Provisions, contingent assets and liabilities (IAS 37)

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1 Measurement

Best estimate of expenditure
Expected values (various different outcomes)
Discount to present value if materially different

2 Subsequent treatment

Review the provision annually
Only use the provision for expense originally created

Example 1 – Provisions and contingent liabilities

York operates in the oil industry and is regularly involved in the contamination of land, seas and rivers given the nature of the business. It does however have a publicised environmental policy on its website and in its annual report that states that it will clean up any environmental damage incurred.

It is currently involved in three major projects where the costs of cleaning up the contamination and the local laws regarding environmental clean-up are given.

*Environmental clean-up costs*	*Local laws*
$4 million	Law enforces the clean-up of environmental damage
$5 million	No law exists for the clean-up of environmental damage
$6 million	Law to enforce clean-up of environmental damage will come into force in the next accounting period

Explain how York should account for the above environmental clean-up costs in its financial statements.

Example Answer 1 – Provisions and contingent liabilities

York should record a provision for $15 million to cover all of the three major projects that have environmental clean-up costs.

York has created a constructive obligation to clean-up any environmental damage, regardless of whether there is a law enforcing it, as it has a clear communicated policy on its website and in its annual report.

If York had not created the constructive obligation then it would only have provided for the $4 million as here there is a law enforced, creating a legal obligation.

3 Specifics

Future operating losses

No provision can be made for anticipated losses as there is no obligation.

Onerous contracts

An onerous contract is whereby the cost of fulfilling the contract exceed the benefits received from the contract.

Restructuring

Sale or closure of a line of business
Ceasing activities in a geographical location
Relocating activities
Re-organisation (management or focus of operations)

A provision is recognised if there is a detailed formal plan and the plan has been announced.

The provision only includes costs which are necessarily to be incurred and not associated with continuing activities.

Environmental provisions

Assume that a company builds a wind farm. The cost of construction is $40 million. At the end of the wind farm's life, the company is required by law to demolish the wind farm and clean up the site. The present value of this cost is $8 million.

What is the double entry at the time of construction of the wind farm?

Dr PPE 48 million Cr Cash 40 million Cr Provision 8 million.

A decommissioning provision like this one is not left alone once recognised: if the timing or the estimated cost changes, remeasure it and adjust the related asset. Where the scenario says a provision already exists, marks do not come from re-proving the recognition criteria — they come from the remeasurement.