized as a

separate asset (not netted off) when, and only when, it
is virtually certain that the reimbursement will be
received. The amount recognized may not exceed the
amount of the related provision.

The income and expense in the SPL relating to the

reimbursement and the provision can be netted off.

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Disclosures required under IAS 37

For each class of provision, disclose the following

• Reconciliation of movements in year

• Brief description of nature, timing, and uncertainties

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Disclosures required under IAS 37

For each class of provision, a company must disclose a
reconciliation of the carrying amount at the beginning and
end of the period showing any movements relating to new
provisions in the period, any amounts used, unused
amounts reversed and any unwinding of the discount to
present value.

Also disclose the following:

 Description of the nature of the obligation

 Uncertainties regarding amount or timing
 Any expected reimbursements

We’ve discussed details regarding IAS 37, now it’s time for
you to apply the knowledge you’ve gained.

66
 Domino’s — Provisions, contingent liabilities, and contingent assets
Reversionary share plan provisions

As discussed more fully in note 2 of the consolidated financial statements, the employment tax provision relates to certain of the Group’s historical share-based
compensation arrangements with grant dates dating from 2003 to 2010. As a result of the legal advice received a provision was recorded in 2017 of £11.om,
comprising £2.6m employer’s NIC, and £8.4m employees’ s NIC and PAYE. Within this an estimate of interest on overdue tax of £3.0m has been provided for.

An additional £2.0 provision has been recorded in the year ended 26 December 2021 for additional potential tax liabilities following further correspondence with
HMRC around the tax treatment of options with vesting dates from 2012 through 2014, which comprises an additional £1.5m relating to employees’ NIC and PAYE,
and £0.5m employers’ NIC.

No contingent asset has been recognised in the financial statements in relation to the indemnities provided by the beneficiaries of the arrangements. As the tax
liability has not crystallised, the Group is not yet entitled to seek recovery of the amounts due under the indemnities.

The timing of the utilisation of the provision is uncertain, as discussed more fully in note 2.

Dilapidations provisions
On acquisition of the London corporate stores, the Group acquired dilapidations provisions which were recognised at fair value. During the period, none of these
provisions were released or utilised (2020: £nil).

Onerous contract provision

The onerous contract provisions of £0.4m in the prior period related to onerous contracts for IT equipment, this provision was utilised during the current period.

Other provisions
Other provisions include £0.4m (2020: £0.8m) for closure costs of Domino’s Pizza Germany Limited, £0.2m (2020: £0.2m) for legal claims arising on the acquisition
of London corporate stores, and a further £1.7m for potential liabilities relating to the disposal of the international operations.
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Domino’s: Provisions, contingent liabilities, and contingent assets

A quick look at the Domino’s accounts shows a provision relating to a provision for a tax liability arising on a historic share
based payment scheme.

The dilapidations provision related to their London stores. The

other side to the entry would have been a debit to the leased
asset as we mentioned when discussing IFRS 16 Leases.

They also had an onerous contract provision relating to contracts

for IT equipment which was utilized in the period.
Other provisions relate to legal claims and closure costs.

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Comparison to U.S. GAAP
IFRS U.S. GAAP
Probable = more likely than not (>50%) Probable = likely to occur (>75%)
Could result in earlier recognition under IFRS
Measurement is best estimate of expenditure No one standard addresses measurement.
required. Companies must refer to specific guidance.
Provisions must be discounted to present value Generally, record at amount that will be paid to
if time value of money is material. settle.
Provisions recognized when a contract becomes Provisions not recognized for onerous contracts
onerous. unless entity ceased using the rights under the
contract.
Reimbursement assets recognized when probable. Reimbursement assets only recognized when
virtually certain.

Single approach to all termination benefits. Different guidance for different types of termination
benefits.
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Comparison to U.S. GAAP

There are a number of significant differences between U.S.
GAAP and IFRS, which could result in differences regarding
the timing and amount of provisions recognized.

The most notable are the differences between the

definitions of “probable” and the concept of discounting
to present value.

Under IFRS, an obligation is probable if it is “more likely

than not,” which is taken to be a 50 percent chance and
over. Under U.S. GAAP, probable means “likely to occur,”
which is taken to be 75 percent chance or more. This will
result in earlier recognition of provisions under IFRS.

U.S. GAAP does not require provisions to be discounted to

present value. Rather, the provision is recorded at the
amount that will be paid to settle.

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