IAS 37 Provisions, Contingent Liabilities and Contingent Assets is one of the “most talked about” standards in financial accounting. The standard governs the requirements for an entity to recognise provision in its financial statements. The recognition of provision means that there is an increase in the liability amount of the entity’s balance sheet and this will essentially affect some of the entity’s key performance ratios. We have explained what liability is in our Accounting 101 series article, Accounting 101: Liability and equity.
Certain entities would try to minimise the provision that needed to be recognised in their book while entities which performed well, may on the other hand, try to make extra/additional amounts of provision as “reserves” for future rainy days. Accordingly, careful consideration and judgment are crucial in this area.
Let us now bring to you the quick facts on IAS 37.
#1: What is IAS 37 provision?
IAS 37 covers both the requirements for the provision and contingent liability. Both provision and contingent liability are the potential outflow of resources by the entity. Provision is defined by IAS 37 as ‘a liability of uncertain timing and amount’. The recognition of provision requires an entity to assess and determine whether the event meets the recognition criteria of a provision which are:
- An entity has a present obligation as a result of a past event;
- It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
- A reliable estimate can be made of the amount of the obligation.
If any of the above conditions are not met, no provision should be recognised in the financial statements. Provision is also different from other types of liabilities such as trade payables and accruals as there is the element of uncertainty about the timing or amount required in the settlement.
#2: What is contingent liability?
A contingent liability is defined by IAS 37 as:
- 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.
- A present obligation that arises from the past events but it is not recognised because:
- It is not probable that an outflow of resources will be required to settle the obligation; and
- The amount of the obligation cannot be measured with sufficient reliability.
#3: What is the difference between provision and contingent liability?
From the definition of provision and contingent liability above, you will notice that the differences between provision and contingent liability are:
- For contingent liability, the obligation is a possible obligation that depends on the occurrence or non-occurrence of future events. On the other hand, for provision, there must be a present obligation (either legal or constructive obligation).
- If the obligation is a present obligation (i.e., does not depend on the occurrence or non-occurrence of future events), the distinction between provision and contingent liability lies in the (i) probability of outflows of resources, and (ii) the reliability of the amount measured. They are summarised below:
|Probability of outflow of resources||Probable||Not probable but more than remote|
|Reliability of the amount measured||An estimate can be made reliably||Cannot measure the amount with sufficient reliability|
Provision is recognised in the financial statements while contingent liability is not. IAS 37 only requires an entity to disclose the contingent liability in the financial statements unless the possibility of an outflow of resources is remote.
#4: What is a contingent asset and its requirements?
Similar to contingent liability, a contingent asset is 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. A contingent asset is not recognised in the financial statements because it may result in the recognition of income that may never be realised. However, a contingent asset is disclosed in the financial statements where the inflow of economic benefits is probable. Where the realisation of income is virtually certain, the related asset is recognised appropriately.
|Contingent asset||Contingent liability|
|Probability of inflow/outflow of resources||Probable||Not probable but more than remote|
#5: How do we measure a provision?
A provision is measured based on the entity’s best estimates of the expenditure required to settle the present obligation at the end of the reporting period or to transfer it to a third party at that time. Because of this, the measurement of the provision requires lots of management judgment in the area of risk and uncertainties. Accordingly, it is only making sense for IAS 37 to also require an entity to disclose the uncertainties surrounding the amount of the expenditure.
The measurement of provision may also be affected by:
- Time value of money – if the effect of the time value of money is material, entities are required by IAS 37 to present value the amount of a provision (i.e., to discounted present value of the expenditure expected to be required to settle the obligation) using the pre-tax discount rates.
- Future events – IAS 37 also requires an entity to consider how future events may affect the amount required to settle its obligations. For example, new legislation and new technology in the market.
Because provision reflects the entity’s best estimates of the expenditure required to settle the present obligation at the end of the reporting period, entities are required to review the amount of provision at the end of each reporting period and to adjust the amount when necessary.
#6: Can an entity recognise the provision for future operating losses?
IAS 37 is very clear that an entity is prohibited to recognise a provision for future operating losses. This is because future operating losses do not meet the definition of a liability and the recognition criteria for provision. IAS 37 states that an expectation of future operating losses is an indication that certain assets may be impaired and should be assessed under IAS 36 Impairment of Assets. In practice, careful consideration is needed to determine and assess whether an entity is making a provision for onerous contracts or future operating losses as these two areas are often confused.
#7: Do we need to make provisions for onerous contracts?
The most contentious issue within IAS 37 is the provision for onerous contracts. IAS 37 defines an onerous contract as ‘a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.’ We have covered discussion on onerous contracts and amendments to its requirements in Amendments to MFRS 137: Onerous Contracts (note: MFRS 137 is equivalent to IAS 37).
#8: What are the requirements for the provision of restructuring costs?
Entities are allowed to make provisions for restructuring costs only when the recognition criteria for provisions are met. IAS 37 further explains that a constructive obligation to restructure arise only when an entity has both the following:
- A detailed formal plan for the restructuring with at least the following information:
- The business (or part of a 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.
- Raised a valid expectation that it will carry out the restructuring either by starting to implement the plan or announcing its main features to those affected.
IAS 37 is strict in terms of expenditure to be included in the restructuring provision. A restructuring provision must only include the direct expenditure arising from the restructuring that both:
- Necessarily entailed by the restructuring; and
- Not associated with the ongoing activities of the entity.
Entities need to apply judgment and careful consideration of the expenditure in this area.
The quick facts above summarise the principles included in IAS 37.
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