IAS 37 Provisions, contingent assets and liabilities

IAS 37 Provisions, Contingent Liabilities and Contingent Assets is the standard for accounting for uncertainty. An employee has an accident at work and sues; the case will not be decided for two years; nobody yet knows whether the company will pay anything at all, or how much. Something has to appear in this year's financial statements, and IAS 37 decides what.

Three outcomes are possible for that kind of item — recognise a provision, disclose a contingent liability, or say nothing — and the whole chapter is about which one applies. A fourth possibility, the contingent asset, is the same question with the roles reversed: the company is the one doing the suing.

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1 Why the standard has rules at all

A provision is a credit to a liability and a debit to an expense, so creating one reduces this year's profit — and releasing one, when it turns out not to be needed, increases a later year's profit. Before IAS 37 that was an open invitation.

In a very good year the directors could create provisions that were not really needed, pushing reported profit down. In a poor year they could release them, pushing reported profit back up. The result was a smooth, steadily rising profit line that owed nothing to how the business had actually performed — profit smoothing, and in its most extreme form the big bath: dumping a large number of provisions into one already-bad year so that every year afterwards looks better.

2 Provisions

That is what separates a provision from an ordinary payable or accrual: not that it is estimated, but that either the amount or the date of settlement — or both — is genuinely uncertain.

2.1 The recognition test

A provision is recognised only when all three of the following are met — and each "no" leads to the same place:

Each condition, in turn:

2.2 Legal and constructive obligations

3 Measurement

A provision is measured at the best estimate of the expenditure required to settle the present obligation at the reporting date. How that estimate is arrived at depends on what is being measured:

3.1 Other measurement rules

• Discounting. Where the effect of the time value of money is material, the provision is the present value of the expenditure expected to settle the obligation.

• Unwinding the discount. In each later period the carrying amount of a discounted provision increases as the settlement date approaches. That increase is recognised as a finance cost, not as an operating expense — it is interest, not a revision of the estimate.

• Gains on the expected disposal of assets are not taken into account, even if the disposal is closely linked to the event giving rise to the provision. They are recognised when the disposal happens, under the standard that governs it.

• Reimbursements — from an insurer, say — are recognised only when receipt is virtually certain. The reimbursement is a separate asset, not a deduction from the provision, and it may not exceed the provision. In profit or loss the two may be presented net.

4 Subsequent measurement

• Provisions are reviewed at each reporting date and adjusted to the current best estimate.

• If it is no longer probable that an outflow will be required, the provision is reversed — released back to profit or loss.

• A provision may be used only for the expenditure for which it was originally recognised. A provision set up for a legal claim cannot later be spent against a restructuring; setting a different cost against it would hide that cost from profit or loss, which is exactly the abuse the rule exists to prevent.

5 Contingent liabilities

A contingent liability is never recognised. It is disclosed — the nature of the obligation, an estimate of its financial effect where practicable, and an indication of the uncertainties — unless the possibility of an outflow is remote, in which case nothing is said at all.

The three routes into contingent-liability territory are the three failed conditions of the recognition test. In practice the first two do all the work:

• A possible obligation, not a present one. An employee slipped at work and is claiming the entity was at fault — but the cleaner had put a warning sign out. Whether the entity did anything wrong will be settled by the court, not by the entity. Until then there is only a possible obligation.

• A present obligation with an outflow that is only possible. The entity accepts it may have to pay, but its lawyers put the chance at less than 50%. Not probable, so not a provision.

• No reliable estimate — which IAS 37 describes as extremely rare.

6 Contingent assets

The same situation, with the roles reversed: the entity is the one suing. The treatment, however, is not the mirror image, and that asymmetry is the most examinable point in this part of the chapter. It exists because recognising a gain that may never arrive overstates both profit and net assets, while failing to recognise a liability that may arrive understates both — so the standard sets a higher bar for the asset.

7 Specific applications

7.1 Future operating losses

No provision may be made for future operating losses. They arise from future trading, so there is no past event and therefore no present obligation. An expectation of future losses is instead an indicator of impairment of the assets of the operation concerned, which is an IAS 36 question.

7.2 Repairs and maintenance

For the same reason, no provision is made for the cost of future repairs, overhauls or refurbishment of the entity's own assets — even where the expenditure is unavoidable in practice, because the entity could avoid it by selling the asset. There is no obligation to anyone else. Where a major overhaul is a condition of continuing to operate an asset, the cost is dealt with by depreciating that element of the asset separately (IAS 16), not by building a provision.

7.3 Onerous contracts

The present obligation under an onerous contract is recognised and measured as a provision. The unavoidable cost is the lower of the cost of fulfilling the contract and any compensation or penalties arising from failing to fulfil it — the entity is assumed to take whichever escape route is cheapest, so it can never be worse off than that.

The cost of fulfilling a contract comprises the costs that relate directly to it: the incremental costs of fulfilling it, plus an allocation of other costs that relate directly to fulfilling it. Before recognising an onerous-contract provision, the entity first recognises any impairment loss on assets dedicated to that contract.

7.4 Restructuring

A restructuring is a programme planned and controlled by management that materially changes either the scope of the business or the manner in which it is conducted. Typical examples:

• the sale or termination of a line of business;

• the closure of business locations, or the relocation of activities from one country or region to another;

• changes in management structure — for example removing a layer of management;

• fundamental reorganisations that have a material effect on the nature and focus of the entity's operations.

A restructuring creates a constructive obligation only when the entity has both:

1. a detailed formal plan identifying at least the business or part of the business concerned, the principal locations affected, the location, function and approximate number of employees who will be compensated for terminating their services, the expenditure that will be undertaken and when the plan will be implemented; and

2. raised a valid expectation in those affected that it will carry the restructuring out, by starting to implement the plan or announcing its main features to them.

A restructuring provision includes only the direct expenditures arising from the restructuring, which are those both necessarily entailed by it and not associated with the ongoing activities of the entity. It therefore excludes the cost of retraining or relocating continuing staff, marketing, and investment in new systems and distribution networks — all of which relate to how the business will be run in future.

8 Disclosure

For each class of provision, an entity discloses a reconciliation of the carrying amount from the beginning to the end of the period — additions, amounts used, unused amounts reversed and the increase from the unwinding of the discount — together with a brief description of the nature of the obligation, the expected timing of the outflow, the uncertainties about the amount or timing, and the amount of any expected reimbursement.

For a contingent liability that is not remote, and for a contingent asset whose inflow is probable, the entity gives a brief description and, where practicable, an estimate of the financial effect.

9 Where this appears under IFRS 18

IFRS 18 Presentation and Disclosure in Financial Statements replaces IAS 1 for accounting periods beginning on or after 1 January 2027. Recognition and measurement are unchanged — provisions are still IAS 37, and no amount in this chapter moves.

Presentation, though, splits a discounted provision in two. The expense of creating or increasing the provision is an operating item, so it sits in the operating category, above the required subtotal *operating profit*. The unwinding of the discount is an interest effect on a liability, so it sits in the financing category, below the subtotal *profit before financing and income taxes*.

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