IAS 37 Provisions, Contingent Liabilities and Contingent Assets sets out when a liability of uncertain timing or amount is recognised on the balance sheet, how it is measured, and what must be disclosed when it is not recognised.
The three recognition criteria
A provision is recognised when all three conditions are met:
- The entity has a present obligation (legal or constructive) as a result of a past event.
- It is probable that an outflow of resources embodying economic benefits will be required to settle it. "Probable" means more likely than not.
- A reliable estimate can be made of the amount of the obligation.
A constructive obligation arises from the entity's own actions, such as an established pattern of past practice or a published policy, that creates a valid expectation in others that it will discharge certain responsibilities. A future intention alone is not an obligation. An entity cannot provide for future operating losses.
Provision, contingent liability or nothing
- If all three criteria are met: recognise a provision.
- If the existence of the obligation is only possible, or it is present but an outflow is not probable or cannot be reliably measured: it is a contingent liability. It is not recognised, but is disclosed unless the possibility of an outflow is remote.
- A contingent asset (a possible asset arising from past events) is never recognised. It is disclosed where an inflow of benefits is probable. When realisation is virtually certain, the asset is no longer contingent and is recognised.
Measurement
- The provision is the best estimate of the expenditure required to settle the present obligation at the reporting date.
- For a large population of items, such as warranty claims, use the expected value. For a single obligation, the most likely outcome is generally the best estimate, adjusted for other possible outcomes.
- Where the time value of money is material, the provision is discounted using a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability. The unwinding of the discount is recognised as a finance cost.
- A reimbursement from a third party is recognised as a separate asset only when its receipt is virtually certain, and is capped at the provision.
- Provisions are reviewed at each reporting date and adjusted to reflect the current best estimate.
Onerous contracts
If an entity has a contract in which the unavoidable costs of meeting its obligations exceed the economic benefits expected to be received, it recognises a provision for the present obligation under the contract. The unavoidable cost is the lower of the cost of fulfilling the contract and any compensation or penalties from failing to fulfil it. Since the 2020 amendments, effective for annual periods beginning on or after 1 January 2022, the cost of fulfilling includes both incremental costs and an allocation of other costs directly related to contract activities. Before a separate provision is recognised, the entity first recognises any impairment on assets dedicated to the contract.
Restructuring provisions
A provision for restructuring is recognised only if the general criteria are met and there is a detailed formal plan for the restructuring, and the entity has raised a valid expectation in those affected that it will carry it out, by starting to implement the plan or by announcing its main features. The provision includes only the direct expenditure arising from the restructuring (such as termination benefits), not costs associated with the ongoing activities of the entity.
A short worked illustration
An entity sells products with a one-year warranty. Based on past experience, 5% of products are expected to need minor repairs costing an average of 40, and 1% major repairs costing an average of 300. For 10,000 units sold before the year end:
- Minor: 10,000 × 5% × 40 = 20,000
- Major: 10,000 × 1% × 300 = 30,000
- Expected value of the warranty provision = 50,000 (before discounting, if material)
Where this typically goes wrong
- Providing for a future intention or a general business risk with no present obligation
- Recognising a restructuring provision on a board decision alone, before a detailed plan is communicated
- Recognising an insurance recovery before it is virtually certain
- Not updating provisions at each reporting date for new information
- Missing the disclosure of contingent liabilities that are not remote
- Building an onerous contract provision from incremental costs only, after the 2022 change