IAS 37 Provisions, Contingent Liabilities and Contingent Assets

1 Introduction

Chapter 2 defined a liability as a present obligation to transfer an economic resource as a result of past events. Most liabilities are certain: a supplier’s invoice tells us exactly how much we owe and when it must be paid. Some are not. A business that gives a one-year guarantee on the goods it sells knows that some customers will bring goods back for repair, but it does not know how many, how much the repairs will cost or exactly when they will happen.

IAS 37 Provisions, Contingent Liabilities and Contingent Assets deals with these uncertain items. It applies the ideas of Chapter 23: the accruals concept (the cost is recognised in the year the obligation arises, not when the cash is paid), prudence (liabilities are not understated) and accounting estimates (the amount has to be estimated, and the estimate is revised when better information arrives).

This chapter is an optional extension: IAS 37 is not one of the topics named in the BA3 syllabus. Read it to understand the terms and when each item is recognised, disclosed in a note or ignored, and work the examples for practice; the full detail of IAS 37 is not covered.

2 Provisions, contingent liabilities and contingent assets

Contingent means “depending on something”. A provision is a liability we will have to pay, even though the amount or timing is uncertain. A contingent liability is one we might have to pay — it depends on the outcome of a future event.

The obligation behind a provision can be of two kinds:

Older books, and some people, use the word “provision” for the allowance for receivables (Chapter 8) and for accumulated depreciation (Chapter 5). Those are not IAS 37 provisions: they reduce the carrying amount of an asset, while an IAS 37 provision is a liability.

3 When is a provision recognised?

A provision is recognised (shown as a liability in the statement of financial position) only when all three of these conditions are met:

1. there is a present obligation, legal or constructive, as a result of a past event;

2. it is probable that money (or other resources) will have to be paid out to settle it — probable means more likely than not; and

3. a reliable estimate can be made of the amount.

If any one of the conditions is not met, no provision is recognised. The item may then be a contingent liability (section 4).

When a provision is set up, the cost is charged as an expense in the year the obligation arises:

The key word is obligation. A business does not provide for costs it merely intends or expects to incur, because it could still avoid them by its own future actions:

• Future operating losses. A branch that is expected to make a loss next year does not create a provision: there is no obligation to anyone at the year end, and the business could close the branch or change the way it trades.

• Plans and budgets. Next year’s budget for training, advertising or repairs is not a provision, however firmly management intends to spend the money. The cost is recognised next year, when it is incurred.

• Restructuring. A decision to close or reorganise part of the business creates a constructive obligation only when there is a detailed formal plan and the business has raised a valid expectation in those affected (staff, customers, suppliers) that it will be carried out — for example by announcing the plan to them or by starting to carry it out. A decision taken privately by the board, and not announced, is not enough.

4 Probable, possible, remote

Whether an uncertain obligation is provided for, disclosed or ignored depends on how likely it is that money will have to be paid. The business does not guess: it takes advice from experts, such as its lawyers in a court case. IAS 37 defines only ‘probable’: more likely than not. It gives no percentages for ‘remote’ or ‘virtually certain’ — these are judgements made on the evidence. Some textbooks quote rough figures, such as 5% for remote and 95% for virtually certain; these are teaching conventions, not thresholds in the standard, so they never decide an item on their own.

The note for a contingent liability describes it and, where practicable, gives an estimate of its financial effect. In the rare case where there is a present obligation and payment is probable, but no reliable estimate of the amount can be made, no provision is recognised: the item is disclosed as a contingent liability instead (unless the chance of paying is remote).

Contingent assets are treated more cautiously, so that income is not recognised before it is earned (prudence):

The event that creates the obligation must have happened by the year end. If a customer slips on a wet floor before the year end and sues, the accident is a past event and the rules above apply. If the accident happens after the year end, there was no obligation at the year end and there is no provision; if the claim is material it is described in a note, as an event after the reporting period (Chapter 26).

5 Measuring a provision

A provision is measured at the best estimate of the amount needed to settle the obligation at the year end. Like any accounting estimate, it is based on the information available, past experience and expert advice.

• A large number of similar items (for example guarantees on thousands of products): the best estimate is the expected value — each possible cost is weighted by its probability, and the results are added.

• A single obligation (for example one court case): the best estimate is usually the most likely amount to be paid.

• Payments a long way in the future: where the effect of the time value of money is material, the provision is discounted to its present value. This chapter does not cover that calculation.

5.1 Onerous contracts

An onerous contract is a contract in which the unavoidable costs of meeting the obligations are more than the benefits the business expects to receive from it. The business has signed the contract, so it has a present obligation, and a provision is recognised.

Where the contract will bring no benefits at all, the provision is the unavoidable cost of the contract: the lower of the cost of carrying it out and any compensation or penalty the business would have to pay to get out of it. A sensible business takes the cheaper way out.

6 Changes in provisions and reimbursements

A provision is an estimate, so it is reviewed at every year end and adjusted to the current best estimate. As with the allowance for receivables in Chapter 8, only the change goes to the statement of profit or loss:

If a payment is no longer probable, the provision is reversed in full (it may then need to be disclosed as a contingent liability). A provision may be used only for the expenditure it was set up for: a provision for a court case cannot be used to pay for repairs.

Sometimes another party, such as an insurance company, will pay back some or all of the cost of settling a provision. The reimbursement is recognised only when it is virtually certain to be received if the business settles the obligation. It is shown as a separate asset — the provision is not reduced — and the asset cannot be more than the provision. For example, a provision of $50,000 with a virtually certain insurance recovery of $30,000 is shown as a liability of $50,000 and an asset of $30,000.

7 Summary

8 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.