IFRS 37: Provisions, Contingent Liabilities, and Assets

International Accounting Standard 37 (IAS 37) establishes the accounting and disclosure rules for provisions, contingent liabilities, and contingent assets. The standard’s purpose is to ensure these items are handled with a consistent approach, providing a framework for applying specific recognition criteria and measurement principles. This guidance helps ensure that financial statements present a faithful representation of a company’s obligations and potential assets.

A core principle is that a provision should only be recognized when a genuine liability from a past event exists. By setting these boundaries, the standard prevents the premature recognition of liabilities for future spending that is not yet obligatory. The rules also mandate that companies disclose enough information in the notes of their financial statements for users to understand the nature, timing, and potential amount of these items.

Criteria for Recognizing a Provision

A provision is a liability where the timing or amount is uncertain. For a company to formally recognize a provision, it must meet three distinct and mandatory criteria outlined in IAS 37. These conditions act as a filter to ensure that only genuine obligations are recorded. The assessment of these criteria requires careful judgment based on all available evidence at the end of the reporting period.

A Present Obligation

The first criterion is the existence of a present obligation arising from a past event, known as the “obligating event.” This means the company has a duty to another party that it cannot realistically avoid. This obligation can be either legal or constructive. A legal obligation derives from a contract or legislation, such as a contract to decommission an oil rig at the end of its life. A constructive obligation arises from a company’s actions where it has created a valid expectation in other parties that it will discharge certain responsibilities, such as a retailer’s long-standing public policy of providing refunds.

A Probable Outflow of Resources

The second criterion requires that it is probable an outflow of resources embodying economic benefits will be needed to settle the obligation. “Probable” is defined as “more likely than not,” a probability greater than 50%. The company must evaluate the likelihood of having to transfer cash, assets, or provide services. If there are several possible outcomes, the company should consider all of them to determine the overall probability. This assessment must be objective and consider any evidence from outside experts, such as lawyers or engineers.

A Reliable Estimate Can Be Made

The final criterion is that a reliable estimate can be made of the amount of the obligation. While provisions are uncertain, a company must be able to determine a reasonable estimate of the expenditure required to settle it, often involving judgment and historical data. In the rare circumstance that no reliable estimate can be made, a provision cannot be recognized.

How to Measure a Provision

Once an obligation meets the recognition criteria, a company must determine the monetary value to record in its financial statements. The measurement is guided by principles within IAS 37 to ensure the amount reflects the most accurate assessment of the future economic outflow.

Best Estimate

A provision must be measured at the best estimate of the expenditure required to settle the present obligation. This reflects the amount an entity would rationally pay to settle the obligation or transfer it to a third party at the end of the reporting period. This judgment must be supported by experience with similar transactions or reports from independent experts.

For a provision involving a large population of items, like product warranties, the estimate is determined by weighting all possible outcomes by their probabilities, an “expected value” technique. For a single obligation, like a lawsuit, the best estimate is the single most likely outcome. When there is a continuous range of equally likely outcomes, the midpoint is used.

Time Value of Money

When the settlement of a provision is expected to occur far in the future, the time value of money can have a material effect, and the provision must be measured at its present value. This means the estimated future cash flows are discounted using a pre-tax discount rate that reflects current market assessments of the time value of money and risks specific to the liability. The discount rate should not reflect risks for which future cash flow estimates have already been adjusted. The carrying amount of the provision is then increased in each subsequent period to reflect the passage of time, with this increase recognized as a finance cost.

Consideration of Future Events

The measurement of a provision can be influenced by future events, but only if there is sufficient objective evidence they will occur. For example, an estimate for environmental cleanup can account for expected changes in technology that might reduce costs. Similarly, new legislation affecting settlement costs can be considered if its enactment is virtually certain. General business improvements or unconfirmed technological advancements are not sufficient to adjust the measurement.

Accounting for Contingent Liabilities and Assets

IAS 37 also addresses contingent liabilities and assets. These items do not meet the recognition criteria for a provision or asset and are not recorded on the balance sheet. Instead, they are communicated to users through disclosures in the notes to the financial statements.

Contingent Liabilities

A contingent liability is defined in two ways. First, it can be a possible obligation from past events whose existence will be confirmed only by uncertain future events not fully within the company’s control, such as a lawsuit where lawyers believe the probability of losing is less than 50%. Second, it can be a present obligation that is not recognized because it is not probable that an outflow of resources will be required, or the amount cannot be measured reliably. These items are not recorded as liabilities but are disclosed in the notes unless the possibility of an economic outflow is remote.

Contingent Assets

A contingent asset is a possible asset from past events whose existence will be confirmed only by uncertain future events not wholly within the company’s control. A common example is a legal claim a company is pursuing where the outcome is uncertain but a favorable result is probable. Contingent assets are not recognized in financial statements to avoid recognizing income that may never be realized. A contingent asset is disclosed in the notes only when an inflow of economic benefits is probable, including a description and an estimate of its financial effect. If the inflow becomes virtually certain, the asset is recognized.

Common Application Scenarios

The principles of IAS 37 are applied to a wide range of business situations. The thought process involves assessing whether a present obligation exists from a past event, if an outflow is probable, and if a reliable estimate is possible.

Warranties

Product warranties are a classic example where a provision is recognized. The sale of goods with a warranty is the past event creating a legal or constructive obligation. Companies can use historical data to reliably estimate the probable number of claims and their average cost. A provision for the best estimate of future warranty costs is recognized at the time of sale for the entire pool of products sold.

Restructuring

A provision for restructuring costs is recognized only when a company has a detailed, formal plan and has created a valid expectation in those affected that it will carry out the restructuring, such as by announcing its main features. A board decision alone is not sufficient. The provision must only include direct expenditures from the restructuring, like employee termination benefits. It cannot include costs of ongoing activities like retraining staff, marketing, or investing in new systems.

Onerous Contracts

An onerous contract is one where the unavoidable costs of meeting the obligations exceed the expected economic benefits. When a contract becomes onerous, the present obligation must be recognized as a provision. For example, if a company has a non-cancellable lease for a factory it no longer uses and cannot sublet, a provision is needed for the unavoidable future lease payments. An amendment to IAS 37 clarified that the costs of fulfilling a contract include both incremental costs and an allocation of other directly related costs.

Lawsuits and Legal Claims

When a company is a defendant in a lawsuit, the filing is the past event. If legal counsel advises that it is more likely than not the company will lose, a provision is recognized for the best estimate of the settlement. If the probability of losing is 50% or less, no provision is recognized. Instead, the lawsuit is disclosed as a contingent liability, unless the chance of loss is remote.

Required Financial Statement Disclosures

Clear and comprehensive disclosure is a fundamental requirement of IAS 37. The information provided in the notes to the financial statements is intended to help users understand the nature, timing, and amount of a company’s provisions and contingencies. These disclosures supplement the figures on the balance sheet and income statement, offering context and insight into potential future cash flows.

Disclosures for Provisions

For each class of provision, a company must disclose a reconciliation of the carrying amount from the beginning to the end of the reporting period, showing the opening balance, additions, amounts used, unused amounts reversed, and the closing balance. A company must also provide a brief description of the nature of the obligation and the expected timing of outflows. An indication of the uncertainties about the amount or timing and information about major assumptions made concerning future events are also required.

Disclosures for Contingent Liabilities

For each class of contingent liability, a company must disclose a brief description of its nature unless the possibility of an outflow is remote. Where practicable, the disclosure should also include an estimate of its potential financial effect, an indication of uncertainties related to the amount or timing, and the possibility of any reimbursement.

Disclosures for Contingent Assets

When an inflow of economic benefits is probable, a company must disclose a brief description of the nature of the contingent asset. It must also provide an estimate of its financial effect where this is practicable. If required information for contingent assets or liabilities is not disclosed because it is not practicable, that fact must be stated.