IAS 37 : Provisions, Contingent Liabilities and Contingent Assets Flashcards
Definition 1
Liability : A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. [IAS 37.10].
Provision : A liability of uncertain timing or amount.
[IAS 37.10]
Obligating event : An event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation.
[IAS 37.10].
Liability : A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. [IAS 37.10].
Provision : A liability of uncertain timing or amount.
[IAS 37.10]
Obligating event : An event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation.
[IAS 37.10].
Definition 2
Legal obligation : An obligation that derives from a contract (through its explicit or implicit terms); legislation; or other operation of law. [IAS 37.10].
Constructive obligation :
An obligation that derives from an entity’s actions where:
(a) by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and
(b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities. [IAS 37.10].
Legal obligation : An obligation that derives from a contract (through its explicit or implicit terms); legislation; or other operation of law. [IAS 37.10].
Constructive obligation :
An obligation that derives from an entity’s actions where:
(a) by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and
(b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities. [IAS 37.10].
Definition 3
Contingent liability :
(a) 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; or
(b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability. [IAS 37.10]
Contingent liability :
(a) 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; or
(b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability. [IAS 37.10]
Definition 4
Contingent asset : 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. [IAS 37.10]
Onerous contract : A contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. [IAS 37.10].
Contingent asset : 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. [IAS 37.10]
Onerous contract : A contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. [IAS 37.10].
Definition 5
Restructuring : A programme that is planned and controlled by management, and materially changes either:
(a) the scope of a business undertaken by an entity; or
(b) the manner in which that business is conducted. [IAS 37.10].
Executory contract : A contract under which neither party has performed any of its obligations or both parties have partially performed their obligations to an equal extent. [IAS 37.3].
Restructuring : A programme that is planned and controlled by management, and materially changes either:
(a) the scope of a business undertaken by an entity; or
(b) the manner in which that business is conducted.
[IAS 37.10].
Executory contract : A contract under which neither party has performed any of its obligations or both parties have partially performed their obligations to an equal extent. [IAS 37.3].
Objective
‘is to ensure that appropriate recognition criteria and
measurement bases are applied to provisions, contingent liabilities and contingent assets and that sufficient information is disclosed in the notes to enable users to understand their nature, timing and amount’. [IAS 37 Objective].
‘is to ensure that appropriate recognition criteria and
measurement bases are applied to provisions, contingent liabilities and contingent assets and that sufficient information is disclosed in the notes to enable users to understand their nature, timing and amount’. [IAS 37 Objective].
Scope
The standard is required to be applied by all entities in accounting for provisions, contingent liabilities and contingent assets, except those arising from executory
contracts (unless the contract is onerous) and those covered by another standard. [IAS 37.1].
The standard is required to be applied by all entities in accounting for provisions, contingent liabilities and contingent assets, except those arising from executory
contracts (unless the contract is onerous) and those covered by another standard. [IAS 37.1].
Recognition - Provision
IAS 37 requires that a provision should be recognised when:
(a) an entity has a present obligation (legal or constructive) as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
(c) a reliable estimate can be made of the amount of the obligation.
No provision should be recognised unless all of these conditions are met. [IAS 37.14].
IAS 37 requires that a provision should be recognised when:
(a) an entity has a present obligation (legal or constructive) as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
(c) a reliable estimate can be made of the amount of the obligation.
No provision should be recognised unless all of these conditions are met. [IAS 37.14].
Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’
The standard defines both legal and constructive obligations. The definition of a legal obligation is fairly straightforward and uncontroversial; it refers to an obligation that derives from a contract (through its explicit or implicit terms), legislation or other operation of law. [IAS 37.10].
The standard defines both legal and constructive obligations. The definition of a legal obligation is fairly straightforward and uncontroversial; it refers to an obligation that derives from a contract (through its explicit or implicit terms), legislation or other operation of law. [IAS 37.10].
Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’
The definition of a constructive obligation, on the other hand, may give rise to more problems of interpretation.
A constructive obligation is defined as an obligation that derives from an entity’s actions where:
(a) by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and
(b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities. [IAS 37.10].
The definition of a constructive obligation, on the other hand, may give rise to more problems of interpretation.
A constructive obligation is defined as an obligation that derives from an entity’s actions where:
(a) by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and
(b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities. [IAS 37.10].
Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’
Example 27.1: Recognising a provision because of a constructive obligation
Scenario 1: Environmental policy – contaminated land
An entity in the oil industry operates in a country with no environmental legislation. However, it has a widely
published environmental policy in which it undertakes to clean up all contamination that it causes and it has a record of honouring this published policy. During the period the entity causes contamination to some land in this country. In these circumstances, the contamination of the land gives rise to a constructive obligation because the entity (through its published policy and record of honouring it) has created a valid expectation on the part of those affected by it that the entity will clean up the site. [IAS 37 IE Example 2B].
Example 27.1: Recognising a provision because of a constructive obligation
Scenario 1: Environmental policy – contaminated land
An entity in the oil industry operates in a country with no environmental legislation. However, it has a widely
published environmental policy in which it undertakes to clean up all contamination that it causes and it has a record of honouring this published policy. During the period the entity causes contamination to some land in this country. In these circumstances, the contamination of the land gives rise to a constructive obligation because the entity (through its published policy and record of honouring it) has created a valid expectation on the part of those affected by it that the entity will clean up the site. [IAS 37 IE Example 2B].
Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’
Example 27.1: Recognising a provision because of a constructive obligation
Scenario 2: Refunds policy – product returns
A retail store has a generally known policy of refunding purchases by dissatisfied customers, even though it is under no legal obligation to do so. In these circumstances, the sale of its products gives rise to a constructive obligation because the entity (through its reputation for providing refunds) has created a valid expectation on the part of customers that a refund will be given if they are dissatisfied with their purchase. [IAS 37 IE Example 4].
These examples demonstrate that the essence of a constructive obligation is the creation of a valid expectation that the entity is irrevocably committed to accepting and discharging its responsibilities.
Example 27.1: Recognising a provision because of a constructive obligation
Scenario 2: Refunds policy – product returns
A retail store has a generally known policy of refunding purchases by dissatisfied customers, even though it
is under no legal obligation to do so. In these circumstances, the sale of its products gives rise to a constructive obligation because the entity (through its reputation for providing refunds) has created a valid expectation on the part of customers that a refund will be given if they are dissatisfied with their purchase. [IAS 37 IE Example 4].
These examples demonstrate that the essence of a constructive obligation is the creation of a valid expectation that the entity is irrevocably committed to accepting and discharging its responsibilities.
Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’
The standard states that in almost all cases it will be clear whether a past event has given rise to a present obligation. However, it acknowledges that there will be some rare cases, such as a lawsuit against an entity, where this will not be so because the occurrence of
certain events or the consequences of those events are disputed. [IAS 37.16]. When it is not clear whether there is a present obligation, a ‘more likely than not’ evaluation (taking into account all available evidence) is deemed to be sufficient to require recognition of
a provision at the end of the reporting period.
[IAS 37.15].
The standard states that in almost all cases it will be clear whether a past event has given rise to a present obligation. However, it acknowledges that there will be some rare cases, such as a lawsuit against an entity, where this will not be so because the occurrence of
certain events or the consequences of those events are disputed. [IAS 37.16]. When it is not clear whether there is a present obligation, a ‘more likely than not’ evaluation (taking into account all available evidence) is deemed to be sufficient to require recognition of a provision at the end of the reporting period.
[IAS 37.15].
Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’
The evidence to be considered includes, for example, the opinion of experts together with any additional evidence provided by events after the reporting period. If on the basis of such evidence it is concluded that a present obligation is more likely than not to exist at the end of the reporting period, a provision will be required (assuming that the other recognition criteria are met). [IAS 37.16]. This is an apparent relaxation of the standard’s first criterion for the recognition of a provision as set out at 3.1 above, which requires there to be a definite obligation, not just a probable one
The evidence to be considered includes, for example, the opinion of experts together with any additional evidence provided by events after the reporting period. If on the basis of such evidence it is concluded that a present obligation is more likely than not to exist at the end of the reporting period, a provision will be required (assuming that the other recognition criteria are met). [IAS 37.16]. This is an apparent relaxation of the standard’s first criterion for the recognition of a provision as set out at 3.1 above, which requires there to be a definite obligation, not just a probable one
Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’
It also confuses slightly the question of the existence
of an obligation with the probability criterion, which strictly speaking relates to whether it is more likely than not that there will be an outflow of resources. However, this interpretation is confirmed in IAS 10 – Events after the Reporting Period, which includes ‘the settlement after the reporting period of a court case that confirms that the entity had a present obligation at the end of the reporting period’ as an example of an adjusting event. [IAS 10.9]
It also confuses slightly the question of the existence
of an obligation with the probability criterion, which strictly speaking relates to whether it is more likely than not that there will be an outflow of resources. However, this interpretation is confirmed in IAS 10 – Events after the Reporting Period, which includes ‘the settlement after the reporting period of a court case that confirms that the entity had a present obligation at the end of the reporting period’ as an example of an adjusting event. [IAS 10.9]
Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’
The second half of this condition uses the phrase ‘as a result of a past event’. This is based on the concept of an obligating event, which the standard defines as ‘an event that creates a legal or constructive obligation and that results in an entity having no realistic alternative to settling that obligation’. [IAS 37.10]. The standard says that this will be the case only:
(a) where the settlement of the obligation can be enforced by law; or
(b) in the case of a constructive obligation, where the event (which may be an action of the entity) creates valid expectations in other parties that the entity will
discharge the obligation. [IAS 37.17].
The second half of this condition uses the phrase ‘as a result of a past event’. This is based on the concept of an obligating event, which the standard defines as ‘an event that creates a legal or constructive obligation and that results in an entity having no realistic alternative to settling that obligation’. [IAS 37.10]. The standard says that this will be the case only:
(a) where the settlement of the obligation can be enforced by law; or
(b) in the case of a constructive obligation, where the event (which may be an action of the entity) creates valid expectations in other parties that the entity will
discharge the obligation. [IAS 37.17].
Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’
The standard emphasises that the financial statements deal with the financial position of an entity at the end of its reporting period, not its possible position in the future. Accordingly, no provision should be recognised for costs that need to be incurred to operate in the future. The only liabilities to be recognised are those that exist at the end of the reporting period. [IAS 37.18]. It is not always easy to distinguish between the current
state at the reporting date and the entity’s future possible position, especially where IAS 37 requires an assessment to be made based on the probability of obligations and expectations as to their outcome. However, when considering these questions it is
important to ensure that provisions are not recognised for LIABILITIES that arise from events after the reporting period
The standard emphasises that the financial statements deal with the financial position of an entity at the end of its reporting period, not its possible position in the future. Accordingly, no provision should be recognised for costs that need to be incurred to operate in the future. The only liabilities to be recognised are those that exist at the end of the reporting period. [IAS 37.18]. It is not always easy to distinguish between the current state at the reporting date and the entity’s future possible position, especially where IAS 37 requires an assessment to be made based on the probability of obligations and expectations as to their outcome. However, when considering these questions it is important to ensure that provisions are not recognised for LIABILITIES that arise from events after the reporting period
Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’
Example 27.2: No provision without a past obligating event
The government introduces a number of changes to the income tax system. As a result of these changes, an entity in the financial services sector will need to retrain a large proportion of its administrative and sales staff in order to ensure continued compliance with financial services regulation. At the end of the reporting period, no training has taken place. In these circumstances, no event has taken place at the reporting date to create an obligation. Only once the
training has taken place will there be a present obligation as a result of a past event.
[IAS 37 IE Example 7].
Example 27.2: No provision without a past obligating event
The government introduces a number of changes to the income tax system. As a result of these changes, an entity in the financial services sector will need to retrain a large proportion of its administrative and sales
staff in order to ensure continued compliance with financial services regulation. At the end of the reporting
period, no training has taken place. In these circumstances, no event has taken place at the reporting date to create an obligation. Only once the training has taken place will there be a present obligation as a result of a past event. [IAS 37 IE Example 7].
Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’
IAS 37 prohibits certain provisions that might otherwise qualify to be recognised by stating that it ‘is only those obligations arising from past events existing independently of an entity’s future actions (i.e. the future conduct of its business) that are recognised
as provisions’. In contrast to situations where the entity’s past conduct has created an obligation to incur expenditure (such as to rectify environmental damage already caused), a commercial or legal requirement to incur expenditure in order to operate in a particular way in the future, will not of itself justify the recognition of a provision. It argues that because the entity can avoid the expenditure by its future actions, for example by changing its method of operation, there is no present obligation for the future expenditure.
[IAS 37.19]
IAS 37 prohibits certain provisions that might otherwise qualify to be recognised by stating that it ‘is only those obligations arising from past events existing independently of an entity’s future actions (i.e. the future conduct of its business) that are recognised as provisions’. In contrast to situations where the entity’s past conduct has created an obligation to incur expenditure (such as to rectify environmental damage already caused), a commercial or legal requirement to incur expenditure in order to operate in a particular way in the future, will not of itself justify the recognition of a provision. It argues that because the entity can avoid the expenditure by its future actions, for example by changing its method of operation, there is no present obligation for the future expenditure.
[IAS 37.19]
Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’
Example 27.3: Obligations must exist independently of an entity’s future actions
Under legislation passed in 2018, an entity is required to fix smoke filters in its factories by 30 June 2020.
The entity has not fitted the smoke filters. At 31 December 2019, the end of the reporting period, no event has taken place to create an obligation. Only
once the smoke filters are fitted or the legislation takes effect, will there be a present obligation as a result of
a past event, either for the cost of fitting smoke filters or for fines under the legislation. At 31 December 2020, there is still no obligating event to justify provision for the cost of fitting the smoke filters required under the legislation because the filters have not been fitted. However, an obligation may exist as at the reporting date to pay fines or penalties under the legislation because the entity is operating its factory in a non-compliant way. However, a provision would only be recognised for the best estimate of any fines
and penalties if, as at 31 December 2020, it is determined to be more likely than not that such fines and penalties will be imposed. [IAS 37 IE Example 6]
Example 27.3: Obligations must exist independently of an entity’s future actions
Under legislation passed in 2018, an entity is required to fix smoke filters in its factories by 30 June 2020.
The entity has not fitted the smoke filters. At 31 December 2019, the end of the reporting period, no event has taken place to create an obligation. Only
once the smoke filters are fitted or the legislation takes effect, will there be a present obligation as a result of
a past event, either for the cost of fitting smoke filters or for fines under the legislation. At 31 December 2020, there is still no obligating event to justify provision for the cost of fitting the smoke filters required under the legislation because the filters have not been fitted. However, an obligation may exist as at the reporting date to pay fines or penalties under the legislation because the entity is operating its factory in a non-compliant way. However, a provision would only be recognised for the best estimate of any fines and penalties if, as at 31 December 2020, it is determined to be more likely than not that such fines and penalties will be imposed.
[IAS 37 IE Example 6]
Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’
The standard expects strict application of the requirement that, to qualify for recognition, an obligation must exist independently of an entity’s future actions. Even if a failure to incur certain costs would result in a legal requirement to discontinue an
entity’s operations, no provision can be recognised. IAS 37 considers the example of an airline required by law to overhaul its aircraft once every three years. It concludes that no provision is recognised because the entity can avoid the requirement to perform the overhaul, for example by replacing the aircraft before
the three year period has expired.
[IAS 37 IE Example 11B].
The standard expects strict application of the requirement that, to qualify for recognition, an obligation must exist independently of an entity’s future actions. Even if a failure to incur certain costs would result in a legal requirement to discontinue an entity’s operations, no provision can be recognised. IAS 37 considers the example of an airline required by law to overhaul its aircraft once every three years. It concludes that no provision is recognised because the entity can avoid the requirement to perform the overhaul, for example by replacing the aircraft before the three year period has expired. [IAS 37 IE Example 11B].
Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’
Significantly, however, such considerations do not apply in the case of obligations to dismantle or remove an asset at the end of its useful life, where an obligation is recognised despite the entity’s ability to dispose of the asset before its useful life has expired. Such costs are required to be included by IAS 16 – Property, Plant and Equipment – as part of the measure of an asset’s initial cost. [IAS 16.16]. Decommissioning provisions are below. Accordingly, the determination of whether an obligation exists independently of an entity’s future actions can be a matter of judgement that depends on the particular facts and circumstances of the case.
Significantly, however, such considerations do not apply in the case of obligations to dismantle or remove an asset at the end of its useful life, where an obligation is recognised despite the entity’s ability to dispose of the asset before its useful life has expired. Such costs are required to be included by IAS 16 – Property, Plant and Equipment – as part of the measure of an asset’s initial cost. [IAS 16.16]. Decommissioning provisions are below. Accordingly, the determination of whether an obligation exists independently of an entity’s future actions can be a matter of judgement that depends on the particular facts and circumstances of the case.
Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’
There is no requirement for an entity to know to whom an obligation is owed. The obligation may be to the public at large. It follows that the obligation could be to one party, but the amount ultimately payable will be to another party. For example, in the case of a constructive obligation for an environmental clean-up, the obligation is to the public, but the liability will be settled by making payment to the contractors engaged to carry out the clean-up. However, the principle is that there must be another party for the obligation to exist. It follows from this that a management or board decision will not give rise to a constructive obligation unless it is communicated in sufficient detail to
those affected by it before the end of the reporting period. [IAS 37.20]
There is no requirement for an entity to know to whom an obligation is owed. The obligation may be to the public at large. It follows that the obligation could be to one party, but the amount ultimately payable will be to another party. For example, in the case of a constructive obligation for an environmental clean-up, the obligation is to the public, but the liability will be settled by making payment to the contractors engaged to carry out the clean-up. However, the principle is that there must be another party for the obligation to exist. It follows from this that a management or board decision will not give rise to a constructive obligation unless it is communicated in sufficient detail to those affected by it before the end of the reporting period. [IAS 37.20]
Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’
The standard discusses the possibility that an event that does not give rise to an obligation immediately may do so at a later date, because of changes in the law or an act by the entity (such as a sufficiently specific public statement) which gives rise to a constructive obligation. [IAS 37.21]. Changes in the law will be relatively straightforward to identify. The only issue that arises will be to determine exactly when that change in the law should be recognised. IAS 37 states that an obligation arises only when the legislation is virtually certain to be enacted as drafted and suggests that in many cases, this will not be until it is enacted.
[IAS 37.22].
The standard discusses the possibility that an event that does not give rise to an obligation immediately may do so at a later date, because of changes in the law or an act by the entity (such as a sufficiently specific public statement) which gives rise to a constructive obligation. [IAS 37.21]. Changes in the law will be relatively straightforward to identify. The only issue that arises will be to determine exactly when that change in the law should be recognised. IAS 37 states that an obligation arises only when the legislation is virtually certain to be enacted as drafted and suggests that in many cases, this will not be until it is enacted. [IAS 37.22].
Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’
The more subjective area is the possibility that an act by the entity will give rise to a constructive obligation. The example given is of an entity publicly accepting responsibility for rectification of previous environmental damage in a way that creates a constructive obligation. [IAS 37.21]. This seems to introduce a certain amount of flexibility to management when reporting results. By bringing forward or delaying a public announcement of a commitment that management had always intended to honour, it can affect the reporting period in which a provision is recognised. Nevertheless, the existence
of a public announcement provides a more transparent basis for recognising a provision than,
for example, a decision made behind the closed doors of a boardroom.
The more subjective area is the possibility that an act by the entity will give rise to a constructive obligation. The example given is of an entity publicly accepting responsibility for rectification of previous environmental damage in a way that creates a constructive
obligation. [IAS 37.21]. This seems to introduce a certain amount of flexibility to management when reporting results. By bringing forward or delaying a public
announcement of a commitment that management had always intended to honour, it can affect the reporting period in which a provision is recognised. Nevertheless, the existence of a public announcement provides a more transparent basis for recognising a provision than, for example, a decision made behind the closed doors of a boardroom.
Recognition - Provision : ‘It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation’
The meaning of probable in these circumstances is that the outflow of resources is more likely than not to occur; that is, it has a probability of occurring that is greater than 50%. [IAS 37.23]. The standard also makes it clear that where there are a number of similar obligations, the probability that an outflow will occur is based on the class of obligations as a whole. This is because in the case of certain obligations such as warranties, the possibility of an outflow for an individual item may be small (likely to be much less than 50%) whereas the possibility of at least some outflow of resources for the population as a whole will be much greater (almost certainly greater than 50%). [IAS 37.24]
The meaning of probable in these circumstances is that the outflow of resources is more likely than not to occur; that is, it has a probability of occurring that is greater than 50%. [IAS 37.23]. The standard also makes it clear that where there are a number of similar obligations, the probability that an outflow will occur is based on the class of obligations as a whole. This is because in the case of certain obligations such as warranties, the possibility of an outflow for an individual item may be small (likely to be much less than 50%) whereas the possibility of at least some outflow of resources for the population as a whole will be much greater (almost certainly greater than 50%). [IAS 37.24]
Recognition - Provision : ‘It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation’
With regard to the measurement of a provision arising from a number of similar obligations, the standard refers to the calculation of an ‘expected value’, whereby the obligation is estimated by weighting all the possible outcomes by their associated probabilities. [IAS 37.39]. Where the obligation being measured relates to a single item, the standard suggests that the best estimate of the liability may be the individual most likely outcome. [IAS 37.40]. For the purposes of recognition, a determination that it is
more likely than not that any outflow of resources will be required is sufficient.
With regard to the measurement of a provision arising from a number of similar obligations, the standard refers to the calculation of an ‘expected value’, whereby the obligation is estimated by weighting all the possible outcomes by their associated probabilities. [IAS 37.39]. Where the obligation being measured relates to a single item, the standard suggests that the best estimate of the liability may be the individual most likely outcome. [IAS 37.40]. For the purposes of recognition, a determination that it is more likely than not that any outflow of resources will be required is sufficient.
Recognition - Provision : A reliable estimate can be made of the amount of the obligation’
The standard takes the view that a sufficiently reliable estimate can almost always be made for a provision where an entity can determine a range of possible outcomes. Hence, the standard contends that it will only be in extremely rare cases that a range of possible outcomes cannot be determined and therefore no sufficiently reliable estimate of the obligation can be made. [IAS 37.25]. In these extremely rare circumstances, no liability is recognised.
Instead, the liability should be disclosed as a contingent liability. [IAS 37.26]
The standard takes the view that a sufficiently reliable estimate can almost always be made for a provision where an entity can determine a range of possible outcomes. Hence, the standard contends that it will only be in extremely rare cases that a range of possible
outcomes cannot be determined and therefore no sufficiently reliable estimate of the obligation can be made. [IAS 37.25]. In these extremely rare circumstances, no liability is recognised. Instead, the liability should be disclosed as a contingent liability. [IAS 37.26]
Recognition - Contingencies
IAS 37 says that contingent liabilities and contingent assets should not be recognised, but only disclosed. [IAS 37.27-28, 31, 34].
Contingent liabilities that are recognised separately as part of allocating the cost of a business combination are covered by the requirements of IFRS 3. [IFRS 3.23]. Such liabilities continue to be measured after the business combination at the higher of:
(a) the amount that would be recognised in accordance with IAS 37, and
(b) the amount initially recognised less, if appropriate, the cumulative amount of income recognised in accordance with the principles of IFRS 15. [IFRS 3.56].
IAS 37 says that contingent liabilities and contingent assets should not be recognised, but only disclosed. [IAS 37.27-28, 31, 34].
Contingent liabilities that are recognised separately as part of allocating the cost of a business combination are covered by the requirements of IFRS 3. [IFRS 3.23]. Such liabilities continue to be measured after the business combination at the higher of:
(a) the amount that would be recognised in accordance with IAS 37, and
(b) the amount initially recognised less, if appropriate, the cumulative amount of income recognised in accordance with the principles of IFRS 15. [IFRS 3.56].
Recognition - Contingencies : Contingent liabilities 1
A contingent liability is defined in the standard as:
(a) 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; or
(b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability. [IAS 37.10].
A contingent liability is defined in the standard as:
(a) 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; or
(b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability. [IAS 37.10].
Recognition - Contingencies : Contingent liabilities 2
At first glance, this definition is not easy to understand because a natural meaning of ‘contingent’ would include any event whose outcome depends on future circumstances. The meaning is perhaps clearer when considering the definition of a liability and the
criteria for recognising a provision in the standard. A possible obligation whose existence is yet to be confirmed does not meet the definition of a liability; and a present obligation in respect of which an outflow of resources is not probable, or which cannot be measured reliably does not qualify for recognition.
[IAS 37.14]
At first glance, this definition is not easy to understand because a natural meaning of ‘contingent’ would include any event whose outcome depends on future circumstances. The meaning is perhaps clearer when considering the definition of a liability and the criteria for recognising a provision in the standard. A possible obligation whose existence is yet to be confirmed does not meet the definition of a liability; and a present obligation in respect of which an outflow of resources is not probable, or which cannot be measured reliably does not qualify for recognition.
[IAS 37.14]
Recognition - Contingencies : Contingent liabilities 3a
On that basis a contingent liability under IAS 37 means one of the following:
(a) an obligation that is estimated to be less than 50+% likely to exist (i.e. it does not meet the definition of a liability). Where it is more likely than not that a present
obligation exists at the end of the reporting period, a provision is recognised. [IAS 37.16(a)]. Where it is more likely than not that no present obligation exists, a
contingent liability is disclosed (unless the possibility is remote); [IAS 37.16(b)]
On that basis a contingent liability under IAS 37 means one of the following:
(a) an obligation that is estimated to be less than 50+% likely to exist (i.e. it does not meet the definition of a liability). Where it is more likely than not that a present
obligation exists at the end of the reporting period, a provision is recognised. [IAS 37.16(a)]. Where it is more likely than not that no present obligation exists, a
contingent liability is disclosed (unless the possibility is remote); [IAS 37.16(b)]
Recognition - Contingencies : Contingent liabilities 3b
(b) a present obligation that has a less than 50+% chance of requiring an outflow of economic benefits (i.e. it meets the definition of a liability but does not meet the recognition criteria). Where it is not probable that there will be an outflow of resources, an entity discloses a contingent liability (unless the possibility is remote); [IAS 37.23] or
(c) a present obligation for which a sufficiently reliable estimate cannot be made (i.e. it meets the definition of a liability but does not meet the recognition criteria).
In these rare circumstances, a liability cannot be recognised and it is disclosed as a contingent liability. [IAS 37.26].
(b) a present obligation that has a less than 50+% chance of requiring an outflow of economic benefits (i.e. it meets the definition of a liability but does not meet the recognition criteria). Where it is not probable that there will be an outflow of resources, an entity discloses a contingent liability (unless the possibility is remote); [IAS 37.23] or
(c) a present obligation for which a sufficiently reliable estimate cannot be made (i.e. it meets the definition of a liability but does not meet the recognition criteria).
In these rare circumstances, a liability cannot be recognised and it is disclosed as a contingent liability. [IAS 37.26].
Recognition - Contingencies : Contingent liabilities 4
The term ‘possible’ is not defined, but literally it could mean any probability greater than 0% and less than 100%. However, the standard effectively divides this range into four components, namely ‘remote’, ‘possible but not probable’, ‘probable’ and ‘virtually certain’. The standard requires a provision to be recognised if ‘it is more likely than not that a present obligation exists at the end of the reporting period’. [IAS 37.16(a)]. Therefore, IAS 37 distinguishes between a ‘probable’ obligation (which is more likely than not to
exist and, therefore requires recognition as a provision) and a ‘possible’ obligation (for which either the existence of a present obligation is yet to be confirmed or where the probability of an outflow of resources is 50% or less). [IAS 37.13]
The term ‘possible’ is not defined, but literally it could mean any probability greater than 0% and less than 100%. However, the standard effectively divides this range into four components, namely ‘remote’, ‘possible but not probable’, ‘probable’ and ‘virtually certain’. The standard requires a provision to be recognised if ‘it is more likely than not that a present obligation exists at the end of the reporting period’. [IAS 37.16(a)]. Therefore, IAS 37 distinguishes between a ‘probable’ obligation (which is more likely than not to exist and, therefore requires recognition as a provision) and a ‘possible’ obligation (for which either the existence of a present obligation is yet to be confirmed or where the probability of an outflow of resources is 50% or less). [IAS 37.13]
Recognition - Contingencies : Contingent liabilities 5
The standard requires that contingent liabilities are assessed continually to determine whether circumstances have changed, in particular whether an outflow of resources embodying economic benefits has become probable. Where this becomes the case, then provision should be made in the period in which the change in probability occurs (except in the rare circumstances where no reliable estimate can be made). [IAS 37.30]. Other changes in circumstances might require disclosure of a previously remote obligation on the grounds that an outflow of resources has become possible (but not probable).
The standard requires that contingent liabilities are assessed continually to determine whether circumstances have changed, in particular whether an outflow of resources embodying economic benefits has become probable. Where this becomes the case, then
provision should be made in the period in which the change in probability occurs (except in the rare circumstances where no reliable estimate can be made). [IAS 37.30]. Other changes in circumstances might require disclosure of a previously remote obligation on the grounds that an outflow of resources has become possible (but not probable).
Recognition - Contingencies : Contingent liabilities 6
Example 27.4: When the likelihood of an outflow of benefits becomes probable
After a wedding in 2019, ten people died, possibly as a result of food poisoning from products sold by the
entity. Legal proceedings are started seeking damages from the entity. The entity disputes any liability and,
up to the date on which its financial statements for the year ended 31 December 2019 are authorised for issue, its lawyers have advised that is probable that the entity will not be found liable. However, when the entity prepares its financial statements for the year ended 31 December 2020, its lawyers advise that, owing to developments in the case, it is probable that the entity will be found liable. At 31 December 2019, no provision is recognised and the matter is disclosed as a contingent liability unless the probability of any outflow is regarded as remote. On the basis of the evidence available when the financial statements were approved, there is no obligation as a result of a past event. At 31 December 2020, a provision is recognised for the best estimate of the amount required to settle the obligation. The fact that an outflow of economic benefits is now believed to be probable means that there is a present obligation. [IAS 37 IE Example 10].
Example 27.4: When the likelihood of an outflow of benefits becomes probable
After a wedding in 2019, ten people died, possibly as a result of food poisoning from products sold by the
entity. Legal proceedings are started seeking damages from the entity. The entity disputes any liability and,
up to the date on which its financial statements for the year ended 31 December 2019 are authorised for issue,
its lawyers have advised that is probable that the entity will not be found liable. However, when the entity
prepares its financial statements for the year ended 31 December 2020, its lawyers advise that, owing to
developments in the case, it is probable that the entity will be found liable. At 31 December 2019, no provision is recognised and the matter is disclosed as a contingent liability unless the probability of any outflow is regarded as remote. On the basis of the evidence available when the financial statements were approved, there is no obligation as a result of a past event. At 31 December 2020, a provision is recognised for the best estimate of the amount required to settle the obligation. The fact that an outflow of economic benefits is now believed to be probable means that there is a present obligation.
[IAS 37 IE Example 10].
Recognition - Contingencies : Contingent assets 1
A contingent asset is defined in a more intuitive way. It is ‘a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of the entity’. [IAS 37.10]. In this case, the word ‘possible’ is not confined to a level of probability of 50% or less, which may further increase the confusion over the different meaning of the term in the definition of contingent liabilities.
A contingent asset is defined in a more intuitive way. It is ‘a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of the entity’. [IAS 37.10]. In this case, the word ‘possible’ is not confined to a level of probability of 50% or less, which may further increase the confusion over the different meaning of the term in the definition of contingent liabilities.
Recognition - Contingencies : Contingent assets 2
Contingent assets usually arise from unplanned or other unexpected events that give rise to the possibility of an inflow of economic benefits to the entity. An example is a claim that an entity is pursuing through legal process, where the outcome is uncertain.
[IAS 37.32].
The standard states that a contingent asset should not be recognised, as this could give rise to recognition of income that may never be realised. However, when the realisation of income is virtually certain, then the related asset is no longer regarded as contingent
and recognition is appropriate. [IAS 37.33].
Contingent assets usually arise from unplanned or other unexpected events that give rise to the possibility of an inflow of economic benefits to the entity. An example is a claim that an entity is pursuing through legal process, where the outcome is uncertain. [IAS 37.32].
The standard states that a contingent asset should not be recognised, as this could give rise to recognition of income that may never be realised. However, when the realisation of income is virtually certain, then the related asset is no longer regarded as contingent
and recognition is appropriate. [IAS 37.33].
Recognition - Contingencies : Contingent assets 3
Virtual certainty is not defined in the standard, but it is certainly a much higher hurdle than ‘probable’ and indeed more challenging than the term ‘highly probable’, defined in IFRS 5 as ‘significantly more likely than probable’. [IFRS 5 Appendix A]. We think it
reasonable that virtual certainty is interpreted as being as close to 100% as to make any remaining uncertainty insignificant. What this means in practice requires each case to be decided on its merits and any judgement should be made in the knowledge that, in any event, it is rarely possible to accurately assess the probability of the outcome of a particular event.
Virtual certainty is not defined in the standard, but it is certainly a much higher hurdle than ‘probable’ and indeed more challenging than the term ‘highly probable’, defined in IFRS 5 as ‘significantly more likely than probable’. [IFRS 5 Appendix A]. We think it reasonable that virtual certainty is interpreted as being as close to 100% as to make any remaining uncertainty insignificant. What this means in practice requires each case to be decided on its merits and any judgement should be made in the knowledge that, in any event, it is rarely possible to accurately assess the probability of the outcome of a particular event.
Recognition - Contingencies : Contingent assets 4
The standard requires disclosure of the contingent asset when the inflow of economic benefits is probable. [IAS 37.34]. For the purposes of the standard ‘probable’ means that the event is more likely than not to occur; that is, it has a probability greater than 50%.
[IAS 37.23]
The standard requires disclosure of the contingent asset when the inflow of economic benefits is probable. [IAS 37.34]. For the purposes of the standard ‘probable’ means that the event is more likely than not to occur; that is, it has a probability greater than 50%.
[IAS 37.23]
Recognition - Contingencies : Contingent assets 5
As with contingent liabilities, any contingent assets should be assessed continually to ensure that developments are appropriately reflected in the financial statements. If it has become virtually certain that an inflow of economic benefits will arise, the asset and the related income should be recognised in the period in which the change occurs. If a previously unlikely inflow becomes probable, then the contingent asset should be disclosed. [IAS 37.35]
As with contingent liabilities, any contingent assets should be assessed continually to ensure that developments are appropriately reflected in the financial statements. If it has become virtually certain that an inflow of economic benefits will arise, the asset and the related income should be recognised in the period in which the change occurs. If a previously unlikely inflow becomes probable, then the contingent asset should be disclosed. [IAS 37.35]
Recognition - Contingencies : Contingent assets 6
The requirement to recognise the effect of changing circumstances in the period in which the change occurs extends to the analysis of information available after the end of the reporting period and before the date of approval of the financial statements. In our view, such information would not give rise to an adjusting event after the reporting period. In contrast to contingent liabilities (in respect of which IAS 10 includes as a specific example of an adjusting event ‘the settlement after the reporting period of a court case that confirms that the entity had a present obligation at the end of the reporting period’ [IAS 10.9]), no adjustment should be made to reflect the subsequent settlement of a legal claim in favour of the entity. In this instance, the period in which the change occurs is subsequent to the reporting period. There is also no suggestion that the example in IAS 10 is referring to anything but liabilities. An asset could only be recognised if, at the end of the reporting period, the entity could show that it was virtually certain that its claim would succeed.
The requirement to recognise the effect of changing circumstances in the period in which the change occurs extends to the analysis of information available after the end of the reporting period and before the date of approval of the financial statements. In our view, such information would not give rise to an adjusting event after the reporting period. In contrast to contingent liabilities (in respect of which IAS 10 includes as a
specific example of an adjusting event ‘the settlement after the reporting period of a court case that confirms that the entity had a present obligation at the end of the reporting period’ [IAS 10.9]), no adjustment should be made to reflect the subsequent settlement of a legal claim in favour of the entity. In this instance, the period in which the change occurs is subsequent to the reporting period. There is also no suggestion that the example in IAS 10 is referring to anything but liabilities. An asset could only be recognised if, at the end of the reporting period, the entity could show that it was virtually certain that its claim would succeed.
Recognition - Contingencies : Contingent liabilities -
Obligations contingent on the successful recovery of a contingent asset 1
Entities may sometimes be required to pay contingent fees to a third party dependent upon the successful recovery of a contingent asset. For example, the payment of fees to a legal advisor in a contract agreed on a ‘no win, no fee’ basis will depend upon the
successful outcome of a legal claim. In such cases, we believe that the obligation for the success fee arises from an executory contract that should be evaluated separately from the legal claim. The liability for the success fee would therefore only be recognised by
the entity upon winning the claim.
Entities may sometimes be required to pay contingent fees to a third party dependent upon the successful recovery of a contingent asset. For example, the payment of fees to a legal advisor in a contract agreed on a ‘no win, no fee’ basis will depend upon the
successful outcome of a legal claim. In such cases, we believe that the obligation for the success fee arises from an executory contract that should be evaluated separately from the legal claim. The liability for the success fee would therefore only be recognised by
the entity upon winning the claim.
Recognition - Contingencies : Contingent liabilities -
Obligations contingent on the successful recovery of a contingent asset 2
IAS 37 uses the term executory contracts to mean ‘contracts under which neither party has performed any of its obligations, or both parties have partially performed their obligations to an equal extent’.
[IAS 37.3]. When a contract for services is wholly contingent on recovering a contingent asset, no service requiring payment is deemed to be provided until or unless the matter is resolved successfully. Unless the contract also required payment to be made in the event of failure, the amount of work put in by the
lawyer to prepare a case and argue for recovery of the contingent asset is irrelevant to the existence of a liability to pay fees.
IAS 37 uses the term executory contracts to mean ‘contracts under which neither party has performed any of its obligations, or both parties have partially performed their obligations to an equal extent’.
[IAS 37.3]. When a contract for services is wholly contingent on recovering a contingent asset, no service requiring payment is deemed to be provided until or unless the matter is resolved successfully. Unless the contract also required payment to be made in the event of failure, the amount of work put in by the lawyer to prepare a case and argue for recovery of the contingent asset is irrelevant to the existence of a liability to pay fees.
Recognition - Contingencies : Contingent liabilities -
Obligations contingent on the successful recovery of a contingent asset 3
If the entity has deemed it appropriate to recognise an asset in respect of the claim, it would be appropriate to take account of any such fees in the measurement of that asset (in determining the net amount recoverable); but no accrual should be made for the legal
fees themselves unless a successful outcome is confirmed. This analysis is specific to a no win-no fee arrangement related to a contingent asset and may not be appropriate in other circumstances.
If the entity has deemed it appropriate to recognise an asset in respect of the claim, it would be appropriate to take account of any such fees in the measurement of that asset (in determining the net amount recoverable); but no accrual should be made for the legal
fees themselves unless a successful outcome is confirmed. This analysis is specific to a no win-no fee arrangement related to a contingent asset and may not be appropriate in other circumstances.
Recognition - How probability determines whether to recognise or disclose 1
The following matrix summarises the treatment of contingencies under IAS 37: Refer OneNote
The following matrix summarises the treatment of contingencies under IAS 37: Refer OneNote
Recognition - How probability determines whether to recognise or disclose 2
The standard does not put a numerical measure of probability on either ‘virtually certain’ or ‘remote’. In our view, the use of such measures would downgrade a process requiring the exercise of judgement into a mechanical exercise. It is difficult to imagine
circumstances when an entity could reliably determine an obligation to be, for example, 92%, 95% or 99% likely, let alone be able to compare those probabilities objectively. Accordingly, we think it reasonable to regard ‘virtually certain’ as describing a likelihood
that is as close to 100% as to make any remaining uncertainty insignificant; to see ‘remote’ as meaning a likelihood of an outflow of resources that is not significant; and for significance to be a matter for judgement and determined according to the merits of
each case.
The standard does not put a numerical measure of probability on either ‘virtually certain’ or ‘remote’. In our view, the use of such measures would downgrade a process requiring the exercise of judgement into a mechanical exercise. It is difficult to imagine
circumstances when an entity could reliably determine an obligation to be, for example, 92%, 95% or 99% likely, let alone be able to compare those probabilities objectively. Accordingly, we think it reasonable to regard ‘virtually certain’ as describing a likelihood that is as close to 100% as to make any remaining uncertainty insignificant; to see ‘remote’ as meaning a likelihood of an outflow of resources that is not significant; and for significance to be a matter for judgement and determined according to the merits of each case.
Recognising an asset when recognising a provision 1
In most cases, the recognition of a provision results in an immediate expense in profit or loss. Nevertheless, in some cases it may be appropriate to recognise an asset. These issues are not discussed in IAS 37, which neither prohibits nor requires capitalisation of
the costs recognised when a provision is made. It states that other standards specify whether expenditures are treated as assets or expenses.
[IAS 37.8].
In most cases, the recognition of a provision results in an immediate expense in profit or loss. Nevertheless, in some cases it may be appropriate to recognise an asset. These issues are not discussed in IAS 37, which neither prohibits nor requires capitalisation of the costs recognised when a provision is made. It states that other standards specify whether expenditures are treated as assets or expenses. [IAS 37.8].
Recognising an asset when recognising a provision 2
Example 27.5: When the recognition of a provision gives rise to an asset.
An entity operates an offshore oilfield where its licensing agreement requires it to remove the oil rig at the end of production and restore the seabed. 90% of the eventual costs relate to the removal of the oil rig and restoration of damage caused by building it, with 10% expected to arise through the extraction of oil. At the end of the reporting period, the rig has been constructed but no oil has been extracted. A provision is recognised in respect of the probable costs relating to the removal of the rig and restoring damage caused by building it. This is because the construction of the rig, combined with the requirement under the licence to remove the rig and restore the seabed, creates an obligating event as at the end of the reporting period. These costs are included as part of the cost of the oil rig. However, there is no obligation to rectify any damage that will be caused by the future extraction
of oil. [IAS 37 IE Example 3].
Example 27.5: When the recognition of a provision gives rise to an asset.
An entity operates an offshore oilfield where its licensing agreement requires it to remove the oil rig at the end of production and restore the seabed. 90% of the eventual costs relate to the removal of the oil rig and restoration of damage caused by building it, with 10% expected to arise through the extraction of oil. At the end of the reporting period, the rig has been constructed but no oil has been extracted. A provision is recognised in respect of the probable costs relating to the removal of the rig and restoring damage caused by building it. This is because the construction of the rig, combined with the requirement under the licence to remove the rig and restore the seabed, creates an obligating event as at the end of the reporting period. These costs are included as part of the cost of the oil rig. However, there is no obligation to rectify any damage that will be caused by the future extraction of oil. [IAS 37 IE Example 3].
Measurement - Best estimate of provision 1
IAS 37 requires the amount to be recognised as a provision to be the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. [IAS 37.36].
This measure is determined before tax, as the tax consequences of the provision, and changes to it, are dealt with under IAS 12. [IAS 37.41].
IAS 37 requires the amount to be recognised as a provision to be the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. [IAS 37.36].
This measure is determined before tax, as the tax consequences of the provision, and changes to it, are dealt with under IAS 12. [IAS 37.41].
Measurement - Best estimate of provision 2
The standard equates this ‘best estimate’ with ‘the amount that an entity would rationally pay to settle the obligation at the end of the reporting period or to transfer it to a third party at that time’. [IAS 37.37]. It is interesting that a hypothetical transaction of this kind should be proposed as the conceptual basis of the measurement required, rather than putting the main emphasis upon the actual expenditure that is expected to be incurred in the future.
The standard equates this ‘best estimate’ with ‘the amount that an entity would rationally pay to settle the obligation at the end of the reporting period or to transfer it to a third party at that time’. [IAS 37.37]. It is interesting that a hypothetical transaction of this kind should be proposed as the conceptual basis of the measurement required, rather than putting the main emphasis upon the actual expenditure that is expected to be incurred in the future.
Measurement - Best estimate of provision 3
The standard does acknowledge that it would often be impossible or prohibitively expensive to settle or transfer the obligation at the end of the reporting period. However, it goes on to state that ‘the estimate of the amount that an entity would rationally pay to settle or transfer the obligation gives the best estimate of the expenditure required to settle the present obligation at the end of the reporting period’.
[IAS 37.37].
The standard does acknowledge that it would often be impossible or prohibitively expensive to settle or transfer the obligation at the end of the reporting period. However, it goes on to state that ‘the estimate of the amount that an entity would rationally pay to settle or transfer the obligation gives the best estimate of the expenditure required to settle the present obligation at the end of the reporting period’.
[IAS 37.37].
Measurement - Best estimate of provision 4
The estimates of outcome and financial effect are determined by the judgement of the entity’s management, supplemented by experience of similar transactions and, in some cases, reports from independent experts. The evidence considered will include any additional evidence provided by events after the reporting period. [IAS 37.38].
The estimates of outcome and financial effect are determined by the judgement of the entity’s management, supplemented by experience of similar transactions and, in some cases, reports from independent experts. The evidence considered will include any additional evidence provided by events after the reporting period. [IAS 37.38].
Measurement - Best estimate of provision 5
The standard suggests that there are various ways of dealing with the uncertainties surrounding the amount to be recognised as a provision. It mentions three, an expected value (or probability-weighted) method; the mid-point of the range of possible outcomes; and an estimate of the individual most likely outcome. An expected value approach would be appropriate when a large population of items is being measured, such as warranty costs. This is a statistical computation which weights the cost of all the various possible outcomes according to their probabilities, as illustrated in the following example taken from IAS 37. [IAS 37.39].
The standard suggests that there are various ways of dealing with the uncertainties surrounding the amount to be recognised as a provision. It mentions three, an expected value (or probability-weighted) method; the mid-point of the range of possible outcomes; and an estimate of the individual most likely outcome. An expected value approach would be appropriate when a large population of items is being measured, such as warranty costs. This is a statistical computation which weights the cost of all the various possible outcomes according to their probabilities, as illustrated in the following example taken from IAS 37. [IAS 37.39].
Measurement - Best estimate of provision 6
Example 27.6: Calculation of expected value.
An entity 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 six months after purchase. If minor defects were detected in all products sold, repair costs of £1 million would result. If major defects were detected in all products sold, repair costs of £4 million would result. The entity’s past experience and future expectations indicate that, for the coming year, 75 per cent of the goods sold will have no defects, 20 per cent of the goods sold will have minor defects and 5 per cent of the goods sold will have major defects. In accordance with paragraph 24 of IAS 37 (see 3.1.2 above) an entity assesses the probability of a transfer for the warranty obligations as a whole. The expected value of the cost of repairs is:
(75% of nil) + (20% of £1m) + (5% of £4m) = £400,000
An entity 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 six months after purchase. If minor defects were
detected in all products sold, repair costs of £1 million would result. If major defects were detected in all
products sold, repair costs of £4 million would result. The entity’s past experience and future expectations
indicate that, for the coming year, 75 per cent of the goods sold will have no defects, 20 per cent of the goods sold will have minor defects and 5 per cent of the goods sold will have major defects. In accordance with paragraph 24 of IAS 37 (see 3.1.2 above) an entity assesses the probability of a transfer for the warranty
obligations as a whole. The expected value of the cost of repairs is:
(75% of nil) + (20% of £1m) + (5% of £4m) = £400,000
Measurement - Best estimate of provision 7
Where the obligation being measured relates to a single item, the standard suggests that the best estimate of the liability may be the individual most likely outcome. However, even in such a case, it notes that consideration should be given to other possible
outcomes and where these are predominantly higher or mainly lower than the most likely outcome, the resultant ‘best estimate’ will be a higher or lower amount than the individual most likely outcome. To illustrate this, the standard gives an example of an
entity that has to rectify a fault in a major plant that it has constructed for a customer. The most likely outcome is that the repair will succeed at the first attempt. However, a provision should be made for a larger amount if there is a significant chance that further attempts will be necessary. [IAS 37.40].
Where the obligation being measured relates to a single item, the standard suggests that the best estimate of the liability may be the individual most likely outcome. However, even in such a case, it notes that consideration should be given to other possible outcomes and where these are predominantly higher or mainly lower than the most likely outcome, the resultant ‘best estimate’ will be a higher or lower amount than the individual most likely outcome. To illustrate this, the standard gives an example of an entity that has to rectify a fault in a major plant that it has constructed for a customer. The most likely outcome is that the repair will succeed at the first attempt. However, a provision should be made for a larger amount if there is a significant chance that further attempts will be necessary. [IAS 37.40].
Measurement - Dealing with risk and uncertainty in measuring a provision 1
It is clear from the definition of a provision as a liability of uncertain timing or amount that entities will have to deal with risk and uncertainty in estimating an appropriate measure of the obligation at the end of the reporting period. It is therefore interesting to consider how the measurement rules detailed in IAS 37 help entities achieve a faithful representation of the obligation in these circumstances. A faithful representation requires estimates that are neutral, that is, without bias. [CF(2010) QC12, QC14]
It is clear from the definition of a provision as a liability of uncertain timing or amount that entities will have to deal with risk and uncertainty in estimating an appropriate measure of the obligation at the end of the reporting period. It is therefore interesting to consider how the measurement rules detailed in IAS 37 help entities achieve a faithful representation of the obligation in these circumstances. A faithful representation requires estimates that are neutral, that is, without bias.
[CF(2010) QC12, QC14]
Measurement - Dealing with risk and uncertainty in measuring a provision 2
The standard does not refer to neutrality as such; however, it does discuss the concept of risk and the need for exercising caution and care in making judgements under conditions of uncertainty. It states that ‘the risks and uncertainties that inevitably
surround many events and circumstances shall be taken into account in reaching the best estimate of a provision’. [IAS 37.42]. It refers to risk as being variability of outcome and suggests that a risk adjustment may increase the amount at which a
liability is measured. [IAS 37.43]
The standard does not refer to neutrality as such; however, it does discuss the concept of risk and the need for exercising caution and care in making judgements under conditions of uncertainty. It states that ‘the risks and uncertainties that inevitably surround many events and circumstances shall be taken into account in reaching the best estimate of a provision’. [IAS 37.42]. It refers to risk as being variability of outcome and suggests that a risk adjustment may increase the amount at which a liability is measured. [IAS 37.43]
Measurement - Dealing with risk and uncertainty in measuring a provision 3
Whilst the standard provides an example of a case in which the best estimate of an obligation might have to be larger than the individual most likely outcome, [IAS 37.40], it gives no indication of how this increment should be determined. It warns that caution is needed in making judgements under conditions of uncertainty, so that expenses or liabilities are not understated. However, it says that uncertainty does not justify the creation of excessive provisions or a deliberate overstatement of liabilities. Accordingly, care is needed to avoid duplicating adjustments for risk and
uncertainty, for example by estimating the costs of a particularly adverse outcome and then overestimating its probability. [IAS 37.43]. Any uncertainties surrounding the amount of the expenditure are to be disclosed. [IAS 37.44].
Whilst the standard provides an example of a case in which the best estimate of an obligation might have to be larger than the individual most likely outcome, [IAS 37.40], it gives no indication of how this increment should be determined. It warns that caution is needed in making judgements under conditions of uncertainty, so that expenses or liabilities are not understated. However, it says that uncertainty does not justify the creation of excessive provisions or a deliberate overstatement of liabilities. Accordingly, care is needed to avoid duplicating adjustments for risk and uncertainty, for example by estimating the costs of a particularly adverse outcome and then overestimating its probability. [IAS 37.43]. Any uncertainties surrounding the amount of the expenditure are to be disclosed. [IAS 37.44].
Discounting the estimated cash flows to a
present value 1
The standard requires that where the effect of the time value of money is material, the amount of a provision should be the present value of the expenditures expected to be required to settle the obligation. [IAS 37.45]. The discount rate (or rates) to be used in
arriving at the present value should be ‘a pre-tax rate (or rates) that reflect(s) current market assessments of the time value of money and the risks specific to
the liability.
The standard requires that where the effect of the time value of money is material, the amount of a provision should be the present value of the expenditures expected to be required to settle the obligation. [IAS 37.45]. The discount rate (or rates) to be used in
arriving at the present value should be ‘a pre-tax rate (or rates) that reflect(s) current market assessments of the time value of money and the risks specific to
the liability.
Discounting the estimated cash flows to a
present value 2
The discount rate(s) shall not reflect risks for which the future cash flow estimates have been adjusted.’ [IAS 37.47]. However, it is worth noting that no discounting is required for provisions where the cash flows will not be sufficiently far into the future for discounting to have a material impact. [IAS 37.46].
The discount rate(s) shall not reflect risks for which the future cash flow estimates have been adjusted.’ [IAS 37.47]. However, it is worth noting that no discounting is required for provisions where the cash flows will not be sufficiently far into the future for discounting to have a material impact. [IAS 37.46].
Discounting the estimated cash flows to a
present value 3
The main types of provision where the impact of discounting will be significant are those relating to decommissioning and other environmental restoration liabilities. IFRIC 1 addresses some of the issues relating to the use of discounting (in the context of provisions for obligations to dismantle, remove or restore items of property, plant and equipment, referred to as ‘decommissioning, restoration and similar liabilities’)
The main types of provision where the impact of discounting will be significant are those relating to decommissioning and other environmental restoration liabilities. IFRIC 1 addresses some of the issues relating to the use of discounting (in the context of provisions for obligations to dismantle, remove or restore items of property, plant and equipment, referred to as ‘decommissioning, restoration and similar liabilities’)
Discounting the estimated cash flows to a
present value - Real versus nominal rate 2
IAS 37 does not indicate whether the discount rate should be a real discount rate or a nominal discount rate. The discount rate to be used depends on whether:
(a) the future cash flows are expressed in current prices, in which case a real discount rate (which excludes the effects of general inflation) should be used; or
(b) the future cash flows are expressed in expected future prices, in which case a nominal discount rate (which includes a return to cover expected inflation) should be used.
IAS 37 does not indicate whether the discount rate should be a real discount rate or a nominal discount rate. The discount rate to be used depends on whether:
(a) the future cash flows are expressed in current prices, in which case a real discount rate (which excludes the effects of general inflation) should be used; or
(b) the future cash flows are expressed in expected future prices, in which case a nominal discount rate (which includes a return to cover expected inflation) should be used.
Discounting the estimated cash flows to a
present value - Real versus nominal rate 1
IAS 37 does not indicate whether the discount rate should be a real discount rate or a nominal discount rate. The discount rate to be used depends on whether:
(a) the future cash flows are expressed in current prices, in which case a real discount rate (which excludes the effects of general inflation) should be used; or
(b) the future cash flows are expressed in expected future prices, in which case a nominal discount rate (which includes a return to cover expected inflation) should be used.
IAS 37 does not indicate whether the discount rate should be a real discount rate or a nominal discount rate. The discount rate to be used depends on whether:
(a) the future cash flows are expressed in current prices, in which case a real discount rate (which excludes the effects of general inflation) should be used; or
(b) the future cash flows are expressed in expected future prices, in which case a nominal discount rate (which includes a return to cover expected inflation) should be used.
Discounting the estimated cash flows to a
present value - Unwinding of the discount
IAS 37 indicates that where discounting is used, the carrying amount of a provision increases in each period to reflect the passage of time, and that this increase is recognised as a finance cost. [IAS 37.60]. This is the only guidance that the standard gives on the unwinding of the discount. IFRIC 1 in relation to provisions for decommissioning, restoration and similar liabilities requires that the periodic unwinding of the discount is recognised in profit or loss as a finance cost as it occurs.
IAS 37 indicates that where discounting is used, the carrying amount of a provision increases in each period to reflect the passage of time, and that this increase is recognised as a finance cost. [IAS 37.60]. This is the only guidance that the standard gives on the unwinding of the discount. IFRIC 1 in relation to provisions for
decommissioning, restoration and similar liabilities requires that the periodic unwinding of the discount is recognised in profit or loss as a finance cost as it occurs.
Discounting the estimated cash flows to a
present value - Unwinding of the discount
IAS 37 indicates that where discounting is used, the carrying amount of a provision increases in each period to reflect the passage of time, and that this increase is recognised as a finance cost. [IAS 37.60]. This is the only guidance that the standard gives on the unwinding of the discount. IFRIC 1 in relation to provisions for decommissioning, restoration and similar liabilities requires that the periodic unwinding of the discount is recognised in profit or loss as a finance cost as it occurs.
IAS 37 indicates that where discounting is used, the carrying amount of a provision increases in each period to reflect the passage of time, and that this increase is recognised as a finance cost. [IAS 37.60]. This is the only guidance that the standard gives on the unwinding of the discount. IFRIC 1 in relation to provisions for
decommissioning, restoration and similar liabilities requires that the periodic unwinding of the discount is recognised in profit or loss as a finance cost as it occurs.
