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Part B: Provisions
Introduction
Part B reviews issues relating to the recognition, measurement and disclosure of provisions,
including the requirements of IAS 37 Provisions, Contingent Liabilities and Contingent Assets
(IAS 37). IAS 37 outlines specific existence, recognition and measurement criteria to be applied
to provisions; it also requires extensive disclosures. The recognition of provisions, and the
disclosure of information about their nature and the timing, amount and likelihood of any
resulting outflows, provides financial statement users with a more complete understanding
of an entity’s existing obligations. However, opportunities exist for managers to exploit the
uncertainty and subjectivity of provisions when recognising and measuring them, in order to
manipulate reported accounting numbers.

This part begins with the definition of a provision, followed by a discussion on key aspects of
the recognition of provisions. Measurement issues are then discussed, including how to deal with
risks and uncertainties, as well as the use of probability in measurement. Part B concludes with a
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discussion on disclosure requirements relating to provisions.

Scope of IAS 37 Provisions, Contingent Liabilities and

Contingent Assets
IAS 37 applies to all provisions (and to contingent liabilities and contingent assets discussed
in Part C) other than those that:
• result from executory contracts, except for onerous contracts
• are covered by another standard (IAS 37, para. 1).

Executory contracts are ‘contracts under which neither party has performed any of its obligations
or both parties have partially performed their obligations to an equal extent’ (IAS 37, para. 3).

Importantly, IAS 37 does not apply to financial instruments (including guarantees) that are within
the scope of IFRS 9 Financial Instruments. Financial instruments are covered in Module 6.

Other provisions, contingent liabilities and contingent assets that are covered by other
standards are:
• income taxes (IAS 12 Income Taxes)
• leases (IFRS 16 Leases), except any lease that becomes onerous before its commencement
date, or short-term leases and leases where the underlying asset is of low value and that
the lease has become onerous
• employee benefits (IAS 19 Employee Benefits)
• insurance contracts within the scope of IFRS 4 (IAS 37, para. 5).

If you wish to explore this topic further you may now read paras 1–9 of IAS 37.

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Definition of provisions
Provisions are a subset of liabilities; therefore, to properly understand provisions it is helpful
to revisit the definition of a liability. The IASB Conceptual Framework for Financial Reporting
(Conceptual Framework) defines a liability as:
… 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 (Conceptual
Framework, para. 4.4(b)).

Provisions are defined in IAS 37 as ‘liabilities of uncertain timing or amount’ (IAS 37, para. 10).
A key aspect of this definition is the requirement that uncertainty exists. However, not all
uncertainties give rise to a provision. An estimate of timing or amount does not automatically
result in uncertainty. For example, estimates used to determine the depreciation of property,
plant and equipment over the period of use do not make depreciation a provision. The precise
pattern in which economic benefits are consumed may be uncertain, but the fact that economic
benefits of the asset will eventually be consumed is not uncertain.

When there is a significant level of certainty (i.e. an insignificant level of uncertainty), the amount
is not recognised as a provision, but as a liability. Examples of these types of liabilities are
borrowings, trade creditors and accruals.

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In cases where the degree of uncertainty in relation to the timing or amount of the liability
cannot be measured with sufficient reliability, the amount is classified as a contingent liability
(discussed in Part C of this module).

➤➤Question 3.5
With reference to the scope of IAS 37 and the definition of a provision, identify which of the
following is likely to be a provision within the scope of IAS 37, and which is likely to be another
form of liability and explain why.
• An obligation to repair or replace goods sold if they are determined to be faulty

• A warranty provided for a television sold by a retailer

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• Annual leave

Check your work against the suggested answer at the end of the module.

Recognition of provisions
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The Conceptual Framework criteria for the recognition of liabilities state that a liability should
be recognised when:
… it is probable that an outflow of resources embodying economic benefits will result from the
settlement of a present obligation and the amount at which the settlement will take place can be
measured reliably (Conceptual Framework, para. 4.38).

Consistent with this requirement, IAS 37 requires the following conditions to be met for a
provision to be recognised:
(a) an entity has a present obligation (legal or constructive) as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be required
to settle the obligation; and
(c) a reliable estimate can be made of the amount of the obligation (IAS 37, para. 14).

Present obligation and past event

The first recognition criterion in para. 14 of IAS 37 requires the entity to have a present obligation
‘as a result of a past event’. The importance of this recognition criterion was outlined by the
G4+1 Group of accounting standard setters:
If the trigger point for recognition is set too early, the result would be to recognise a liability and an
expense where none exist, thus reducing the relevance and reliability of the financial statements.
A provision could be recognised for expenditures that, in the event, are never made. The effect
would be to misstate both the entity’s financial position (by recording a liability that does not
actually exist) and its financial performance (by recognising an expense in one accounting period
and income in another in relation to amounts that are never actually paid or received).
Conversely, it would be incorrect not to provide for expenditures that are clearly unavoidable,
result from past events, and are measurable with a high degree of reliability simply on the grounds
that the outflow of cash or other resources will not occur until a future date. Failure to recognise
a provision in such circumstances would result in the financial statements not portraying faithfully
either the expenses incurred in the accounting period or the liabilities of the entity at the statement
of financial position date.

Source: Lennard, A. & Thompson, S. 1995, Provisions: Their Recognition, Measurement and Disclosure
in Financial Statements, Financial Accounting Standards Board, Norwalk, paras 2.1.5–6. © Financial
Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, USA. Reproduced with permission.

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The standard setters believed that it will normally be clear whether a past event has given rise to
a present obligation that should be recognised in the statement of financial position. However,
in rare cases it may not be clear whether a present obligation exists. In such cases, IAS 37
provides the following guidance:
[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 end of the reporting
period (IAS 37, para. 15).

Such evidence is not limited only to what is available at the closing date of the financial
statements; it specifically includes information from events that may occur between the end
of the reporting period and the time of completion of the financial report.

The Conceptual Framework notes that an obligation ‘is a duty or responsibility to act or perform
in a certain way. Obligations may be legally enforceable as a consequence of a binding contract
or statutory requirement’ (Conceptual Framework, para. 4.15). The obligation must involve
another party to whom the obligation is owed—that is, a third party. For a present obligation
to exist, the entity must have no realistic alternative to settling the obligation created by the
event (IAS 37, para. 17).

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The most common form of present obligation is a legal obligation, in which an external party has
a present legal right to force the entity to pay or perform. However, it may also be a constructive
obligation to the extent that there is a valid expectation in other parties that the entity will
discharge the obligation. Consistent with the Conceptual Framework definition of a liability,
a constructive obligation is defined in IAS 37 as:
… an obligation that derives from an entity’s actions where:
(a) 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
(b) as a result, the entity has created a valid expectation on the part of those other parties
that it will discharge those responsibilities (IAS 37, para. 10).

By including constructive obligations as a form of present obligation, the Conceptual Framework

extends the definition of liabilities beyond the issue of legal enforceability. The definition
includes liabilities arising from normal business practice or custom, a desire to maintain good
business relations or a desire to act in an equitable manner (e.g. habitually providing staff with
bonus payments or performing environmental remediation to a standard higher than that
required by law), but not from a contractual agreement with another entity.

If you wish to explore this topic further you may now read paras 15–22 of IAS 37, as well as the
implementation guidance: ‘Guidance on Implementing IAS 37’, C. Examples: recognition, Example 2B
‘Contaminated land and constructive obligation’ in Part B of the Red Book 2017.

Probable outflow of economic benefits

The second criterion in para. 14 of IAS 37 for the recognition of provisions is that ‘it is probable
that an outflow of resources embodying economic benefits will be required to settle the
obligation’. This occurs when the outflow of resources or another event is more likely than not
to occur. That is, the probability that the event will occur is greater than the probability that it
will not (IAS 37, para. 23). Where there are a number of similar obligations, such as warranty
obligations arising from product sales, the class of obligations is considered as a whole in
determining whether an outflow of resources is probable (IAS 37, para. 24).

If you wish to explore this topic further you may now read paras 23 and 24 of IAS 37.

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Reliable measurement
The third recognition criterion in para. 14 of IAS 37 is that ‘a reliable estimate can be made
of the amount of the obligation’. IAS 37 notes that:
… except in extremely rare cases, an entity will be able to determine a range of possible
outcomes and can therefore make an estimate of the obligation that is sufficiently reliable to
use in recognising a provision (IAS 37, para. 25).

Consequently, a provision is considered to be capable of being reliably measured even if a

number of possible outcomes exist.

The use of reasonable estimates is an essential part of the preparation of financial statements
and does not undermine the reliability of the statements (Conceptual Framework, para. 4.41).

If you wish to explore this topic further you may now read paras 25 and 26 of IAS 37.

➤➤Question 3.6
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 remedy, by repair or replacement,
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manufacturing defects that become apparent within three years from the date of sale. As this
is the first year that the warranty has been available, there is no data from the firm to indicate
whether there will be claims under the warranties. However, industry research suggests that it
is likely that such claims will be forthcoming.
Should the manufacturer recognise a provision in accordance with the requirements of IAS 37?
Why or why not?

Check your work against the suggested answer at the end of the module.

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Measurement of provisions
One of the more difficult aspects of accounting for provisions is determining the amount to be
recognised in the financial statements given the inherent uncertainty surrounding provisions.

As the actual amount of sacrifice of economic resources is often not known with certainty
(by definition), estimates of the provisions are required to be made.

IAS 37 requires that:

… the amount recognised as a provision shall be the best estimate of the expenditure required
to settle the present obligation at the end of the reporting period (IAS 37, para. 36).

The best estimate is the amount that an entity would rationally pay either to settle the obligation
at that date or to transfer it to a third party at that time. The estimation requirements differ
depending on whether the provision involves a large population of items or a single obligation,
and are outlined in IAS 37 as follows:
• ‘Where the provision being measured involves a large population of items, the obligation is
estimated by weighting all possible outcomes by their associated probabilities. The name for
this statistical method of estimation is “expected value”’ (IAS 37, para. 39).

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• ‘Where a single obligation is being measured, the individual most likely outcome may be the
best estimate of the liability’ (IAS 37, para. 40).

With regard to determining best estimates, IAS 37 suggests that the most appropriate estimate
of the provision is determined by using:
… the judgement of the management of the entity, supplemented by experience of similar
transactions and, in some cases, reports from independent experts. The evidence considered
includes any additional evidence provided by events after the reporting period (IAS 37, para. 38).

IAS 37 states that ‘where there is a continuous range of possible outcomes, and each point in
that range is as likely as any other, the mid-point of the range is used’ (IAS 37, para. 39).

These criteria are consistent with the enhancing qualitative characteristic of verifiability. As noted
in para. QC26 of the Conceptual Framework, quantified information need not be a single point
estimate to be verifiable. A range of possible amounts and the related probabilities can also
be verified.

If you wish to explore this topic further you may now read paras 36–40 of IAS 37.

Example 3.12: Calculation of best estimate

Part A
An entity faces 100 warranty claims relating to a faulty widget. The entity’s management has determined
there is a 30 per cent likelihood that each of these claims is unsubstantiated and will not cost the entity
anything. There is a 70 per cent likelihood that the cost of each claim will be $100.

According to the expected value method, the best estimate of the provision can be calculated as
70% × 100 × $100 = $7000.

Part B
Now assume that the same entity is facing a single warranty claim with the same probabilities as in
Part A. In such circumstances, IAS 37 requires the individual most likely outcome be used to calculate
the amount of the provision. In this example, the most likely outcome is that $100 will be paid to settle
the warranty claim. As such, the cost of $100 is the most likely outcome because it has a 70 per cent
chance of occurring, whereas there is a 30 per cent chance of no payout being required.

Therefore, $100 would be the amount required to be recognised in accordance with IAS 37.

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Discounting
Example 3.12 ignored the effect of discounting. However, IAS 37 requires that:
… where the effect of the 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
(IAS 37, para. 45).

Consequently, provisions are discounted when the effect of this discounting is material.
The discount rate should be a pre-tax rate that reflects current market assessments of the
time value of money and the risks specific to the liability. The discount rate must not reflect
risks for which the future cash flow estimates have been adjusted (IAS 37, para. 47).

If you wish to explore this topic further you may now read paras 45–47 of IAS 37.

IAS 37 also notes that risks and uncertainties should be taken into account in reaching the best
estimate of a provision. It cautions, however, that ‘uncertainty does not justify the creation of
excessive provisions or a deliberate overstatement of liabilities’ (IAS 37, para. 43).

If you wish to explore this topic further you may now read paras 42–44 of IAS 37.
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➤➤Question 3.7
Refer to the background material in Question 3.6.
The firm has now been operating its warranty for five years, and reliable data exists to suggest
the following:
• If minor defects occur in all products sold, repair costs of $2 million would result.
• If major defects are detected in all products, costs of $5 million would result.
• The manufacturer’s past experience and future expectations indicate that each year
80 per cent of the goods sold will have no defects, 15 per cent of the goods sold will have
minor defects, and 5 per cent of the goods sold will have major defects.
Calculate the expected value of the cost of repairs in accordance with the requirements of IAS 37.
Ignore both income tax and the effect of discounting.

Check your work against the suggested answer at the end of the module.

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IAS 37—Provisions, Contingent Liabilities

and Contingent Assets: Disclosure
Provisions
IAS 37 includes a number of disclosure requirements relating to provisions, which assist financial
statement users to understand the reasons, uncertainty and subjectivity behind the recognised
end of period carrying amount. As discussed in greater detail shortly, subjectivity in recognising
and measuring provisions makes them a potential tool for entities to manage their earnings,
where earnings management is the manipulation of revenue and expense to smooth out profit
fluctuations or to achieve a predetermined (and often an overstated) profit result. The disclosure
requirements of IAS 37 aim to reduce the ability of entities to use provisions as a means of earnings
management. The key disclosures required by IAS 37 relating to provisions are outlined as follows:
For each class of provision, an entity shall disclose:
(a) the carrying amount at the beginning and end of the period;
(b) additional provisions made in the period, including increases to existing provisions;
(c) amounts used (i.e. incurred and charged against the provision) during the period;

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(d) unused amounts reversed during the period; and
(e) the increase during the period in the discounted amount arising from the passage of time
and the effect of any change in the discount rate.
Comparative information is not required.
An entity shall disclose the following for each class of provision:
(a) a brief description of the nature of the obligation and the expected timing of any resulting
outflows of economic benefits;
(b) 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, as addressed in paragraph 48; and
(c) the amount of any expected reimbursement, stating the amount of any asset that has
been recognised for that expected reimbursement (IAS 37, paras 84 and 85).

If you wish to explore this topic further you may now read paras 84 and 85 of IAS 37.

The requirements of para. 84 of IAS 37 are illustrated in Note 15 of the Techworks Ltd
financial statements.

To explore this topic further, read Note 15—‘Provisions’, in the Techworks Ltd financial statements
provided in the appendix to the Study guide, and also available on My Online Learning.

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➤➤Question 3.8
Review Note 15 ‘Provisions’ of the Techworks Ltd financial statements. Focusing on the Provision
for warranties class of provisions, highlight how Techworks Ltd has complied with the requirements
of para. 85 of IAS 37 in this disclosure.
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Check your work against the suggested answer at the end of the module.

If you wish to explore this topic further you may now read paras 84 and 85 of IAS 37.

➤➤Question 3.9
Consider the following quote:
At present, banks create provisions to meet the costs of … restructuring. When analysts
analyse these, they classify them as significant items so that they appear below the
operating profit line; this ensures the cost of these provisions disappears from their
calculations of the operating profit. By over-provisioning with below-the-line significant
items in a good year, the company can use the over-provisions during a bad year when
there are additional write-offs. The write-offs do not appear in the operating profit
(Washington 2002, p. 74).
Explain how the disclosure requirements contained in IAS 37 reduce the ability of entities to engage
in earnings management through the increase and then subsequent write-back of provisions.

Check your work against the suggested answer at the end of the module.

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Exemptions
Although the disclosure requirements of IAS 37 are more extensive than many entities would
like, the standard does provide some relief from compliance with the requirements. This relief
includes when:
… disclosure of some or all of the information required … can be expected to prejudice seriously
the position of the entity in a dispute with other parties on the subject matter of the provision,
contingent liability or contingent asset (IAS 37, para. 92).

IAS 37 notes that this exemption would occur only in extremely rare cases and, therefore,
cannot be used to circumvent the disclosure requirements. Also, even when the exemption
is applicable, the general nature of the dispute, together with the fact and reason why that
information has not been disclosed, must be stated.

If you wish to explore this topic further you may now read para. 92 of IAS 37.

Provisions and professional judgment

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An entity’s accountant is required to exercise professional judgment in determining whether
an obligation constitutes a provision. If it is a provision, professional judgment is also required
in measuring the provision. The need for professional judgment introduces discretion and
subjectivity into financial reporting, which creates potential pressures from management
for the accountant to manipulate reported accounting numbers, including engaging in
earnings management.

For example, a distinguishing feature between provisions and other types of liabilities,
such as trade payables, is the degree of uncertainty in the timing or amount of the obligation.
Recall that it is when the level of uncertainty is significant that the obligation is recognised as a
provision. When deciding on the degree of uncertainty, an accountant is required to exercise
professional judgment.

Professional judgment is also required in the measurement of provisions. Recall that IAS 37 states
that the best estimate is to be used to measure provisions. The best estimate includes the use
of either the ‘expected value’ method or the ‘most likely outcome’ method. The inputs used to
derive the best estimate under either method, namely the likelihood of an outcome or outcomes
occurring, are often subject to the discretion of an entity’s management. Management may
exploit this discretion to understate provisions, and thereby reduce the entity’s total liabilities.
An accountant must exercise professional judgment in ensuring that these inputs can be verified.

Example 3.13: Discretion in the calculation of best estimate

Continuing on from Example 3.12, now assume that management has revised its estimates so that
there is a 45 per cent likelihood that each of the warranty claims is unsubstantiated and a 55 per cent
likelihood that the cost of each claim will be $100.

According to the expected value method, the best estimate of the provision is now $5500 (55% × 100 ×
$100 = $5500), which is $1500 lower compared with the original estimate in Example 3.12.

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The use of professional judgment in recognising and measuring provisions not only enables
manipulation of reported liabilities in the statement of financial position, but also creates
opportunities for earnings management. This is because the understatement of provisions
also results in an understatement of the corresponding expense, and in so doing overstates
reported profit for the current period. Using Example 3.13 to illustrate this, both the warranty
provision and warranty expense would be $1500 lower compared with their original amounts in
Example 3.12 due to management’s revised estimates. Exercising discretion in the recognition
and measurement of provisions, therefore, simultaneously affects an entity’s reported financial
position and its profit.

Summary
This part focused on accounting for provisions under IAS 37.

IAS 37 outlines specific criteria to be applied to provisions in their recognition and measurement,
and requires extensive disclosures. The recognition of provisions provides financial statement
users with an understanding of the entity’s existing obligations. The disclosure of information
about the nature of provisions and the timing, amount and likelihood of any resulting outflows
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assists users to understand the reasons, uncertainty and subjectivity behind the recognised end
of period carrying amount. It is the presence of this uncertainty and subjectivity that enables
managers to manipulate reported accounting numbers. The discretion exercised in measuring
provisions creates opportunities for managers to understate provisions in the statement
of financial position and the corresponding expense, thereby, overstating reported profit.
While the measurement of provisions is subject to an entity’s accountant verifying the accuracy
of management’s estimates, financial statement users should be mindful of subjectivity in the
measurement of provisions.

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Part C: Contingent liabilities and

contingent assets
Introduction
Part C reviews the requirements of IAS 37 in relation to contingent liabilities and contingent
assets. The objective of the standard is to assist users in assessing the nature and amount of
contingent assets and contingent liabilities, as well as the uncertainties that are expected to
affect their outcomes. The standard’s ultimate aim is to ensure consistent reporting practices,
even though recognition of contingent liabilities and contingent assets is prohibited in the
financial statements and note disclosure is generally required.

Contingent assets

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Recognition of assets
The guidance related to the recognition and disclosure of assets in the Conceptual Framework
(para. 4.4) provides a foundation for considering issues of contingent assets. The Conceptual
Framework defines assets as:
… a resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity (Conceptual Framework, para. 4.4(a)).

The notion of future economic benefit is the essence of an asset. Other properties of assets,
such as exchangeability, are indicative but not essential characteristics, as future economic
benefits can be gained from the use of assets, even though they may have no disposal value.

In relation to assets, control refers to the capacity of the entity either to benefit from the asset
in pursuing its objectives, or to deny or regulate others’ access to that benefit. Ownership of a
resource is not necessary for an asset to exist.

Should an item comply with the definition above, an asset exists. However, for it to be reported
in the entity’s statement of financial position, two recognition hurdles must be overcome.
First, it must be ‘probable that the future economic benefits will flow to the entity’, and second,
the asset must possess ‘a cost or value that can be measured reliably’ (Conceptual Framework,
para. 4.44).

‘Probable’ is generally described as meaning more likely than not, or more than 50 per cent.
This is the generally accepted interpretation of the meaning of the term ‘probable’. In relation
to the recognition criterion of ‘reliable measurement’, the assets must be faithfully represented.
‘Faithful representation’ means information that is complete, neutral and free from error.
Paragraph QC15 of the Conceptual Framework notes that ‘faithful representation’ does not
mean information that is ‘accurate in all respects’. In the context of estimates, a representation
of an estimate (as is the case for provisions) can be faithful if:
… the amount is described clearly and accurately as being an estimate, the nature and limitations
of the estimating process are explained, and no errors have been made in selecting and applying
an appropriate process for developing the estimate (Conceptual Framework, para. QC15).

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It should also be noted that an item that, at a particular time, fails to meet the recognition criteria
in para. 4.38 of the Conceptual Framework may qualify for recognition at a later date as a result
of subsequent circumstances or events (Conceptual Framework, para. 4.42).

Contingent assets
The definition of contingent assets in IAS 37 is based on the definition of assets provided in the
Conceptual Framework. However, the definition overcomes some of the difficulties associated
with the recognition criteria.

A contingent asset is defined in IAS 37 as:

… 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 (IAS 37, para. 10).

Contingent assets are not recognised in the statement of financial position. They are disclosed
in the notes to the financial statements. An example of a contingent asset provided by IAS 37
is ‘a claim that an entity is pursuing through legal processes, where the outcome is uncertain’
(IAS 37, para. 32). Another example is a buyer entitled to a full cash refund for faulty products
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purchased, who has made a refund claim during the warranty period, but the supplier is disputing
the claim and the dispute is being decided by an independent arbiter. Until the dispute has been
settled, the buyer has a contingent asset.

A possible asset is identified and disclosed in accordance with IAS 37. It is a contingent asset
if, after all the available evidence has been considered, the existence of an asset is still unclear
and will not be clarified until an uncertain future event that is not wholly within the control
of the entity occurs or fails to occur. In relation to the second part of the definition—dealing
with probability and reliable measurement—IAS 37 only requires disclosure when the inflow
of economic benefits is probable. This is consistent with the asset recognition criteria in the
Conceptual Framework.

If you wish to explore this topic further you may now read paras 31–35 of IAS 37.

Table 3.1 summarises the key requirements of IAS 37 in relation to contingent assets.

Table 3.1: Application of probability criteria to contingent assets

Probability of inflow of Accounting treatment in accordance with IAS 37 Provisions, Contingent

economic benefits Liabilities and Contingent Assets
Virtually certain Where the realisation of income is virtually certain, the asset is not a contingent
asset and it is appropriate to recognise the asset (IAS 37, para. 33).

Probable but not If there is a possible asset for which future benefits are probable, but not
virtually certain virtually certain, no asset is recognised (IAS 37, para. 31), but a contingent
asset is disclosed (IAS 37, para. 89).

Not probable If there is a possible asset for which the probability that future benefits will
eventuate is not probable, no asset is recognised (IAS 37, para. 31) and no
disclosure is required for the contingent asset (IAS 37, para. 89).

Source: Adapted from IFRS Foundation 2017, IAS 37 Provisions, Contingent Liabilities and
Contingent Assets, in 2017 IFRS Standards, IFRS Foundation, London.

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‘Guidance on Implementing IAS 37’, Part A ‘Tables—Provisions, contingent liabilities, contingent

assets and reimbursements’ in the Red Book 2016 provides a useful summary of these requirements.

If you wish to explore this topic further you may now read ‘Guidance on Implementing IAS 37’,
Part A (the part on contingent assets), in Part B of the Red Book 2016.

➤➤Question 3.10
Identify two further examples of contingent assets. For each example, explain why the item
would be a contingent asset rather than being recognised as an asset. Do you believe that the
reporting of contingent assets affects the decisions of equity investors or other finance providers?
Why or why not?

MODULE 3
Check your work against the suggested answer at the end of the module.

IAS 37 requires disclosure of the nature of the contingent assets at the end of the reporting
period and, where practicable, an estimate of their financial effect. Estimates of contingent assets
are measured using the principles set out for the measurement of provisions in paras 36–52 of
IAS 37 (IAS 37, para. 89).

Contingent liabilities
IAS 37 adopts a broad concept of contingent liabilities. Contingent liabilities are defined as:
(a) a possible obligation that arises from past events and whose existence will be confirmed only
by the occurrence or non-occurrence of one or more uncertain future events not wholly within
the control of the entity; or
(b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability (IAS 37, para. 10).

Contingent liabilities, like contingent assets, are not recognised in the statement of financial
position. IAS 37 requires the disclosure of contingent liabilities unless the possibility of an outflow
of resources is remote (IAS 37, para. 28).

IAS 37 explains that only those contingent liabilities described in para. 10(a) of the standard
are entirely contingent in nature. However, the standard setters have adopted the view that it is
useful to treat provisions that fail either or both of the recognition criteria as contingent liabilities.
This is done to achieve consistency with the treatment of possible liabilities in para. 10(a)
of IAS 37, and to enable simpler classification of provisions requiring either recognition and
disclosure or disclosure in a note without recognition in the statement of financial position.

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If you wish to explore this topic further you may now read paras 27–30 of IAS 37 and ‘Guidance
on Implementing IAS 37’, Part A (the part on provisions and contingent liabilities) in Part B of the
Red Book 2017.

Table 3.2 summarises the key requirements of IAS 37 in relation to provisions and contingent
liabilities.

Table 3.2: Application of probability criteria to provisions and contingent liabilities

Accounting treatment in accordance with

Obligation and probability of outflow IAS 37 Provisions, Contingent Liabilities and
of economic benefits Contingent Assets
Present obligation that probably requires an outflow A provision is recognised (IAS 37, para. 14)
of resources Disclosures are required for the provision (IAS 37,
para. 84–85)

Possible obligation or present obligation that may, No provision is recognised (IAS 37, para. 27)
but probably will not, require an outflow of resources Disclosed as a contingent liability (IAS 37, para. 86)

Possible obligation or present obligation where the No provision is recognised (IAS 37, para. 27)
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likelihood of outflow of resources is remote No disclosure is required (IAS 37, para. 86)

Extremely rare case where there is a liability, but it No provision is recognised (IAS 37, para. 27)
cannot be measured reliably Disclosed as a contingent liability (IAS 37, para. 86)

Source: Adapted from IFRS Foundation 2017, IAS 37 Provisions, Contingent Liabilities and
Contingent Assets, in 2017 IFRS Standards, IFRS Foundation, London.

A contingent liability will exist in the event of:

1. a possible obligation to be confirmed by uncertain future events
2. a present obligation where the future sacrifice of economic benefits is not probable, or
3. a present obligation with a probable future sacrifice of economic benefits that is not
reliably measurable.

It is only when the probability of future sacrifice is higher than remote that the contingent liability
will be disclosed in a note to the financial statements. In the context of event (3), this is satisfied
as the future sacrifice is probable. For events (1) and (2), however, an assessment must be
made as to the degree to which the future sacrifice is unlikely. If it is remote, then no disclosure
is required.

A provision, however, exists in the event of a present obligation with a probable future sacrifice
of economic benefits, where a reliable estimate of the amount of the obligation can be made.
A provision is clearly distinct from event (1), which relates to a possible obligation, and event (2),
where the future sacrifice is not probable. As such, a provision most closely resembles event (3).
The distinction, however, is whether the estimate is sufficiently reliable to warrant recognition.
If the answer is ‘yes’, it is a provision. If the answer is ‘no’, as per event (3), it is disclosed as a
contingent liability.

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Example 3.14: D
 etermining when to disclose a contingent
liability
Legal proceedings are commenced seeking damages from an entity due to food poisoning, possibly
caused by products sold by the entity. The entity disputes liability, and the entity’s lawyers initially advise
that it is probable that the entity will not be found liable. At this point in time, a possible obligation
(as per contingent liability event (1) ) exists that will be disclosed as a contingent liability unless the
probability of future sacrifice is remote.

If, however, owing to developments in the case it becomes probable that the entity will be found liable,
but the amount of damages to be awarded cannot be measured with sufficient reliability, a contingent
liability still exists (as per event (3)). Disclosure will be required as the future sacrifice is probable and,
thus, cannot be considered remote.

To extend this example, if a reliable estimate could be made of the damages to be awarded, the present
obligation would no longer be a contingent liability under event (3), but rather would be recognised
as a provision.

Source: Based on IFRS Foundation 2017, IAS 37 Provisions, Contingent Liabilities and
Contingent Assets, in 2017 IFRS Standards, IFRS Foundation, London, p. B2556.

MODULE 3
‘Guidance on Implementing IAS 37’, Part B, in the Red Book 2017 provides a decision tree that
clearly differentiates between the requirements for the recognition of an item as a provision,
disclosure of the item as a contingent liability or non-disclosure of the item.

If you wish to explore this topic further you may now read ‘Guidance on Implementing IAS 37’,
Part B (in Part B of the Red Book 2017).

Liabilities versus contingent liabilities

When it is determined whether a liability or a contingent liability exists, it will normally be
clear whether a past event has given rise to a present obligation. In rare cases where there
is uncertainty, the entity must consider all available evidence, including, where necessary,
the opinions of experts. This will also include information from events occurring between
the end of the reporting period and the time the financial statements are completed.
Where the existence of a present obligation is still unclear—and this will only be confirmed
by the occurrence or non-occurrence of some future event outside the control of the
entity—a possible obligation is identified and treated as a contingent liability.

For a past event to give rise to an obligation, the Conceptual Framework requires the entity to
have an irrevocable agreement to settle the obligation that was created. This is normally the
case where the settlement of the obligation is legally enforceable as a consequence of a binding
contract or statutory requirement. An obligation may also arise as a result of custom, a desire to
maintain good business relations or a desire to act in an equitable manner. These obligations
arise where valid expectations that the entity will discharge the obligation are created in
other parties.

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Contingencies and professional judgment

An accountant must exercise professional judgment in determining whether an item should be
recognised as a financial statement element or whether it constitutes a contingency. For example,
an accountant must assess whether, after all available evidence has been considered, it is clear
that an asset exists. If it is clear, the asset must be recognised in the statement of financial
position, provided it satisfies both recognition hurdles (i.e. probable occurrence and reliable
measurement). If it is unclear, a contingent asset exists. An accountant must then exercise
professional judgment in determining whether the inflow of economic benefits is probable,
which then requires disclosure of the contingent asset.

Similarly, professional judgment is required by an accountant in concluding whether a liability

or contingent liability exists, and if it is a contingent liability, whether the liability is to be
disclosed. An accountant must decide whether an obligation is a possible or present obligation.
If it is a possible obligation, a contingent liability exists and must be disclosed. If it is a present
obligation, the accountant must determine whether an outflow of resources is probable and
whether the amount of the obligation is reliably measurable. When an outflow is probable and
the amount is reliably measurable, a liability must be recognised. However, when an outflow
is not probable or the amount cannot be measured reliably, the obligation is a contingent
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liability that must be disclosed provided the likelihood of future sacrifice is higher than remote.
When deciding on the nature of the obligation, the probability of an outflow occurring and
whether the amount of an obligation is reliably measurable, an accountant is required to exercise
professional judgment. The consequence of exercising this judgment is whether the obligation
is recognised, disclosed or not reported.

When a contingency is required to be disclosed, an accountant must also exercise discretion

in deciding the extent to which potentially sensitive information is made public. For example,
an entity subject to a strong legal claim that has been brought against it, where the outcome
is uncertain, has a contingent liability. In applying the disclosure requirements of para. 86 of
IAS 37, the entity must disclose a brief description of the legal claim and, where practicable,
best estimate of the amount required to settle the claim, an indication of any uncertainties
surrounding the amount or timing of the settlement, and the possibility of reimbursement
through insurance. An entity, however, will be reluctant to give extensive details about the
legal claim for fear of prejudicing the outcome or jeopardising settlement negotiations.
Moreover, while an entity has commercial reasons for disclosing confidence in their ability to
defend the claim, this may be misleading to financial statement users. An accountant must,
therefore, exercise professional judgment in ensuring IAS 37 disclosure requirements are met,
but not at the cost of releasing sensitive information that would prove harmful to the entity.

Summary
This part reviewed the requirements of IAS 37 in relation to contingent liabilities and contingent
assets.

The objective of IAS 37 is to assist users in assessing the nature and amount of contingent assets
and contingent liabilities of an entity. Through the disclosure of information on contingent
assets and contingent liabilities, financial statement users are made aware of assets and liabilities
that, while not recognised in the entity’s financial statements, may affect an entity’s financial
position in the future, and, in so doing, enable users to make more informed decisions.

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Review
This module examined the requirements of both IFRS 15, in relation to the recognition of revenue
from customers, and IAS 37, in relation to accounting for provisions, contingent liabilities and
contingent assets.

In Part A, the five-step model for revenue recognition was discussed, beginning with a discussion
on identifying whether a contract with a customer exists. Given the presence of such a contract,
Part A then explored identifying the performance obligation(s) within the contract and quantifying
the transaction price of the contract. How to allocate the transaction price to each performance
obligation was then considered, followed by when to recognise revenue under the contract.
Finally, the accounting treatment of contract costs and the disclosure requirements of IFRS 15
were reviewed—the aim of the disclosures under IFRS 15 being to provide financial statement
users with an understanding of the revenue practices of the entity.

In Part B, provisions were discussed and identified as a subset of liabilities. The definition and
recognition criteria for liabilities were reviewed as a basis for understanding the requirements
for the recognition of provisions. The disclosures relating to provisions were described,
as well as how they assist users in understanding the reasons behind, and the uncertainty

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of, the recognised amount.

Contingent liabilities and contingent assets were covered in Part C. The relationship between
assets and contingent assets was explored, and a summary of the requirements for their
disclosure provided. Contingent liabilities were also discussed, and the provisions of IAS 37
were compared with the position of the Conceptual Framework in relation to liabilities.
IAS 37 requires that neither contingent liabilities nor contingent assets be recognised in the
statement of financial position, but they should be disclosed by way of a note. These disclosures
provide users with a better understanding of the assets, whether recognised or contingent,
and liabilities, whether arising from possible or present obligations, of an entity.

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