IAS 37 Provisions, Contingent Liabilities and Contingent Assets

This document provides a detailed review of the main themes and important ideas presented in the provided sources concerning International Accounting Standard (IAS) 37, “Provisions, Contingent Liabilities and Contingent Assets.” The document synthesizes information from research summaries, exposure drafts, endorsement advice, educational materials, and other related documents.

1. Purpose and Scope of IAS 37:

• IAS 37 applies to all liabilities of uncertain timing and amount (provisions) not within the scope of another IFRS Standard, and all contingent liabilities not within the scope of another IFRS Standard. Examples include settling warranty obligations, environmental clean-up costs, and onerous contracts.
• IAS 37 Provisions, Contingent Liabilities and Contingent Assets applies to all liabilities of uncertain timing and amount (provisions) not within the scope of another IFRS Standard, and all contingent liabilities not within the scope of another IFRS Standard.
• The objective of IAS 37 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 to enable users to understand their nature, timing, and amount.
• OBJECTIVE of IAS 37 ensures 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.
• IPSAS 19, which is drawn primarily from IAS 37 (1998), aims to achieve consistent and comparable financial information across public sector entities.
• This International Public Sector Accounting Standard is drawn primarily from International Accounting Standard IAS 37 (1998), Provisions, Contingent Liabilities and Contingent Assets published by the International Accounting Standards Committee (IASC).

2. Recognition of Provisions:

• A provision should be recognized if and only if three conditions are met:
• (a) Present Obligation (Legal or Constructive) as a Result of a Past Event: The entity must have a current duty or responsibility to transfer economic benefits. This obligation can be legal (arising from a contract, legislation, or other law) or constructive (arising from an established pattern of past practice, published policies, or a specific statement that has created a valid expectation in other parties).
• A provision should be recognised when, and only when: (a) an entity has a present obligation (legal or constructive) as a result of a past event:
  • a) From an established pattern of past practice, published policies or a specific 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 in other parties that it will discharge those responsibilities.
• (b) Probable Outflow of Resources: It must be more likely than not that an outflow of resources embodying economic benefits will be required to settle the obligation. “Probable” is generally understood as a probability greater than 50%.
  • it is probable (ie more likely than not) that an outflow of resources embodying economic benefits will be required to settle the obligation.
• (c) Reliable Estimate: A reliable estimate can be made of the amount of the obligation. In rare cases where no reliable estimate can be made, a liability exists but cannot be recognized as a provision; it is disclosed as a contingent liability.
  • a reliable estimate can be made of the amount of the obligation.
• In the extremely rare case where no reliable estimate can be made, a liability exists that cannot be recognised. That liability is disclosed as a contingent liability (see paragraph 86).
• An intention to make a payment is not enough on its own to justify a provision; there must be an actual obligation.
• An intention to make a payment is not enough on its own to justify a provision. There must be an actual obligation to make a payment.
• Costs that need to be incurred to continue an entity’s ongoing activities in the future are not recognized as provisions because there is no present obligation arising from a past event independent of future actions.
• “Financial statements deal with the financial position of an entity at the end of its reporting period and not its possible position in the future. Therefore, no provision is recognized for costs that need to be incurred to continue an entity’s ongoing activities in the future. The only liabilities recognized in an entity’s statement of financial position are those that exist at the reporting date.”
• It is only those obligations arising from past events existing independently of an entity’s future actions (ie the future conduct of its business) that are recognised as provisions.

3. Contingent Liabilities and Contingent Assets:

• A contingent liability is either:
• A possible obligation arising from past events whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the entity’s control.
• A present obligation that does not meet the recognition criteria for a provision (either it is not probable that an outflow of resources will be required, or the amount cannot be measured reliably).
• A contingent liability may be defined as: * a possible obligation arising from past events whose existence will be confirmed by the occurrence or non-occurrence of events that are not whol-ly within the control of the entity, * or a present obligation that is not recognized because it does not meet the required accounting criteria (for example, because the obligation relates to outflows of resources that are not probable or which cannot be measured reliably).
• Contingent liabilities are not recognized in the financial statements but are disclosed in the notes, unless the possibility of an outflow of economic benefits is remote.
• An entity shall not recognise a contingent liability.
• A contingent liability is disclosed, as required by paragraph 86, unless the possibility of an outflow of resources embodying economic benefits is remote.
• A contingent asset is a possible asset arising from past events whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the entity’s control. Contingent assets are not recognized if it is only probable that the inflow of economic benefits will occur. However, when the realization of income is virtually certain, the related asset is not a contingent asset and its recognition is appropriate. Contingent assets are disclosed when an inflow of economic benefits is probable.

4. Measurement of Provisions:

• The amount recognized as a provision should be the best estimate of the expenditure required to settle the present obligation at the reporting date.
• IAS 37 suggests that the amount recognised as a provision shall be the best estimate of the expenditure required to settle the present obligation at the statement of financial position date.
• The best estimate should consider all available evidence at the reporting date and reflects the time value of money where the effect is material. Therefore, provisions should be discounted to their present value using a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability.
• Environmental Provisions A provision will be made for future environmental costs if there is either a legal or constructive obligation to carry out the work This will be discounted to present value at a pre-tax market rate.
• Uncertainties surrounding the amount are dealt with by various means:
  • For a large population of items, the obligation is estimated by weighting all possible outcomes by their associated probabilities (expected value).
  • “Where the provision being measured involves a large population of items, the obligation is estimated by weighting all possible outcomes by their associated probabilities. The name for this statistical method of estimation is “expected value”.
  • For a single obligation, the individual most likely outcome may be the best estimate, but other possible outcomes should be considered.
  • Where a single obligation is being measured, the individual most likely outcome may be the best estimate of the liability. However, even in such a case, the entity considers other possible outcomes.
• Provisions are reassessed at the end of each reporting period and adjusted to reflect the current best estimate. Changes in provisions are generally recognized in profit or loss.
• Provisions are reassessed at the end of each reporting period and adjusted to reflect the current best estimate.
• The discount rate used should not reflect the effect of the entity’s own credit risk.

5. Application to Specific Scenarios:

• Onerous Contracts: If an entity has a contract where the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it, the present obligation should be recognized and measured as a provision.
• “If an entity has a contract that is onerous, the present obligation under the contract shall be recognised and measured as a provision.”
• “Example 9 A company has ten years left to run on the lease of a property that is currently unoccupied. The present value of the future rentals at the reporting date is €30,000. Required: What is the accounting treatment? Solution A provision of €30,000 would be required in respect of this onerous contract.”
• Restructuring Provisions: A provision for restructuring costs is recognized only when the entity has a constructive obligation to undertake the restructuring, which arises only when certain criteria are met, including the existence of a formal plan and a valid expectation in those affected that the restructuring will be carried out. A management decision alone is not sufficient.
• Under IAS 37, an entity is required to recognise the constructive obligations for restructuring if the following conditions are satisfied:
  • a formal plan exists;
  • a valid expectation that it will carry out the restructuring exists.
• An entity shall recognise a non-financial liability for a cost associated with a restructuring only when the definition of a liability has been satisfied.
• Warranty Obligations: A provision is required for warranty obligations based on past experience and expected claims, as the sale of goods with a warranty creates a constructive obligation to remedy defects.
• Example 1: A retail store has a policy of refunding purchases by dissatisfied customers, even though it is under no legal obligation to do so. Its policy of making refunds is generally known. Should a provision be made at the year-end? Solution The policy is well known and creates a valid expectation. There is a constructive obligation. It is probable some refunds will be made and these can be measured using expected values. Therefore, a provision is required.
• Environmental Provisions: A provision is made for future environmental costs if there is a legal or constructive obligation to carry out the work, such as the substantive enactment of legislation requiring the clean-up of contaminated land.
• A provision will be made for future environmental costs if there is either a legal or constructive obligation to carry out the work This will be discounted to present value at a pre-tax market rate.
• Present obligation as a result of a past event – The past event is the substantive enactment of legislation requiring the contaminated land to be cleaned up. Therefore, the entity has a present obligation to clean up its contamination. Conclusion – A non-financial liability is recognised for the clean-up obligation.
• Refurbishment Costs: No provision is recognized for refurbishment costs if there is no present obligation independent of the entity’s future actions, even if there is an intention or a legal requirement to perform the refurbishment in the future. The obligation arises only when the refurbishment becomes necessary due to the passage of time or usage, not at an earlier date.
• The cost of replacing the lining is not recognised as a liability because, at the balance sheet date, no obligation to replace the lining exists independently of the entity’s future actions—even the intention to incur the expenditure depends on the entity deciding to continue operating the furnace or to replace the lining.
• Even a legal requirement to overhaul does not make the costs of overhaul a liability, because no obligation exists to overhaul the aircraft independently of the entity’s future actions.

6. Potential Amendments and Ongoing Discussions:

• The IASB has had on its work plan a project to make a narrow-scope amendment to IAS 37 to clarify which costs an entity includes in assessing whether a contract is onerous.
• The Board already has on its work plan a project to make one narrow-scope amendment to IAS 37—to clarify which costs an entity includes in assessing whether.
• An Exposure Draft in 2005 proposed clarifying that IAS 37 should apply to all non-financial liabilities not within the scope of other standards and suggested not using provision as a defined term but rather “non-financial liability. It also proposed eliminating the term “contingent liability.
• The Exposure Draft proposes to clarify that IAS 37, except in specified cases, should be applied in accounting for all non-financial liabilities that are not within the scope of other Standards. To emphasise this point, the Exposure Draft does not use ‘provision’ as a defined term to describe liabilities within its scope. Instead, it uses the term ‘non-financial liability’.
• The Exposure Draft proposes to eliminate the term ‘contingent liability’.
• Stakeholders have reported generally not encountering major problems applying IAS 37, but some have suggested deficiencies and asked for amendments. Issues raised include the “probable outflows” recognition criterion and the measurement objective.
• Stakeholders often report that in general they do not encounter major problems applying IAS 37. However, some stakeholders have suggested some aspects of IAS 37 are deficient and asked the International Accounting Standards Board (Board) to consider amending those aspects.
• Should IAS 37 have a ‘probable outflows’ recognition criterion?
  • Some commentators have expressed concerns about the proposed elimination of “contingent liability,” particularly for obligations arising outside of contracts, suggesting a potential lack of consistency in application.
• We understand that the elimination of the term “contingent liability” will focus the recognition of a non-financial liability on whether the definition of a liability has been met. While we do not object to the IASB’s proposal to eliminate this term, we believe that in the absence of a contract or other written agreement, it is not clear whether a potential obligor has an obligation that would meet the definition of a liability.

7. Terminology:

• IAS 37 defines “provisions” as liabilities of uncertain timing or amount.
• This Standard defines provisions as liabilities of uncertain timing or amount.
• The Exposure Draft (2005) proposed using “non-financial liability” instead of “provision” as a defined term for liabilities within its scope, to distinguish them from financial liabilities under IAS 39.
• Instead, it uses the term ‘non-financial liability’.
• The Board is using the phrase ‘non-financial’ to make a clear distinction between liabilities within the scope of IAS 39 and those within the scope of IAS 37.
• The term “provision” is sometimes used more broadly in some jurisdictions to describe various recognized liabilities. IAS 37 does not prescribe how entities should describe their non-financial liabilities.
• In some jurisdictions, some classes of liabilities are described as provisions, for example those liabilities that can be measured only by using a substantial degree of estimation. Although this [draft] Standard does not use the term ‘provision’, it does not prescribe how entities should describe their non-financial liabilities. Therefore, entities may describe some classes of non-financial liabilities as provisions in their financial statements.

This briefing document highlights the core principles of IAS 37 and ongoing discussions related to its application and potential amendments. Understanding these principles is crucial for the appropriate accounting treatment of provisions, contingent liabilities, and contingent assets in financial statements.

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