Provisions and contingent liabilities (IAS 37)

Provisions and contingent liabilities: the short answer

A provision is a liability of uncertain timing or amount that is recognised on the balance sheet because a present obligation exists, an outflow is probable and the amount can be estimated reliably. A contingent liability is a possible obligation, or one that fails those tests, and it is disclosed in the notes rather than recognised. The difference matters because only provisions reduce profit and equity.

Both are governed by IAS 37 Provisions, Contingent Liabilities and Contingent Assets. The standard exists to stop two opposite abuses: hiding real obligations off the balance sheet, and creating general reserves in good years to release in bad ones. Every provision must relate to a specific obligation that exists at the reporting date, and it may be used only for the expenditure it was originally recognised for.

The three recognition tests

IAS 37 para 14 requires a provision when all three conditions are met. First, the entity has a present obligation, legal or constructive, as a result of a past event. Second, it is probable that an outflow of resources will be required to settle it, and IAS 37 defines probable as more likely than not. Third, a reliable estimate of the amount can be made; the standard says that only in extremely rare cases will no reliable estimate be possible.

A legal obligation comes from a contract, legislation or other operation of law. A constructive obligation arises when the entity's established practice, published policy or a sufficiently specific current statement has created a valid expectation in others that it will meet certain responsibilities. A retailer that has always refunded unhappy customers without question, beyond what the law requires, has a constructive obligation to keep doing so.

The past event, called the obligating event, is the anchor. Costs the entity could avoid by its own future actions, such as changing its operations, are not present obligations. That is why a company cannot provide for next year's repairs or for future operating losses (IAS 37 para 63), however certain they seem.

Provision, contingent liability or nothing: the decision

Once the obligation question is answered, the probability of the outflow decides the treatment. IAS 37 works with three bands: probable (more likely than not), possible, and remote. Contingent assets follow a mirror-image, more cautious rule, because recognising income that may never arrive would overstate profit.

• Present obligation and outflow probable, reliable estimate: recognise a provision and disclose it.
• Possible obligation, or present obligation where the outflow is possible but not probable: disclose a contingent liability, no provision.
• Outflow remote: no provision and no disclosure.
• Present obligation but no reliable estimate (extremely rare): disclose a contingent liability.
• Inflow virtually certain: it is no longer contingent, so recognise the asset.
• Inflow probable but not virtually certain: disclose a contingent asset only.
• Inflow not probable: no recognition and no disclosure.

How to measure a provision

A provision is measured at the best estimate of the expenditure required to settle the obligation at the reporting date (IAS 37 para 36): the amount the entity would rationally pay to settle it or transfer it to a third party. For a large population of items, such as product warranties, the best estimate is the expected value, weighting each outcome by its probability. For a single obligation, such as one lawsuit, the most likely outcome is usually the starting point, adjusted if other outcomes are mostly higher or mostly lower. Where a continuous range has every point equally likely, the mid-point is used.

When the time value of money is material, the provision is discounted at a pre-tax rate that reflects current market assessments and the risks specific to the liability (IAS 37 para 45). Each year the discount unwinds, and the increase is recognised as a finance cost, not as an operating expense. Expected reimbursements, for example from an insurer, are recognised as a separate asset only when receipt is virtually certain, never netted against the provision on the balance sheet.

This approach differs from US GAAP. Under ASC 450 a loss contingency is accrued when it is probable, which in practice means likely to occur, a higher bar than more likely than not, and where no amount within a range is a better estimate the low end of the range is accrued rather than the mid-point.

Worked example: a warranty provision

A manufacturer sells 10,000 units in the year at EUR 200 each, revenue of EUR 2,000,000, with a one-year assurance warranty against defects. Past data shows 90% of units need no repair, 7% need a minor repair costing EUR 50 and 3% need a major repair costing EUR 400. The sale of the goods is the obligating event, and the population is large, so the expected value applies.

If the customer could buy the warranty separately, or it provides a service beyond assurance that the product works as specified, it is a separate performance obligation under IFRS 15 and part of the price is deferred as revenue instead of provided for under IAS 37. An assurance-type warranty like this one stays in IAS 37.

• Expected cost per unit = (7% x 50) + (3% x 400) = 3.50 + 12.00 = EUR 15.50.
• Provision = 10,000 units x 15.50 = EUR 155,000.
• Year-end entry: Dr Warranty expense 155,000 / Cr Warranty provision 155,000.
• Next year, repairs costing EUR 120,000 are made: Dr Warranty provision 120,000 / Cr Bank or inventory 120,000.
• Remaining EUR 35,000 is reviewed; if no further claims are expected once the warranty period has expired, it is released: Dr Warranty provision 35,000 / Cr Warranty expense 35,000.

Worked example: a lawsuit and the unwinding of the discount

A customer sues for EUR 800,000. At the year end the company's lawyers advise that the company will more likely than not lose, and that the most likely outcome is a settlement of EUR 441,000 payable in two years. The pre-tax discount rate is 5%. Because this is a single obligation, the most likely outcome is used, and because the payment is two years away, it is discounted.

If instead the lawyers assessed the chance of losing at 30%, the outflow would be possible but not probable. The company would recognise nothing and disclose a contingent liability describing the claim, an estimate of its financial effect and the uncertainties. IAS 37 allows limited disclosure in extremely rare cases where full disclosure would seriously prejudice the entity's position in the dispute, but the general nature of the dispute must still be given.

• Present value = 441,000 / (1.05 x 1.05) = 441,000 / 1.1025 = EUR 400,000.
• Year 0: Dr Legal claims expense 400,000 / Cr Provision for legal claims 400,000.
• Year 1 unwinding: 400,000 x 5% = 20,000; Dr Finance cost 20,000 / Cr Provision 20,000; provision now 420,000.
• Year 2 unwinding: 420,000 x 5% = 21,000; Dr Finance cost 21,000 / Cr Provision 21,000; provision now 441,000.
• Settlement: Dr Provision for legal claims 441,000 / Cr Bank 441,000.

Onerous contracts

A contract is onerous when the unavoidable costs of meeting its obligations exceed the economic benefits expected under it. IAS 37 requires the present obligation under such a contract to be recognised as a provision (IAS 37 para 66). The unavoidable cost is the lower of the cost of fulfilling the contract and any compensation or penalty for failing to fulfil it. Following an amendment effective for annual periods beginning on or after 1 January 2022, the cost of fulfilling includes both the incremental costs, such as materials and direct labour, and an allocation of other costs that relate directly to the contract, such as depreciation of equipment used to fulfil it.

Example. A company has a fixed-price contract to deliver goods for EUR 300,000. Costs have risen and fulfilling the contract will now cost EUR 360,000, a loss of EUR 60,000. The contract allows the company to exit by paying a penalty of EUR 50,000. The unavoidable cost is the lower net cost, so the provision is EUR 50,000: Dr Onerous contract expense 50,000 / Cr Onerous contract provision 50,000. Before recognising it, the company must first recognise any impairment loss on assets dedicated to the contract.

Restructuring provisions

A board decision to restructure does not by itself create an obligation. A constructive obligation to restructure arises only when the entity has a detailed formal plan, identifying at least the business affected, the principal locations, the approximate number of employees to be compensated, the expenditure and the timing, and has raised a valid expectation in those affected by starting to implement the plan or announcing its main features to them (IAS 37 para 72).

The provision includes only direct expenditures that are necessarily entailed by the restructuring and not associated with the ongoing activities. Costs of retraining or relocating continuing staff, marketing, and investment in new systems and distribution networks are excluded, as are expected future operating losses and expected gains on disposal of assets.

Example. A company announces the closure of a plant before the year end and tells the workforce. Estimated severance is EUR 300,000, a penalty to cancel a supplier contract that serves only the plant is EUR 80,000, retraining for staff moving to another site is EUR 40,000, and the plant is expected to lose EUR 120,000 until it closes. The provision is 300,000 + 80,000 = EUR 380,000. The retraining and operating losses are expensed when incurred.

Reviewing, using and disclosing provisions

Provisions are reviewed at every reporting date and adjusted to the current best estimate; if an outflow is no longer probable, the provision is reversed. A provision can be used only for the expenditure it was recognised for, so the warranty provision cannot absorb an unrelated legal settlement. Changes in estimate go through profit or loss in the period of the change, while a provision that was wrong because of information available at the time is an error under IAS 8.

For each class of provision IAS 37 requires a reconciliation of the carrying amount from opening to closing, plus a description of the obligation, the expected timing and the uncertainties. A practical month-end schedule for each provision should show the items below, and the closing balance should agree to the general ledger.

• Opening balance.
• Additional provisions made in the period, including increases to existing provisions.
• Amounts used, meaning incurred and charged against the provision.
• Unused amounts reversed.
• Increase from the passage of time (unwinding of the discount) and from changes in the discount rate.
• Closing balance, agreed to the general ledger account.

Recording provisions in Skyline Nexus ERP

In Skyline Nexus ERP provisions are recorded as manual journal entries in the Fiscal Authority ledger, which keeps each judgemental estimate as a separate, reviewable entry. A journal needs at least two lines and cannot be saved unless total debits equal total credits. Where the Approval Settings require approval, entries at or above the approval threshold go to an approver before posting, which suits judgemental entries such as a new legal provision. A provision account can be flagged Requires Cost Center, so every line posted to it must name the cost centre, which makes the Cost Center Analysis report show where warranty or restructuring costs arise.

Once posted, a provision journal is not edited: it is reversed with a reversal date and reason, or corrected through Correct Journal Entry, which reverses the original and opens a pre-filled replacement. Every create, approve, post and reverse action appears in the Audit Trail with user, old and new values. Periods can be soft-closed or locked, so provision adjustments made after the close are refused rather than slipped into a finished month, and the General Ledger report gives the account movements needed for the roll-forward schedule.

Common mistakes with IAS 37

Auditors test provisions closely because they are judgemental and move profit. These are the errors found most often.

• Providing for future operating losses or future repairs, which are not present obligations.
• Recognising a restructuring provision on a board decision that has not been announced or started.
• Keeping general or round-sum reserves with no specific obligation behind them.
• Netting an insurance reimbursement against the provision instead of showing a separate asset when virtually certain.
• Forgetting to discount long-dated provisions, or booking the unwinding as an operating cost.
• Using a provision for a different purpose from the one it was created for.
• Omitting contingent liability disclosures for possible claims because nothing was recognised.