For some ACCA candidates, specific IFRS® standards are more favoured than others. IAS® 37, Provisions, Contingent Liabilities and Contingent Assets appears to be less popular than other standards because, usually, answers to Financial Reporting (FR) questions require a balanced discussion of whether criteria are met, as opposed to calculating numbers. However, IAS 37 is often a key standard in FR exams and candidates must be prepared to demonstrate application of the criteria.
This article will consider the aims of the standard, followed by the key specific criteria which must be met for a provision to be recognised. Finally, it will examine some specific issues which are often assessed in relation to the standard.
The definition of a provision is key to the standard. A provision is a liability of uncertain timing or amount, meaning that there is some question over either how much will be paid or when this will be paid. Before the introduction of IAS 37, these uncertainties may have been exploited by companies trying to ‘smooth profits’ in order to achieve the results that their various stakeholders wanted.
For example, we will now consider a fictional company known as Rey Co. At the start of the year, Rey Co sets a profit target of $10m for the year ended 31 December 20X8. The chief accountant of Rey Co has reviewed the profit to date and realises they are likely to achieve profits of $13m. The accountant knows that if Rey Co reports a profit of $13m, directors will not get any more of a bonus than if they reported $10m. He also knows that the profit target will be set at $14m next year.
To avoid this, the accountant may be tempted to make some provisions for potential future expenses of $3m, with the impact of making the profit seem lower in the current year. As the double entry for a provision is to debit an expense and credit the liability, this would potentially reduce profit to $10m. Then in the next year, the chief accountant could reverse this provision, by debiting the liability and crediting the statement of profit or loss. This is effectively an attempt to move $3m profit from the current year into the next financial year.
Clearly this is not good for the users of the financial statements, as they would have been given a false impression of the performance of the business. This is where IAS 37 is used to ensure that companies report only those provisions that meet certain criteria.
IAS 37 stipulates the criteria for provisions which must be met for a provision to be recognised so that companies are prevented from manipulating profits. According to IAS 37, three criteria are required to be met before a provision can be recognised. These are:
These criteria will now be examined in further detail to see how they can be applied in practice.
This rule has two parts, first the type of obligation, and second, the requirement for it to arise from a past event (ie something must already have happened to create the obligation).
(a) Type of obligation
The obligation could be a legal one, arising from a court case or some kind of contractual arrangement. Most candidates are able to spot this in exams, identifying the presence of a potential obligation of this type.
Alternatively, the obligation could be constructive. This is where a company establishes an expectation through an established course of past practice.
EXAMPLE
Rey Co has a published environmental policy. In this, Rey Co explains that they always replant trees to counterbalance the environmental damage created by their operations. Rey Co has a consistent history of honouring this policy. During 20X8, Rey Co opened a new factory, leading to some environmental damage. Rey Co estimates that the associated tree planting and environmental clear up costs will be $400,000.
Even if the country that Rey Co operates in has no legal regulations forcing them to replant trees, Rey Co will have a constructive obligation because it has created an expectation from its publications, practice and history.
(b) Past event
The obligation needs to have arisen from a past event, rather than simply something which may or may not arise in the future.
EXAMPLE
An employee was injured at work in 20X8 due to faulty equipment and is suing Rey Co. Rey Co’s lawyers have advised that it is probable that the entity will be found liable. Rey Co would have to provide for the best estimate of any damages payable to the employee. This is because the event arose in 20X8 and, based on the evidence available, there is a present obligation.
If the lawyers had advised Rey Co that they would not be held liable for the employee’s injury, there would be no obligation as a result of a past event and therefore no provision would be recognised. The matter would potentially require disclosure as a contingent liability. Contingent liabilities will be explained further below.
Similarly, Rey Co would not provide for any possible claims which may arise from injuries in the future. That is because there is no past event which has created an obligation and any possible claims could be avoided by implementing new safety measures or selling the factory.
In an exam, it is unlikely that it will not be possible to make a reliable estimate of a provision. Likewise, it is unlikely that an entity will be able to avoid recording a liability when there is an obligation by claiming there is no way of producing an estimate of the amount. The main rule to follow is that where a single obligation is being measured, the best estimate will be the most likely outcome. If the provision being measured involves a large number of items, such as a warranty provision for repairing goods, the expected value should be calculated using the probability of all possible outcomes.
EXAMPLE – best estimate
Rey Co has received legal advice that the most likely outcome of the court case from the employee is that they will lose the case and have to pay $10m. The legal team think there is an 80% chance of this. They believe there is a 10% chance of having to pay $12m, and a 10% chance of paying nothing.
In this case, Rey Co would provide $10m, being the most likely outcome. It is not uncommon for candidates to incorrectly take the $12m, thinking that the worst-case scenario should be provided for. Other candidates may calculate an expected value based on the various probabilities which also would not be appropriate in these circumstances.
EXAMPLE – expected value
Rey Co gives a year’s warranty with all goods sold during the year. Past experience shows that Rey Co needs to do no repairs on 85% of the goods. On average, 10% need minor repairs, and 5% need major repairs. Rey Co’s manufacturing manager has calculated that if minor repairs were needed on all goods, it would cost $100,000 and major repairs on all goods would cost $1m.
Here, the provision would be measured at $60k. The expected cost of minor repairs would be $10k (10% of $100k) and the expected costs of major repairs is $50k (5% of $1m). This is because there will not be a one-off payment, so Rey Co should calculate the estimate of all likely repairs.
The final criteria required is that there needs to be a probable outflow of economic resources. There is no specific guidance of what percentage likelihood is required for an outflow to be probable. A probable outflow simply means that it is more likely than not that the entity will have to pay money.
If it appears that there is a possible outflow then no provision is recorded. In this situation, a contingent liability would be reported. A contingent liability is simply a disclosure note shown in the notes to the accounts. There is no double entry recorded in respect of this. Instead, a description of the event should be given to the users with an estimate of the potential financial effect. In addition to this, the expected timing of when the event should be resolved should also be included.
Similar to the concept of a contingent liability is the concept of a contingent asset. 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. Like a contingent liability, a contingent asset is simply disclosed rather than a double entry being recorded. Again, a description of the event should be recorded in addition to any potential amount. The key difference is that a contingent asset is only disclosed if there is a probable future inflow, rather than a possible one. The table below shows the treatment for an entity depending on the likelihood of an item happening.
Likelihood |
Outflow of resources |
Inflow of resources |
Remote |
Do nothing |
Do nothing |
Possible |
Contingent liability |
Do nothing |
Probable |
Provision |
Contingent asset |
Virtually certain |
Provision |
Asset |
It can be seen here that Rey Co could only recognise an asset from a potential inflow if the realisation of income is virtually certain.
EXAMPLE – Likelihood
Rey Co’s legal advisors continue to believe that it is likely that Rey Co will lose the court case against the employee and have to pay out $10m. However, it has come to light that Rey Co may have a counter claim against the manufacturer of the machinery. The legal advisors believe that there is an 80% chance that the counter claim against the manufacturer is likely to succeed and believe that Rey Co would win $8m.
In this case, Rey Co would include a provision for the $10m legal provision in liabilities. Even though there is a similar likelihood that Rey Co would win the counterclaim, this is a probable inflow and therefore only a contingent asset can be recorded. This will be disclosed in the notes to the financial statements rather than being recorded as an asset in the statement of financial position. Whilst this seems inconsistent, this demonstrates the asymmetry of prudence in this standard, that losses will be recorded earlier than potential gains.
1. The time value of money
If the time value of money is material (generally if the potential outflow is payable in one year or more), the provision should be discounted to present value initially. Subsequently, the discount on this provision would be unwound over time, to record the provision at the actual amount payable. The unwinding of this discount would be recorded in the statement of profit or loss as a finance cost.
EXAMPLE
At 31 December 20X8, the legal advisors of Rey Co now believe that the $10m payment from the court case would be payable in one year. Rey Co has a cost of capital of 10%.
On 31 December 20X8, Rey Co should record the provision at $10m/1.10, which is $9.09m. This should be debited to the statement of profit or loss, with a liability of $9.09m recorded.
By 31 December 20X9, when Rey Co is required to make the payment, the liability should be showing at $10m, not $9.09m. Therefore, the liability is increased by 10% over the year, giving an increase of $910k which would be recorded in finance costs.
2. Restructuring costs
Restructuring costs associated with reorganising divisions provide two issues. The first is to assess whether an obligation exists at the reporting date. The key here is whether the restructuring has been announced to the affected employees. If the employees have been informed, then an obligation exists and a provision must be made. If the employees have not been informed, then the company could change its mind. In this case, there is no present obligation to incur the costs associated with this.
The second issue for consideration is which costs should be included within the provision. These costs should exclude any costs associated with any continuing activities. Therefore, any provision should only include items such as redundancy costs and closure costs. Ongoing costs such as the costs of relocating staff should be excluded from the provision and should instead be expensed as they are incurred.
3. Onerous contracts
Onerous contracts are those in which the costs of meeting the contract will exceed any benefits which will flow to the entity from the contract. As soon as an entity is aware that a contract is onerous, the full loss should be provided for as a liability in the statement of financial position.
4. Decommissioning costs associated with assets
So far, all the items considered in this article have involved the provision being recorded as a liability with the debit being shown as an expense in the statement of profit or loss. The exception to this is if an entity creates an obligation for future costs due to the construction of a non-current asset. In this case, the provision should be included within the original cost of the asset, as this is directly attributable to the construction of that asset.
EXAMPLE
Rey Co constructed an oil platform in the sea on 1 January 20X8 at a cost of $150m. As part of obtaining permission to construct the platform, Rey Co has a legal obligation to remove the asset at the end of its 25-year useful life. This obligation has a present value of $20m.
Here, Rey Co would capitalise the $170m as part of property, plant and equipment. As only $150m has been paid, this amount would be credited to cash, with a $20m provision set up. Over the useful life of the asset, the $170m will be depreciated. In addition to this, the discount on the provision will be unwound and debited to finance costs. Consequently, the provision will increase each year until it becomes $20m at the end of the asset’s 25-year useful life.
5. Future operating losses
Future operating losses do not meet the criteria for a provision, as there is no obligation to make these losses. Therefore, they cannot be included in the financial statements.
In summary, IAS 37 is a key standard for FR candidates. Candidates are required to learn the three key criteria for a provision, as they are likely to have to explain these in an exam. Careful attention must also be paid to the calculations involved in the recording of a provision, particularly those around long-term provisions and including them at present value. If candidates are able to do this, then provisions can be an area where they can score highly in the FR exam.
Written by a member of the Financial Reporting examining team