IAS 37

Provisions, Contingent
Liabilities and Contingent
Assets
 Overview

 Provisions

 Contingent liabilities

 Contingent assets

 Disclosures
 Objective
Objective To ensure that appropriate recognition criteria,
measurement bases and sufficient disclosures are
applied to provisions, contingent liabilities and
contingent assets
Scope All provisions, contingent liabilities and contingent
assets unless more specifically addressed by another
standard
Core • provisions are recognised if:
principle o present obligation exists as a result of past
events
o outflow of economic benefits is probable
o reliable estimate can be made
• contingent liabilities and contingent assets are not
recognised
Key • provision
definitions • legal and constructive obligation
• contingent liability
• contingent asset
 Definitions
A PROVISION IS A LIABILITY OF UNCERTAIN TIMING OR AMOUNT.

Item Description Uncertaint Classifications

y
Trade Goods/services that: No NOT A
payables • have been received uncertaint PROVISION
and y
• have been
invoiced/agreed
Accruals Goods/services that: Not a NOT A
• have been received significant PROVISION
but uncertaint
• have not been paid, y
invoiced or agreed
Warrant Obligation to repair significant PROVISION
y defects for Goods that uncertaint (Provided that
obligatio were sold y other conditions
 Recognition criteria
A PROVISION IS A LIABILITY OF UNCERTAIN TIMING OR
AMOUNT.

A provision should be recognised when:

An entity has a Probable outflow of

A reliable
present legal or resources embodying
estimate can be
constructive economic benefits will be
made of the
obligation as a result required to settle the
obligation
of a past event obligation
The
obligatin
g
event
If these conditions are not met, no provision should be recognised.
 Legal versus constructive
obligations
Present obligation arising from a past event is
either:

Legal obligation Constructive

• contractual
obligations
• statutory (current law
OR • past practice,
or virtually certain to
be enacted) published policies,
specific statement
• valid expectations in
others
Examples: Examples:
• legal obligation to • published
decommission an asset environmental policy
• fines, penalties, levies • non-contractual returns
• warranties policy

Only obligations that exist independently of entity's future

actions are recognised as provisions
 Constructive obligation
Example

• Entity A, a clothing retailer that sells high-end clothing,

has a long-established practice of accepting returns
of any items returned within two weeks of sale
without question
• this policy is not required under the contractual terms
of sale.
Entity A’s long-established practice of accepting returned
goods is likely to have created a valid expectation on others
and therefore gives rise to a constructive obligation.
Therefore, Entity A should recognise a provision (assuming
other conditions are met).
 Legal obligation
Example

• under legislation passed in 20X3, Entity B is required to fit

smoke filters to its coal-burning power stations no later than 30
June 20X5
• if Entity B fails to do this the law provides the energy regulator
with powers to levy fines and penalties
• at 31 December 20X4 Entity B has not fitted any smoke filters
• at 31 December 20X5 Entity B has still not fitted any smoke
filters
• Entity B is exposed to pay fines in accordance with the law but it
What
has not is
yetthe accounting
received treatment infrom
any communication accordance with
the relevant
IAS 37?
authorities about this.
 Legal obligation
Solution
31 DECEMBER 20X4
Do nothing. There is no obligating event at 31 December 20X4
because Entity B can avoid any future expenditure eg by selling
or converting its coal-burning power stations.

31 DECEMBER 20X5
Smoke filters
Do nothing. There is still no obligating event even though the
deadline has passed, because Entity B can avoid the
expenditure through its future actions.

Potential fine
Entity B should recognise a provision by estimating the fines
and penalties if they are more likely than not to be imposed.
The past event that creates the obligation (the obligating
event) is the passing of the deadline to achieve compliant
operation of the factory.
 Provisions
Recognition criteria

A provision should be recognised when:

1. an entity has a present legal or constructive
More likely obligation as a result of a past
than not (ie event
more than
50%). 2. it is probable outflow of resources embodying
economic benefits required to
settle the obligation and
Only in
extremely 3. a reliable estimate can be made of the
rare cases, obligation.
no reliable If these conditions are not met, no provision should be
estimate can recognised.
be made
 Provisions- recognition
Example

• on 28 December 20X4, a new law has been enacted by the

parliament making Entity A:
o responsible for cleaning up the environmental damage
caused by its machines and
o making it necessary for the company to alter its
machines in order to become more environmentally
friendly
• the expected cost of the clean-up is CU1,000,000 and of
At the year ended 31 Dec 20X4, should the following costs be provided
for: modifying the machines is CU50,000.
1. cost of rectifying the damage?
2. cost of modifying machines?
 Provisions- recognition
Solution
Cost of rectifying the damage
Yes.
The past obligating event is the contamination of the land and
the enactment of the legislation.
Entity A has no realistic alternative to settling the legal obligation.

Cost of modifying machines

No provision is recognised (there is no obligating event).
The modification of the machines will be done in order to
continue to operate within the law in the future.
 Provisions
Measurement
Best estimate of required expenditure (the amount
Basic
entity would rationally pay to settle)
principle Excludes expected disposal of assets
Large populations
Portfolio • expected value
Single obligation
• most likely outcome may
vs single (probability-weighting be best estimate
obligation of all possible • other outcomes should
s outcomes) also be considered
• mid-point of range

Risks & Risks and uncertainties must be taken into account

uncertain • risk adjustments may increase liability
• risk adjustments should not be duplicated
ty
Discount to PV if time value material, using rate
Time that:
value • is pre-tax
• reflects risks specific to liability (either adjust
cash flows or adjust discount rate).
 Provisions – measurement
of a single obligation
Example 1
• Entity A has manufactured and delivered a custom-designed ship
and has a warranty obligation to repair any faults in the next
12 months
• management estimates the following two possible outcomes, their
associated probability and cost:
o no faults: 20% probability, zero cost
o normal faults: 80% probability, cost CU10,000.
What is the accounting treatment in accordance with IAS 37
(ignoring the time value)?

A provision of CU10,000 is an appropriate 'best estimate' since

the most likely outcome is CU10,000.
 Provisions – measurement of a single
obligation
Example 2

• Entity B has manufactured and delivered a custom-designed ship

and has a warranty obligation to repair any faults in the next 12
months
• management estimates the following three possible
outcomes, their associated probability and cost:
o no faults: 25% probability, zero cost
o normal faults: 40% probability, cost CU10,000
o is
What major faults: 35%treatment
the accounting probability, cost CU100,000.
in accordance with IAS 37 (ignoring
the time value)?
a provision of CU39,000 (being: CU10,000*40%+ CU100,000*35%) is an
appropriate 'best estimate'.
 Provisions – measurement
of a large population
Example
• Entity C sells goods with a warranty under which customers
are covered for the cost of repairs of any manufacturing defects
that become apparent within the first month after purchase
• if minor defects were detected in all products sold, repair costs
of CU1million would result
• if major defects were detected in all products sold, repair costs
of CU4million would result
• the entity's past experience and future expectations indicate that,
for the coming year:
– 75% of the goods sold will have no defects
– 20% of the goods sold will have minor defects
– 5% of the goods sold will have major defects.

What amount should Entity C provide for this obligation?

 Provisions – measurement
of a large population
Solution
• Entity C assesses the probability of an outflow for the
population of warranty obligations as a whole

• the expected value of the costs of repairs is:

– 75% x nil = nil
– 20% x 1m = 200,000
– 5% x 4m = 200,000
Total provision CU400,000

• Entity C should recognise a provision of CU400,000.

 Reimbursement right

Some or all expenditure required Examples:

to settle a provision is expected • insurance claim
to be reimbursed by another • supplier warranty
party.
How likely is reimbursement if the
entity settles the related
obligation? No provision or
reimbursement

!
expected but
virtually asset is
not virtually
certain? recognised if the
certain?
entity has no
Disclos Recognis obligation to
e e right as settle if the
only an asset reimbursing party
fails to pay
• separate asset (not offset from the
provision)
• the asset cannot exceed related
provision
 Provisions
Onerous contracts
Onerous contract:
A contract in which
1. the unavoidable costs of meeting the obligations
EXCEED
2. the expected economic benefits to be received

Events that
Obligating Signing the make
event contract contract
onerous

Measured as a provision, the "Least cost of exit"

• eg lower of:
Amount to o fulfilment cost and
be provided o cancellation penalty
• BUT after recognising any impairment losses on related
assets
• costs and benefits of contract must be identifiable and
distinguishable from general operating losses.
 Onerous contracts
Example
• Entity A operates from several leased premises (all operating leases), each
is a separate CGU for IAS 36 purposes
• for a particular site (site B), the lease has three years to run with no break
clause. Management's forecasts indicate that the:
o net future operating cash inflows are CU800 per annum
o the unavoidable lease costs are CU1,000 per annum
• management intends to continue to operate the site only for three years
because the operating cash flows contribute to the lease costs
• there is no evidence that an alternative course of action (eg sub-letting)
would generate higher net cash inflows
• the CGU has been tested for impairment
• the applicable discount rate is 5%.
What is the accounting treatment in accordance with IAS 37?
 Onerous contracts
Solution

The facts indicate that the site B lease is onerous since the
unavoidable costs exceed the economic benefits. Management has
no alternative courses of action that would result in the unavoidable
lease costs being more fully recoverable.
Set out below the cash flow forecasts:

Year 1 Year 2 Year 3 Total

The unavoidable costs CU1,000 CU1,000 CU1,000 CU3,000
The expected economic CU800 CU800 CU800 CU2,400
benefits
Net cash flow CU200 CU200 CU200 CU600
Discounted cash flow CU190 CU181 CU173 CU544

Entity A should recognise an onerous contract provision of CU544.

 Provisions
Restructuring
A restructuring is a programme that is planned and controlled by
management, and materially changes either:
• the scope of a business undertaken by an entity or
• the manner in which that business is conducted

Examples:
• sale or termination of line of business (binding sale agreement is
required)
• closure/relocation of business locations in country/region
• changes in management structure
• fundamental reorganisation that have a material effect

A restructuring provision is recognised when it meets the

general recognition criteria and the specific conditions in IAS
37 regarding constructive restructuring (see the next slide).
 Provisions
Restructuring-
Constructive obligation
2 CONDITIONS:

Detailed formal plan:

• part of business affected
• principal locations
• location, function and approximate employees affected
• expenditures that will be undertaken
• timing of implementation

Valid expectation in those affected to implement the plan

• starting implementation eg selling or dismantling assets or
• publicly announcing the plan's main features
• planned to begin as soon as possible
• to be completed in a timeframe that makes significant changes to the plan
unlikely
 Restructuring - costs to be
provided
Only provide costs that are:
• necessarily entailed by the restructuring
• do not relate to the future conduct of the business

Type of cost Include Exclude

Redundancy costs

Operating losses up to date of closure

Retraining or relocating staff

Investment in new systems or distribution networks

Lease payments/exit costs on vacated site

Costs of staff retained to clear old site and dismantle

PP&E for disposal
 Restructuring
Example
• at year-end Entity A's Board of Directors has made a decision to
close one of its factories. It has passed a formal Board resolution to
this effect
• the closure decision has not yet been announced or communicated
to employees/parties, and implementation has not started
• management wants to recognise a provision and argues that the
closure is highly probable based on the Board's decision.
Should a provision be recorded in accordance with IAS 37?

No. A constructive obligation exists once the entity:

• has started to implement the plan or
• it has created a valid expectation in others that it will take certain
actions. This is not possible until the decision has been communicated
or implementation has started. (Note: answer might differ if the Board
includes employee or trade union representatives).
 Restructuring provision
Example
Entity A has publicly announced two restructuring plans:

1. the sale of 50% of the cotton group business in three years

from now, which involves the laying off of:
– 15% of employees and
– 10% of middle management.
A purchaser has been sourced and a sales agreement entered
into which is binding on both parties

2. the reorganisation of the headquarters over one year

(commencing within two years), which involves the laying off
of 20% of the head-quarter’s workforce.

What is the accounting treatment in accordance with IAS 37?

 Restructuring provision
Solution
Cotton group business
Record a restructuring provision.
A binding sale agreement is in place, which creates an
obligation.

Headquarters
Do nothing.
This is a judgemental matter but probably there is
no constructive obligation because of the length of time before
the restructuring begins (potentially two years).
This means that the plan is unlikely to raise valid expectations
among the parties affected by it since the time frame allows
 Contingent liability

A contingent liability is:

1. a POSSIBLE 1. a PRESENT 1. a PRESENT
obligation that obligation that obligation that
arises from past arises from past arises from past
events AND events BUT events BUT
2. its existence will be 2. is not recognised 2. is not
confirmed only by the because it is not recognised
occurrence/non‑occurre probable that an because the
nce of uncertain future outflow of economic amount of the
events not wholly benefits will be obligation
within the control of required cannot be
the entity reliably
measured
OR OR

An entity should not recognise a contingent liability

Disclosure only (unless possibility of outflow is remote)
 Contingent Liabilities
Example
• during the reporting period Entity A received a legal claim from a
competitor alleging past infringements of the competitor’s
patent rights
• Entity A’s legal advisers have indicated that the claim is not likely
to succeed, although it is not remote
• Entity A intends to fight the claim in court, which will require it to
incur future legal costs
• Entity A is considering whether it should recognise a provision for:
– the claim itself
–
What is future legal costs
the accounting treatment in accordance with IAS 37?
 Contingent Liabilities
Solution
The claim
Disclose a contingent liability.
This is an example of:
1. a present obligation that arises from a past event
2. BUT IT is not recognised because it is not probable that an
outflow economic benefits will be required. Therefore, a type of
contingent liability.
It must be disclosed as it is not “remote”.

The legal costs (our preferred view)

Not to recognise a provision for the cost of future legal services
because the entity does not have a present legal or constructive
obligation as a result of a past event.
 Provisions and contingent
liabilities
Decision tree
Present obligation
No Possible No
as a result of
obligation
an obligating event

Yes Yes
No Yes
Probable Remote
outflow
No
Yes
No (rare)
Reliable estimate

Yes
PROVIDE DISCLOSE DO NOTHING
 Contingent assets
1. possible asset that arises from past events and
2. whose existence will be confirmed only by the occurrence or non-
occurrence of uncertain future events not wholly within the
entity’s control

How likely is realisation of income?

Not probable but

virtually
probable? not virtually
certain?
certain?
Recognise
Do Disclose under
nothing only applicable
IFRS

Contingent asset Actual asset

 Key disclosures - summary

• for each class of provision

– carrying amount at period beginning and end
– changes (additions, used, released, discounting effects)
– brief description, expected timing of cash flows
– information about cash flow uncertainties
– reimbursement rights
• for each class of contingent liability (unless remote)
– estimate of financial effect
– information about uncertainties
– possibility of reimbursement
• information about contingent assets if probable
• in extremely rare cases: relief from disclosure if seriously
prejudicial.
Thank You
Questions and
Discussion