Provisions, contingent liabilities and contingent assets IAS 37 Provisions, contingent liabilities and contingent assets

Learning objectives Describe the issues IAS 37 attempts to address Define provisions and contingencies Account for provisions and contingencies in accordance with IAS 37 Appraise the recognition and measurement criteria of IAS 37 Describe the presentation requirements in relation to provisions and contingencies

Provisions, contingent liabilities and contingent assets IAS 37 Provisions, Contingent Liabilities and Contingent Assets outlines the accounting for provisions (liabilities of uncertain timing or amount), together with contingent assets (possible assets) contingent liabilities (possible obligations and present obligations that are not probable or not reliably measurable)

Key definitions [IAS 37.10] The key principle established by the Standard is that a provision should be recognised only when there is a liability i.e. a present obligation resulting from past events. The Standard thus aims to ensure that only genuine obligations are dealt with in the financial statements

Key definitions [IAS 37.10] (Cont’d) Provision: a liability of uncertain timing or amount. Liability: present obligation as a result of past events settlement is expected to result in an outflow of resources (payment) A provision is simply a kind of liability and the Only difference between a provision and other liability is the degree of uncertainty involved.

Key definitions [IAS 37.10] (Cont’d) Contingent liability: a possible obligation depending on whether some uncertain future event occurs, or a present obligation but payment is not probable or the amount cannot be measured reliably Contingent asset: 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.

Recognition of a provision An entity must recognise a provision if, and only if: [IAS 37.14] a present obligation (legal or constructive) has arisen as a result of a past event (the obligating event), payment is probable ('more likely than not'), and the amount can be estimated reliably. If any of these conditions are not satisfied, a provision must not be recognised.

Some Examples provisions Circumstance – Warranty Recognise a provision? When an obligating event occurs (sale of product with a warranty and probable warranty claims will be made) Circumstance – Customer refunds Recognise a provision if the entity's established policy is to give refunds (past event is the sale of the product together with the customer's expectation, at time of purchase, that a refund would be available)

Obligating Events An obligating event is an event that creates a legal or constructive obligation and, therefore, results in an entity having no realistic alternative but to settle the obligation. [IAS 37.10] A constructive obligation arises if past practice creates a valid expectation on the part of a third party, for example, a retail store that has a long-standing policy of allowing customers to return merchandise within, say, a 30-day period. [IAS 37.10]

Examples of Obligating Events & Constructive Obligations A, a leisure entity, causes severe damage to the habitat of wildlife in a country where there is no legal protection for the wildlife. The company has a high profile in the support of wildlife as it makes large contributions to the World Wildlife Fund and campaigns vigorously on its behalf. To rectify the damage to the habitat, a charge of €1m is likely.

Decision tree to determine existence of provision or contingent liability

Accounting For Provisions, contingent liabilities and contingent assets Measurement of provisions

Measurement of provisions (c) Future events that may affect the amount required to settle an obligation should be taken into account when measuring a provision, so long as there is sufficient objective evidence that these events will occur. For instance, the estimated costs of cleaning up environmental damage might be reduced by anticipated changes in technology.

Measurement of provisions The amount of a provision should be the best estimate of the expenditure required to settle the obligation concerned. This is of course a matter of judgement and may require advice from independent experts. Note that: The "best estimate" of the required expenditure is the amount that the entity would rationally pay to settle the obligation or transfer it to a third party. If the effect of the time value of money is material, the amount of a provision should be calculated as the present value of the expenditure required to settle the obligation

Example Measurement of provisions This example is based upon an example provided in IAS37. A company sells goods with a six-month warranty. If minor defects were detected in all of the goods covered by warranties at the end of the reporting period, the company would incur costs of £1 million. If major defects were detected in all of these goods, the company would incur costs of £4 million. Experience shows that 75% of goods sold have no defects, 20% have minor defects and 5% have major defects. What is the expected value of the cost of repairs under warranties?

Example Measurement of provisions Solution The expected value of the cost of repairs is: (75% × £nil) + (20% × £1m) + (5% × £4m) = £400,000.

Measurement of provisions Provisions for one-off events (restructuring, environmental clean-up, settlement of a lawsuit) are measured at the most likely amount. [IAS 37.40] Provisions for large populations of events (warranties, customer refunds) are measured at a probability-weighted expected value. [IAS 37.39] Both measurements are at discounted present value using a pre-tax discount rate that reflects the current market assessments of the time value of money and the risks specific to the liability. [IAS 37.45 and 37.47]

Disclosures of provisions Reconciliation for each class of provision: [IAS 37.84] opening balance additions used (amounts charged against the provision) unused amounts reversed unwinding of the discount, or changes in discount rate closing balance]

Disclosures of provisions For each class of provision, a brief description of: [IAS 37.85] nature timing Uncertainties assumptions reimbursement, if any.

Summary A provision is defined by IAS37 as a liability of uncertain timing or amount. To recognise a provision, there must be a present obligation arising from a past event, it must be probable that an outflow of benefits will be required to settle this obligation and it must be possible to make a reliable estimate of the amount involved