Chapter 7: IAS 37 Provisions, Contingent Liabilities and Contingent
Assets
1.1 Meaning
Definition
A provision is a liability of uncertain timing or amount. (IAS 37)
A liability is a present obligation arising from past events, the settlement of which is
expected to result in an outflow of economic resources. (IAS 37)
Note: The definition of liability used in IAS 37 is slightly different from that used in the IFRS
conceptual Framework discussed in Chapter 2.
Some common examples of liabilities are:
Warranty provisions: where businesses give warranties on their products. If the product
is faulty, the customer can return it.
Provisions for clean-up costs: companies may have an obligation to clean up land at
the end of the life of their production facilities. The liability would consist of the future
costs of cleaning up.
1.2 Recognition Criteria
For any provision, to be recognised, all three of the following criteria must be satisfied:
1. A present obligation (legal or constructive) exists due to a past event (obligating
event).
2. An outflow of economic resources (e.g. cash) to settle the obligation is probable.
3. A reliable estimate of the obligation can be made.
(Only in rare cases would it not be possible to make a reliable estimate.)
Key Point
An outflow of resources is probable if the event is “more likely than not” to occur
(greater than 50% likelihood).
1.3 Measurement
Key Point
The amount provided should be the best estimate, at the period end, of the
expenditure required to settle the obligation.
The best estimate might be:
evidenced by events after the period end
the mid-point of a range of possible values (Example 1)
the most likely outcome for single/one-off obligations
an expected value after weighting all possible outcomes by their probabilities which
can be used to estimate obligations such as warranties for products sold or
other similar obligations (Example 2)
Example 1
In 20X6, Benedict was sued for damages by a significant customer for breach of
contract. In March 20X7, the court ruled in favour of the customer but deferred its ruling
on the number of damages until June. For legal advice in defence of this claim, Benedict
paid $15,000 in 20X6; a further $20,000 has been incurred to date (to be paid once the
matter is settled in June), and Benedict expects to pay an additional $10,000 before the
case is wholly settled.
Benedict’s legal adviser thinks that Benedict will be required to reimburse the
customer's legal costs, which he estimates will be as much as Benedict’s. Based on the
level of damages claimed, he also believes these are likely to be in the region of
$250,000 to $300,000.
Analysis of best estimate
Benedict should provide for the following:
its legal costs incurred after the end of the reporting period ($15,000 incurred in
20X6 is already expensed, so not considered in calculating the provision.)
the best estimate of the customer's legal costs
the best estimate of the damages. This is the most subjective. As the estimated
range of the outcome is relatively narrow, any amount in this range may be
considered as good an estimate as any other. However, a midpoint may be
selected as the lower end of the range may be considered imprudent, and the
upper end over prudent.
For Benedict’s legal costs ($20,000 + $10,000) $30,000
For the customer's legal ($15,000 + $20,000 + $45,000
costs $10,000)
For the award of (mid-point of range) $275,00
damages 0
$350,00
Example 1
Therefore, the best estimate might be $350,000 to be recognised as a provision in the
statement of financial position.
Example 2
The facts are the same as in Example 1, except that the legal adviser is of a different
opinion regarding the damages to be awarded.
The legal adviser suggests that the most likely award of damages will be $120,000.
However, there is an outside chance that the court may rule for punitive damages
amounting to $500,000.
He thinks there also is an outside chance that the ruling may consider some
contributory negligence on the part of the customer and award only nominal damages
(of a minimal monetary amount).
Analysis of best estimate
Even if specific probabilities could be assigned to the extremes (say 10% each), the
calculation of an expected value is not appropriate.
For example, taking $0 as an approximation of nominal: (10% × $0) + (80% ×
$120,000) + (10% × $500,000) = $146,000
This amount does not correspond to any of the outcomes envisaged. (Also, as a
relatively specific amount, it suggests an inappropriate degree of precision.)
The best estimate is the most likely item, $120,000.
This example shows that an expected value approach is inappropriate for a single
obligation.
Example 3
Cassie sells skateboards with a six-month warranty. During the second half of the year
to 30 June 20X5, she sold 504 boards. (The warranty on boards sold in the year’s first
half will have expired.) If a board comes back for minor repairs, it will cost her $10; If it
needs major repairs, it will cost her $30.
From experience, Cassie estimates that 20% of boards will come back for minor repairs,
and 5% will come back for major repairs.
How should Cassie estimate the amount of provision needed?
Provisions for warranties, such as in Cassie’s case, involve many individual items.
Example 3
Cassie will know her repair costs, but she must estimate how many items will be
affected.
This can be done using the expected value method.
Minor repairs: (504 × 20%) × $10= $1,008
Major repairs: (504 × 5%) × $30 = $756
This gives her an amount of $1,764 ($1,008 + $756) for potential repairs under
warranty as at 30 June 20X5.
1.4 Accounting Treatment
Key Point
Provisions must be recognised in the financial statements when all the recognition
criteria have been met.
The steps needed to account for the Provisions are:
1. Calculate the closing provision balance at the year-end.
2. Calculate the difference between the closing and opening provision balance.
3. The increase or decrease is adjusted in the Provisions ledger account to reflect the
closing Provision amount.
If the current provision calculated is more than the opening provision balance,
General ledger Catego Explanation
account ry
DR Individual expense Expense Individual expense
increased
CR Provisions Liability Provisions (liability)
increased
If the current provision calculated is less than the opening provision balance,
General ledger Catego Explanation
account ry
DR Provisions Liability Provisions (liability)
decreased
CR Individual Expense Expense Individual expense
decreased
Example 4
Tamara operates a factory. The local government has told all businesses in the area that
they must install smoke detectors on their premises by 30 March 20X6. It is 30 April
20X6 – Tamara's reporting period end. She has not yet installed the smoke detectors
and intends to do so the following day. She has been quoted a cost of $12,000.
1. Is the requirement to install smoke detectors an obligation due to a past
event?
Yes. The obligation is legal as it is a local government requirement, and the deadline for
installing the smoke detectors has passed; it was 30 March.
2. Will there be a transfer of economic benefits?
Yes. The business is expected to pay to install smoke detectors, so money will leave the
business.
3. Can we make a reliable estimate of the cost?
Yes. Tamara has been quoted $12,000 to install the smoke detectors.
4. Should we record the addition of the smoke detectors as an expense in
the statement of profit or loss?
No, they will last for more than one year if maintained, which would be a non-current
asset and not an expense. Once the smoke detectors have been purchased, we should
record the smoke detectors as non-current assets.
5. Should the provision be presented in the financial statements as a
liability?
Yes, this provision should be recognised as a liability in the statement of financial
position. It is a current liability as it must be settled in less than one year.
Example 5
Harry's business sells cookers through his retail shop. Harry hopes the cookers will not
develop faults once delivered to the customer. However, he knows there will always be
Example 5
faulty goods that will be returned.
At each year’s end, he estimates the amount of repair work he will have to pay for and
therefore accounts for a provision. He will record the movement in this provision.
In the past, the provision has been based on 2% of annual sales. However, this year
there have been more repairs than usual required, so the agreed provision level has
increased to 3.5%. Sales for the year were $157,143.
Last year, Harry’s business made a provision for repairs of $4,000 and $3,000 was
utilised. Therefore, last year’s closing provision balance (opening this year) is $1,000
($4,000 − $3,000).
At the end of the current reporting period, 31 December 20X5, the new provision should
be 3.5% × 157,143 = $5,500
Since the current provision calculated is more than the opening provision balance by
$4,500, the double entry to record the movement is:
DR Repairs expense $4,50
(SPL) 0
CR Provisions $4,50
(Liability) 0
DR Provisions (Liability) CR
01-Jan- Balance b/d $1,00
X5 (Opening) 0
31-Dec- Balance $5,50 31-Dec- $4,50
X5 c/d 0 X5 Repairs expense 0
$5,50 $5,50
0 0
01-Jan- $5,50
X6 Balance b/d 0
The closing balance on the provision account is $5,500. This is recorded as a liability in
the Statement of Financial Position for the year ended 31 December 20X5.
2.1 Contingent liabilities
2.1.1 Meaning
Definition
A contingent liability is:
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
A contingent liability is not recognised in the statement of financial position, but is disclosed
in the notes to the accounts
A liability may be a contingent liability rather than a provision because:
It is not clear whether or not an obligation actually exists. The occurrence (or
non-occurrence) of future uncertain events will confirm whether or not the obligation
exists. Or
A present obligation does exist, but either of the following would mean that the
obligation does not meet the definition of a provision:
o The probability that there will be an outflow of resources required to settle the
obligation is less than 50%, or
o The amount required to settle the obligation cannot be estimated reliably.
2.1.2 Accounting Treatment
Key Point
Contingent liabilities should not be recognised as liabilities.
Since contingent liabilities do not meet the definition of a provision, they are not included as
a liability in the statement of financial position.
Contingent liabilities should be disclosed (unless the possibility of expenditure is remote) in
the notes to the financial statements.
If the likelihood of expenditure becomes probable, a provision will then be recognised
(assuming a reliable estimate can be made). This is another example of the application of
the prudence concept.
2.1.3 Reliable estimate of amount
The mere fact that estimation is involved does not necessarily mean that the amount
required to settle the obligation cannot be estimated reliably. Many obligations recognised as
provisions require the accountants to make a best estimate of the amount required to meet
the obligation (e.g. a warranty provision requires an estimate of how many customers will
return goods for repair or replacement, and the cost of this).
It will be rare that reliable estimates of obligations cannot be made.
2.1.4 Probability of outflow of resources
Under IAS 37, an obligation does not meet the definition of a provision if it is not probable
that there will be an outflow of economic resources required to meet that obligation.
A range of outcomes can express the uncertainty of a contingency. The approaches range
from specific to general.
Quantified probabilities (40% chance of A and 60% chance of B) are specific. This
suggests a level of precision which is unlikely to be supported by available information.
General descriptions, better supported by the available information, use terms
ranging from probable to remote.
Example 6 – Contingent Liabilities
Sharif is the guarantor of the loan for another business. Sharif may or may not
have an obligation – it depends on whether the business defaults on paying the
overdraft (a future uncertain event). Therefore this would be a contingent liability.
Sanjay has been taken to court by a competitor, Ashwin, who is claiming that
Sanjay copied products that are protected by patents. Sanjay denies this and has
shown that the products he sold were designed in house. Sanjay’s lawyers believe
that it is unlikely that the court will agree with Ashwin’s action, and therefore
Sanjay will not have to pay any damages. This would not be recognised as a
provision for two reasons. Firstly, there does not appear to be an obligation as
Sanjay claims he has not breached copyright. Secondly, the lawyers believe it is
unlikely that the court will agree with Ashwin’s claim, so it is not probable that
there will be an outflow of resources required to settle the claim.
Navi has been taken to court by the tax authorities, who are questioning Navi’s
interpretation of the tax laws relating to whether or not certain expenses are tax
deductible. Tax experts have said that the court case will be a very interesting
test case as it will clarify something in the tax laws that is not clear. The general
consensus among tax experts is that the case could go either way. This would be
a contingent liability. It is not clear whether Navi has an obligation to pay
additional tax or not – that will be decided by that court case.
2.2 Contingent Assets
2.2.1 Meaning
Definition
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.
IAS 37
For example:
Sharif had to write off computers held as inventory due to a fire in the warehouse. He
has claimed on the insurance but has not heard if he is covered for such losses. This is
a contingent asset because he may receive some insurance monies.
Sharif has decided to take a builder to court as they have failed to complete work due
on his premises, and this delay has led to a loss of earnings for the business. The
lawyers think that it is likely that Sharif will win the case. He can therefore disclose a
contingent asset.
2.3.2 Accounting Treatment
For contingent assets, the following apply:
Existence should be disclosed if it is probable that a gain (economic benefits) will be
realised. The disclosure must avoid giving misleading implications about the likelihood
of realisation.
When the realisation is virtually inevitable, there is no contingency, and recognition is
appropriate.
Key Point
Contingent assets should not be recognised as assets (because this may result in the
recognition of revenue which may never be realised).
The following table summarises how liabilities and assets would be treated in the financial
statements based on the probability of cash inflows/ outflows required to settle them.
Conditions Assets Liabilities
Expected/ Virtually Certain Recognised as Recognised as
(>95%) an Asset a Liability
Disclosed as Recognised as
Probable (51% - 95%) Contingent Asset a Provision
Possible (5% - 50%) No disclosure Disclosed as
Contingent Liability
Remote (<5%) No disclosure No disclosure
3.1 Scope of IAS 37
IAS 37 Provisions, Contingent Liabilities and Contingent Assets apply to all entities and
details the accounting treatment for provisions, contingent liabilities and contingent assets,
excluding those covered by other Standards.
3.2 Disclosure Requirements
3.2.1 Provisions
For each class of provision, the following must be disclosed:
A brief description of the obligation (nature and timing)
An indication of uncertainties and assumptions about the amount or timing of outflows
Any expected reimbursement due relating to the provision
A detailed breakdown of the movement in the provision – opening and closing
balances, additions, amounts used and any reversals
3.2.2 Contingencies
The following disclosures are required for contingencies:
Nature of the contingent liability/asset.
Estimate of financial effect (where practicable).
The uncertainties affecting the amount or timing.
Provisions, contingent liabilities and contingent assets all lack certainty about when the
events will occur and the value placed on them. This affects the way these items are
reported in the financial statements.