IAS 37 PROVISIONS, CONTINGENT LIABILITIES, AND CONTINGENT ASSETS
1 SCOPE
IAS 37 specifies the accounting treatment of provisions, contingent liabilities and contingent assets in the financial statements.
Executory contracts only fall under IAS 37 if they are onerous,1 i.e. if losses are expected. Executory contracts represent contracts under which neither party has performed any of its obligations or both parties have partially performed their obligations to an equal extent (IAS 37.1 and 37.3).
Furthermore, IAS 37 does not apply to provisions, contingent liabilities, and contingent assets covered by another Standard. Examples are financial instruments (including guarantees) that are within the scope of IFRS 9, current and deferred tax liabilities (IAS 12), as well as provisions relating to employee benefits (IAS 37.1c, 37.2, and 37.5).
IAS 37 applies to provisions for restructurings (including discontinued operations). When a restructuring meets the definition of a discontinued operation (IFRS 5Appendix A), additional disclosures may be required by IFRS 5 (IAS 37.9).
2 DEFINITION AND RECOGNITION OF PROVISIONS
2.1 Overview
Provisions are liabilities of uncertain timing or amount. A liability represents a present obligation of the entity that arises from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. A liability is created by a legal or constructive obligation2 that results in the entity having no realistic alternative to settling the obligation. A provision is only recognized if an outflow of resources is probable, which means that the outflow is more likely than not, or in other words, the probability of the outflow is more than 50%. If a reliable estimate of the amount of the obligation cannot be made, a provision must not be recognized (IAS 37.10, 37.14, 37.19, and 37.23).
2.2 Existence of a Present Obligation
Recognition of a provision requires that the entity has a present obligation that may be on a legal or constructive basis (IAS 37.14a).
A legal obligation is an obligation that derives from a contract (through its explicit or implicit terms), legislation or other operation of law (IAS 37.10).
A constructive obligation derives from an entity's actions where (IAS 37.10):
- the entity has indicated to other parties that it will accept certain responsibilities by an established pattern of past practice, published policies or a sufficiently specific current statement and
- as a result the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.
2.3 Past Event
A provision only exists when the present (legal or constructive) obligation results from a past event (IAS 37.10, 37.14a, and 37.17). Expected future operating losses must not be recognized as provisions unless they result from an onerous contract (IAS 37.18 and 37.63–37.65).3
It is only those obligations that arise from past events which exist independent of the entity's future actions that are recognized as provisions. An intention or a future law does not result in an unavoidable obligation. For example, it may be necessary to fit smoke filters in a certain type of factory in the future or to retrain employees in order to comply with new laws so that the entity can continue its activities in the respective country in the future. In such cases, the expenditures can be avoided by the entity's future actions (e.g. by relocating production to another country or by employing new employees who already have the necessary knowledge), even if the entity does not intend to do so. Hence, no obligating event exists in such situations (IAS 37.19 and 37.C6).
Pursuant to laws, a manufacturer may become liable for waste management costs on historical electrical and electronic household equipment based on its share of the market during a measurement period and not as a result of the production or sale of the equipment. In this case, it is the participation of the entity in the market during the measurement period that is the obligating event and not the sale or production of the household equipment (IFRIC 6).4
An obligation always involves another party to whom it is owed. However, it is not necessary to know the identity of the party to whom the obligation is owed. Indeed, it is possible that the obligation is to the public at large (IAS 37.20).
Where details of a proposed new law have yet to be finalized, an obligation arises only when the legislation is virtually certain to be enacted as drafted. In many cases it will be impossible to be virtually certain of the enactment of a law until it is enacted (IAS 37.22).
2.4 Probability of an Outflow of Resources
Recognition of a provision requires (among others) that it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation. The term “probable” has to be interpreted as a likelihood of more than 50% (more likely than not) (IAS 37.14b and 37.23).
In the case of a number of similar obligations (e.g. product warranties), the probability that an outflow will be required in settlement is determined by considering the class of obligations as a whole. Although the likelihood of outflow for any one item may be small, it might be probable that some outflow of resources will be needed to settle the class of obligations as a whole. If this is the case and if the other recognition criteria are met, a provision is recognized (IAS 37.24).
2.5 Reliable Estimate of the Amount of the Obligation
Except in extremely rare cases, it is possible to determine the amount of the obligation reliably. Therefore, the criterion “reliable estimate” is almost always met (IAS 37.25–37.26).
2.6 Distinction from Other Liabilities
Contingent liabilities are discussed in Section 3. Provisions are distinguished from other liabilities (e.g. trade payables and amounts relating to accrued vacation pay) in that the uncertainty about the timing or amount of the future expenditure is generally much less in the case of other liabilities than for provisions (IAS 37.11).
3 CONTINGENT LIABILITIES
The term “contingent liability” encompasses different types of obligations (IAS 37.10):
- The first type is 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.
- The second type is a present obligation that arises from past events but is not recognized because:
- it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation or
- the amount of the obligation cannot be determined with sufficient reliability. Such a situation is, however, extremely rare (IAS 37.25–37.26).
A contingent liability also exists when it is not probable that the entity has a present obligation (IAS 37.16b and 37.23).
Contingent liabilities must not be recognized in the statement of financial position. However, disclosures relating to contingent liabilities have to be made in the notes unless the possibility of an outflow of resources embodying economic benefits is remote (IAS 37.27–37.28 and 37.86).
4 CONTINGENT ASSETS
A contingent asset represents 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 37.10). An example of a contingent asset is a claim that an entity is pursuing through legal processes for which the outcome is uncertain (IAS 37.32).
Contingent assets must not be recognized in the statement of financial position (IAS 37.31). However, disclosures relating to contingent assets have to be made in the notes if an inflow of economic benefits is probable (IAS 37.34 and 37.89–37.90). Again, the term “probable” has to be interpreted as a likelihood of more than 50% (more likely than not) (IAS 37.23).
When the realization of income is virtually certain, the related asset does not represent a contingent asset and its recognition in the statement of financial position is appropriate (IAS 37.33).
5 MEASUREMENT
The amount recognized as a provision is the best estimate of the expenditure that the entity would rationally pay to settle the obligation or to transfer it to a third party at the end of the reporting period. Deliberate overstatement or understatement of provisions is prohibited (IAS 37.36–37.37 and 37.42–37.43).
IAS 37 is based on the following distinction with regard to the measurement of provisions:
- When the provision being measured involves a large population of items, the provision is measured at expected value. Expected value is estimated by weighting all possible outcomes by their associated probabilities. When there is a continuous range of possible outcomes and each point in that range is as likely as any other, the mid-point of the range is used (IAS 37.39).
- When 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, other possible outcomes are considered. Where other possible outcomes are either mostly lower or mostly higher than the most likely outcome, the best estimate will be a higher or lower amount (IAS 37.40).
Provisions are measured before tax as the tax consequences of provisions are dealt with under IAS 12 (IAS 37.41).
If the effect of the time value of money is material, discounting of the expected expenditure is necessary. The discount rate is a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability. The discount rate must not reflect risks for which future cash flow estimates have been adjusted (IAS 37.45–37.47). The periodic unwinding of the discount in subsequent periods represents a component of interest expense (IAS 37.60).
Future events that may affect the amount required to settle an obligation have to be reflected in the amount of the provision where there is sufficient objective evidence that they will occur. For example, it is appropriate to take expected cost reductions associated with increased experience in applying existing technology into account (IAS 37.48–37.49).
Gains from the expected disposal of assets must not be taken into account when measuring a provision (IAS 37.51–37.52).
6 REIMBURSEMENTS
Where some or all of the expenditure necessary to settle a provision is expected to be reimbursed by another party (e.g. by an insurance company), the reimbursement has to be recognized when it is virtually certain that reimbursement will be received if the entity settles the obligation. The reimbursement represents a separate asset. The amount recognized for the reimbursement must not exceed the amount of the provision. In the statement of comprehensive income, the expense relating to a provision may be netted against the amount recognized for the reimbursement (IAS 37.53–37.54 and IAS 1.34b).
7 CHANGES IN PROVISIONS
Provisions have to be adjusted to reflect the current best estimate at the end of each reporting period (IAS 37.59).
A change in a provision may be the result of the following:
- Reversal of a provision or of part of it: If it is no longer probable that an outflow of resources embodying economic benefits will be required to settle the obligation, the provision has to be reversed (IAS 37.59). Also, part of a provision may be reversed.
- Where discounting is used when measuring a provision,5 the carrying amount of a provision increases in each subsequent period to reflect the passage of time (unwinding of the discount). This increase represents a component of interest expense (IAS 37.60).
- Use of a provision: A provision is only used for expenditures for which the provision was originally recognized (IAS 37.61–37.62).
8 SPECIFIC ISSUES
8.1 Onerous Contracts
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. The unavoidable costs reflect the least net cost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfill it. If an entity has a contract that is onerous, the present obligation under the contract has to be recognized and measured as a provision (IAS 37.10, 37.66, 37.68, and 37.C8).
Contracts that can be cancelled without paying compensation to the other party do not constitute an obligation. Other contracts establish both rights and obligations for each of the parties to the contract. Where events make such a contract onerous, the contract falls within the scope of IAS 37 and a liability exists which is recognized (IAS 37.67).
Before a separate provision for an onerous contract is established, the entity recognizes any impairment loss that has occurred on assets dedicated to that contract (IAS 37.69 and IAS 36).
8.2 Provisions for Decommissioning, Restoration, and Similar Obligations
Provisions for decommissioning, restoration, and similar obligations relating to property, plant, and equipment are dealt with in the chapter on IAS 16,6 and those relating to investment properties are dealt with in the chapter on IAS 40.7
8.3 Restructurings
A restructuring is a program that is planned and controlled by management and materially changes either the scope of a business undertaken by an entity or the manner in which that business is conducted (IAS 37.10). The definition of restructuring may be met in the following cases (IAS 37.70):
- The termination or sale of a line of business.
- The closure of business locations in a region or country or the relocation of business activities from one region or country to another.
- Changes in management structure (e.g. eliminating a layer of management).
- Fundamental reorganizations that have a material effect on the nature and focus of the entity's operations.
Recognition of a restructuring provision requires that the general recognition criteria for provisions (IAS 37.14) are met. IAS 37.72–37.83 set out how the general recognition criteria apply to restructurings (IAS 37.71).
A constructive obligation to restructure arises only when both of the following criteria are met (IAS 37.72):
- The entity has a detailed formal restructuring plan identifying at least;
- the business or part of a business concerned,
- the principal locations affected,
- the function, location, and approximate number of employees who will be compensated for terminating their services,
- the expenditures that will be undertaken, and
- when the plan will be implemented, and
- 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.
For a plan to be sufficient to give rise to a constructive obligation when communicated to those affected by it, the implementation of the plan needs to be planned to begin as soon as possible and to be completed in a timeframe that makes significant changes to the plan unlikely. Should it be expected that there will be a long delay before the restructuring begins or that the restructuring will take an unreasonably long time, it is unlikely that the plan will raise a valid expectation on the part of others that the entity is presently committed to restructuring because the timeframe allows opportunities for the entity to change its plans (IAS 37.74).
No obligation arises for the sale of an operation until the entity is committed to the sale (i.e. there is a binding sale agreement). When a sale is only part of a restructuring, a constructive obligation may arise for the other parts of the restructuring before existence of a binding sale agreement (IAS 37.78–37.79).
A restructuring provision only includes the direct expenditures arising from the restructuring. These are expenditures that are both (IAS 37.80):
- necessarily entailed by the restructuring, and
- not associated with the ongoing activities of the entity.
A restructuring provision does not include costs such as (IAS 37.81):
- relocating or retraining of continuing staff,
- marketing, or
- investment in new systems and distribution networks.
These expenditures relate to the future conduct of the business and do not represent liabilities for restructuring at the end of the reporting period. Such expenditures have to be recognized on the same basis as if they arose independently of a restructuring (IAS 37.81).
8.4 Decommissioning Funds
The contributor must recognize its obligation to pay decommissioning costs as a liability and recognize its interest in the fund separately unless the contributor is not liable to pay decommissioning costs even if the fund fails to pay (IFRIC 5.7).
The contributor must determine whether it has control, joint control or significant influence over the fund. For this assessment and its consequences, IAS 27, SIC 12, IAS 28, and IAS 31 are relevant (IFRIC 5.8).8 If the contributor does not have control, joint control or significant influence over the fund, the contributor has to recognize the right to receive reimbursement from the fund as a reimbursement according to IAS 37. This reimbursement is measured at the lower of the following amounts (IFRIC 5.9):
- The amount of the decommissioning obligation recognized.
- The contributor's share of the fair value of the fund's net assets attributable to contributors.
In some cases, there may be contingent liabilities (IFRIC 5.10).
9 EXAMPLES WITH SOLUTIONS
References to other chapters
Provisions for decommissioning, restoration, and similar obligations relating to property, plant, and equipment are dealt with in the chapter on IAS 16 (Example 4). Such provisions relating to investment properties:
- Accounted for according to the fair value model are dealt with in the chapter on IAS 40 (Example 4).
- Accounted for according to the cost model are dealt with in the chapter on IAS 16 (Example 4).
1 See Section 8.1.
2 See Section 2.2.
3 See Section 8.1 with regard to onerous contracts.
4 See KPMG, Insights into IFRS, 7th edition, 3.12.90.30.
5 See Section 5.
6 See the chapter on IAS 16, Sections 3 and 4.4.
7 See the chapter on IAS 40, Sections 3, 4.2, and 4.3.
8 We refer to the corresponding chapters and sections of this book.
9 This example is based on IAS 37. Appendix C.
10 This example is based on IAS 37.C5A–37.C5B.