Provisions, Contingent
Liabilities and Contingent
Assets: IAS 37
Wiecek and Young
IFRS Primer
Chapter 5
Provisions, Contingent Liabilities and
Contingent Assets
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Related standards
IAS 37
Current GAAP comparisons
Looking ahead
End-of-chapter practice
Related Standards
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FAS 5 Accounting for Contingencies
FAS 143 Accounting for Asset Retirement
Obligations
FAS 146 Accounting for Costs Associated with
Exit or Disposal Activities
CON 5 Recognition and Measurement in
Financial Statements of Business Enterprises
CON 6 Elements of Financial Statements
CON 7 Using Cash Flow Information and
Present Value in Accounting Measurements
Related Standards
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Framework for the Preparation and
Presentation of Financial Statements
IFRS 4 Insurance Contracts
IAS 1 Presentation of Financial Statements
IAS 11 Construction Contracts
IAS 12 Income Taxes
IAS 17 Leases
IAS 19 Employee Benefits
IAS 37 – Overview
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Objective and scope
Recognition
Measurement
Reimbursements
Changes in and use of provisions
Application of the recognition and
measurement rules
Disclosures
IAS 37 – Objective and Scope
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Standard seeks to ensure that provisions and contingencies are appropriately
dealt with in terms of recognition, measurement, and disclosure
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It does not cover:
– Executory contracts unless they are onerous
– Provisions or contingencies that are covered by other standards
– Depreciation and impairments
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The key thing that separates a provision from other liabilities is the uncertainty
associated with it, including:
• Uncertainty of the timing of a future expenditure, and/or
• Uncertainty of measurement
IAS 37 – Objective and Scope
The standard defines provisions, contingent liabilities, and contingent assets as follows:
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A provision is a liability of uncertain timing or amount
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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 recognized 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
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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 – Objective and Scope
How are provisions differentiated from contingencies?
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Both have significant uncertainty associated with them, although contingencies
have considerably more - relating either to the outcome of a future event or the
measurement of the element
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The terms contingent assets/liabilities are used to refer to assets/liabilities that
are not recognized in the financial statements because of significant uncertainty
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Provisions, by contrast, are recognized. They reflect an existing obligation that is
measurable and probable
IAS 37 – Recognition
PROVISIONS:
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Provisions are recognized only when all of the following criteria are met:
(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
The above definition is essentially the definition of a liability, including
recognition criteria
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IAS 37 – Recognition
Present Obligation Resulting from a Past Event, Which Is Independent of
an Entity’s Future Actions
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To determine whether we should recognize a liability or not depends on
whether an obligation exists at the present time
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This is differentiated from a future commitment, although the latter may create a
present obligation if there are significant negative consequences
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The obligation must also result from a past event (sometimes referred to as an
obligating event) and according to IAS 37.17, there is no realistic alternative to
settling the obligation (there is little or no discretion to avoid settlement)
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The standard notes that this would be the case, for instance:
• Where the obligation is enforceable by law (known as a legal obligation), or
• Where a valid expectation has been created that the entity will discharge the
obligation (known as a constructive obligation)
IAS 37 – Recognition
Constructive and legal obligations are specifically defined as follows:
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A constructive obligation is 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
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A legal obligation is an obligation that derives from:
(a) A contract (through its explicit or implicit terms)
(b) Legislation or
(c) Other operation of law.
An entity should take care to avoid accruing provisions for things that it can
avoid through future actions
IAS 37 – Recognition
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IAS 37 – Recognition
Probable Outflow of Resources Embodying Economic Benefits
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For recognition, the potential outflow of resources must be probable (more
likely than not)
If it is not probable, then note disclosure is required, unless the probability
is remote
Reliable Estimates of an Obligation
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Provisions, by definition, are very uncertain and therefore may be difficult to
measure
In general, the standard presumes that the entity should be able to
determine a reliable range of outcomes; however, if the provision is not
estimable (in rare situations), then note disclosure is required
CONTINGENT LIABILITIES AND ASSETS:
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Note disclosure only, unless the probability of occurrence is remote, in
which case note disclosure is not required
IAS 37 – Measurement
BEST ESTIMATE AND RISKS/UNCERTAINTIES:
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According to IAS 37, an entity must accrue the best estimate of the amount
for the provision
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Best estimate is defined as follows:
– 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
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Entities must gather evidence to support the assessment of best estimate,
which may require market data and the use of independent experts
IAS 37 – Measurement
There are differing methodologies for measuring the provision, and the
technique chosen depends upon the nature of the item that the provision
relates to
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IAS 37 – Measurement
PRESENT VALUE:
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Where the time value is material, the present value of the cash
flows must be used in estimating the amount
The discount rate shall
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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
Not reflect risks for which future cash flow estimates have been adjusted
Since IAS 37 gives little guidance as to how to discount, the
following approaches would be acceptable:
1. Adjust the discount rate to reflect the riskiness of the cash flows
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This is sometimes referred to as the traditional present value technique
or a discount rate adjusted approach
2. Use a risk-free rate as the discount rate but consider multiple
cash flow scenarios that reflect differing outcomes and their
probability of occurrence
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This method is referred to as the expected present value technique
IAS 37 – Measurement
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Either the discount rate or the cash flows are adjusted for risk but not both
Recall that IAS 37 gives little guidance and thus leaves it to professional judgment
IAS 37 – Measurement
FUTURE EVENTS:
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In estimating the provision, entities may consider future events if there is
sufficient evidence regarding the occurrence of the events
EXPECTED DISPOSAL OF ASSETS:
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No gains are taken into income for assets that are expected to be sold
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Since they are not realized
IAS 37 – Reimbursements
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In some cases, some of the cash outflows will be reimbursed
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This should be assessed separately and recognized when the
receipt of cash inflows is virtually certain
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In terms of presentation, the cost and the reimbursement may
be offset in the statement of profit and loss
IAS 37 – Changes In and Use of
Provisions
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The provisions should be continually assessed, at a
minimum, at the end of each reporting period
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If the amount of the provision is discounted, then
borrowing costs are recognized
IAS 37 – Application of the
Recognition and Measurement Rules
FUTURE OPERATING LOSSES:
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Future operating losses are not accrued since they represent future events
that an entity may be able to get out of
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However, future losses may be indicative of asset impairment
ONEROUS CONTRACTS:
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According to IAS 37.10, an onerous contract is
“. . . a contract in which the unavoidable costs of meeting the obligations
under the contract exceed the economic benefits expected to be received
under it”
Present obligations under onerous contracts are recognized as provisions
in the financial statements
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Onerous contracts are often purchase commitments, where the entity is locked
in and must settle the contract according to terms that are unfavourable to it
IAS 37 – Application of the
Recognition and Measurement Rules
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IAS 37 – Application of the
Recognition and Measurement Rules
RESTRUCTURING:
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Restructuring includes termination of a line of business,
closure or relocation of business, changes in management
structure, and fundamental reorganizations
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As a general rule, a restructuring provision should be
recognized when the criteria for recognizing a provision is
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 will be necessary
to settle the obligation and
• The restructuring is measurable (a reliable estimate can be
made)
IAS 37 – Application of the
Recognition and Measurement Rules
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Additionally, the following criteria must also be met in order to argue that a
constructive obligation exists:
(a) [The entity] has a detailed formal plan for the restructuring, identifying at
least
(i) The business or part of a business concerned
(ii) The principal locations affected
(iii) The location, function, and approximate number of employees who
will be compensated for terminating their services
(iv) The expenditures that will be undertaken and
(v) When the plan will be implemented and
(b) [The entity] has raised a valid expectation in those affected that it will carry
out the restructuring by starting to implement that plan or announcing its main
features to those affected by it
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The provision under the standard includes only direct costs that meet both of
the following criteria:
• The costs are necessarily entailed by the restructuring, and
• They are not associated with the ongoing activities of the entity
IAS 37 – Disclosures
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Appropriate detail regarding the nature of the provisions
and uncertainties should be disclosed
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In rare cases where the information to be disclosed may
prejudice the outcome of a dispute with other parties,
there is not a requirement to disclose, other than the
general nature of the dispute and the reason why full
disclosure is not being made
Current GAAP Comparisons
Pages 90 & 100 of
http://www.kpmg.co.uk/pubs/IFRScomparedtoU.S.GAAPAnOverview(2008).pdf
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Looking Ahead
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The IASB originally decided to review IAS 37 as part of its short-term
convergence project with FASB
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It became apparent that the issues being discussed were quite foundational
in terms of the entire body of knowledge
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The IASB issued an Exposure Draft in 2005 and plans to issue a new
standard in 2009
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The standard proposes that all liabilities be recognized unless they cannot
be reliably measured, and that uncertainty relating to the amount and timing
of cash flows be reflected in the measurement of the liability
Looking Ahead
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Some of the items being proposed/clarified are as follows:
1. Scope: Performance obligations will not be covered by the standard
2. Definitions:
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Provision will not be a defined term due to its ambiguity
The terms contingent liability and assets will be deleted
Differentiation of a business risk from a present obligation will be more explicit
3. Recognition: Probability recognition criteria will be deleted
4. Measurement: More guidance on measuring expected values and
reimbursement rights will be included
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End-of-Chapter Practice
5-1 The concept of contingency is different under IFRS.
Instructions
Contrast and compare the definitions of contingencies and contingent liabilities under both IFRS and U.S.
GAAP. How does the accounting differ? Start by looking up the respective definitions under the respective
standards.
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End-of-Chapter Practice
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End-of-Chapter Practice
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End-of-Chapter Practice
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