IAS 37 - Provision, Contingent Liability and Contingent Asset (detailed review)

Objective

This standard provides appropriate recognition and measurement guide lines which are applicable for the accounting treatment of provision, contingent liability and contingent asset along with related disclosure requirements for such items.

Scope

The requirements of this standard are applicable for the accounting treatment of provision, contingent liability and contingent asset other than which relates to:

• An executory contracts i.e. the contracts under which no party has completed any part of its performance obligation or both parties to the contract have carried on their obligation in part to the same extent

• The financial instruments including financial guarantees which are covered under IFRS 9

• The construction contracts which are covered under IAS 11

• The income tax which is covered under IAS 12

• Liability for finance lease which is covered under IAS 17

• Insurance contracts as per contractual terms which are covered under IFRS 4

However, this standard applies to the following:

• The executory contracts which are onerous

• Operating lease contracts which has become onerous

Definition

Provision

It is defined as a liability of uncertain amount or timing.

Liability

It is a present obligation which arises from past obligating event and the settlement of which requires the outflow of economic resources of the entity.

Obligating Event

It is an event which gives rise to a legal or constructive obligation for a party to the contract, and party to the contract does not have any realistic alternative other than the settlement of that obligation.

Legal Obligation

The obligation which arises:

• As a result of a contract, due to its explicit or implicit terms or
• Legislation or
• Operation of law is termed as legal obligation

Constructive Obligation

The obligation which arises because of:

• Entity’s past practices, actions, well known statements and published policies which reflect to others that entity will oblige certain responsibilities and
• It has formed a valid expectation on the part of effected parties that entity will discharge its responsibilities.

Contingent Liability

• It is a possible obligation which arises from past obligating event whose existence depends upon the occurrence or non-occurrence of some uncertain future events, which are not in the control of the entity or

• It is a present obligation which arises from past obligating event but it is not recognized in the financial statements because either:

(i) it does not require probable outflow of economic resources of the entity to settle the obligation or

(ii) The amount of the obligation is not reliably measurable.

Contingent Asset

It is a possible asset which arises from past event whose existence depends upon the occurrence or non-occurrence of some uncertain future events which are not in the control of the entity.

Onerous Contract

It is a contract whose unavoidable cost of performance exceeds its revenue.

Restructuring

It is a plan or program by which management significantly changes the scope, conduct or manner of the business undertaken by the enterprise.

Recognition of Provision

The entity is required to recognize a provision in respect of an event when following conditions are satisfied:

• It is a present obligation (legal or constructive) which arises from a past obligating event;
• Which requires probable outflow of economic resources of the entity to settle the obligation and
• The amount of obligation is reliably measurable.

The entity will not recognize any provision if any of the above mentioned condition is not met.

Present Obligation

The entity is deemed to have a present obligation when considering all the facts and circumstances such as expert opinion the entity is able to identify that:

• It is more likely than not that entity will be found liable or
• It is virtually certain that obligation exist

Probability of Outflow of Economic Resources

For a provision to qualify for recognition it must be requiring the probable outflow of economic resources of the entity to settle that obligation. This will be the case when it is more likely than not that event requiring the outflow will take place such as legislation requiring the cleanup of land already contaminated or a court decision.

Measurement of Provision

This standard requires that the amount recognized as a provision should be the best estimate i.e. the entity should ensure that it is the reliable estimate and should recognize at the amount which is required to settle the obligation at the end of the reporting period or requires to be paid to transfer it to the third party.

• For this purpose, the entity can use expert opinion, legal advice or management's own judgment on the basis of past experience to measure the financial effect of provision

• The provision for the ‘one off events’ is measured on the basis of ‘Most Probable Outcome’ and the events which occur frequently or on regular basis, the provision for such events will be measured using ‘Expected Value Method’.

• The entity should also consider the effect of any related risk and uncertainties in the measurement of provision.

• If there is material time difference for the settlement of provision, then it should be recognize at present value using appropriate pre-tax discount rate

• Future events that may affect the amount required to settle an obligation should be taken into consideration in the measurement of provision if there is sufficient objective evidence that such events will occur, such as reduction in the value of provision because of future technology

• The provision should be used against the expenditure for which it was originally made.

Changes in the Value of Provision

The entity should re-assess the value of provision recognized at each subsequent reporting date and it should adjust the value of provision for any subsequent increase or decrease in the value of such provision. If circumstances indicate that outflow of economic resources is no longer probable, then the provision should be reversed. The increase, decrease or reversal of provision at reporting date will be accounted for as change in accounting estimate and it will have prospective application.

Application of Recognition and Measurement Rule

Future Operating Losses

The entity should not recognize any provision for expected future operating losses as provision is recognized for the past obligating events.

Onerous Contract

The contract whose unavoidable cost of performance exceeds its revenue is termed as onerous contract. This standard requires the entity should recognize a provision in respect of onerous contract in the period in which it becomes onerous at lower of:

• Expected loss from such a contract and
• Amount payable as per the penalty clause of the contract

Restructuring

It is a plan or program by which management significantly changes the scope, conduct or manner of the business undertaken by the enterprise for example

• Sale or closure of a business line
• Termination of layer of employees
• Introduction of management information into business
• Relocation of entity’s business operations from one region to another

A provision for restructuring is recognized if following conditions are satisfied:

a) When management have a formal plan and

b) It is publically announced to the affected parties

• However, a provision for restructuring in the form of sale of operations of the business will only be recognize when management have a binding sale agreement.

• The formal plan includes the identification of:

a) No of employees effected

b) Business location to be restructured

c) Financial effect of the plan

d) Date of execution of the plan

• No provision for restructuring will be recognized just because of the management’s decision for the restructuring before the end of the reporting period until:

a) it has announced the plan or

b) The management has started to implement the plan

• A provision for restructuring should be recognized only for the direct cost of restructuring such as termination payments for employees and damages payable for the cancelled orders and it should not include the expense in respect of the ongoing activities of the business such as investment in the new technology or system and staff re-training etc.

• The measurement of provision for restructuring should not include the effect of any gain from the disposal of asset which is expected to arise as a result of restructuring.

Reimbursement

If all or part of the amount which is required to settle the obligation under a provision is expected to be reimbursed by any other party such as insurance claim or supplier warranties, the entity will recognize that reimbursement as an asset separately in the statement of financial position if it is virtually certain that the reimbursement will be received upon the settlement of related obligation.

• The entity will recognize reimbursement amount receivable as an asset separately in the statement of financial position, while in the statement of profit or loss the expense relating to a provision may be presented net off the amount expected in the form of reimbursement

• The amount of reimbursement should not exceed the amount of provision recognized.

Contingent Liability

Contingent liability is defined in this standard as:

a) It is a possible obligation which arises from past obligating event whose existence depends upon the occurrence or non-occurrence of some uncertain future events which are not in the control of the entity or

b) It is a present obligation which arises from past obligating event but it is not recognized in the financial statements because either:

(i) it does not require probable outflow of economic resources of the entity to settle the obligation or

(ii) The amount of the obligation is not reliably measurable.

 

• The contingent liability is not recognized in the financial statements rather it is disclosed in the notes to accounts unless the possibility of the outflow of economic resources is remote.

• If an entity is jointly and severally liable for an obligation, the part of the obligation that is expected to be paid by the other party will be treated as a contingent liability under this standard.

Contingent Assets

It is a possible asset which arises from past event whose existence depends upon the occurrence or non-occurrence of some uncertain future events which are not in the control of the entity.

• These normally arise from unexpected events which give rise to the possibility of an inflow of economic benefits to the entity such as compensation expected under a law suit where the outcome is not certain.

• Contingent assets will not be recorded in financial statements unless it is virtually certain that inflow of economic benefits will take place and entity will be entitled for the related asset.

• However, if it is probable that the inflow of economic benefits will take place, the entity will disclose such contingent asset in the notes to accounts in such circumstances.

Disclosures

• The entity is required to disclose the following in respect of the provision:

a) The value of recognized provision at the start and end of accounting period

b) The value of provision recognized during the current accounting period

c) Any increase or decrease in the value of provision in the current accounting period

d) Amount of provision settled in the current accounting period

e) Any amount of provision which is reversed in the current accounting period

f) A brief description of the obligation and expected timing of the related outflow

g) The amount of any related reimbursement

h) The amount of reimbursement recognized in the current accounting period

• The entity is required to disclose the following in respect of the contingent liability:

a) The description of uncertainties related to the contingent liability

b) Its financial effect

c) The description of any related reimbursement

• The description of any contingent asset where the inflow of economic benefits is probable and related financial effect

 

Application Examples

Example 1

AB Ltd is engaged in a trading business and it sells its product with warranty. Under the warranty terms all the customers are covered for the cost of repair for any mechanical faults which arise in the first year of purchase. The entity’s past experience shows that if all the products sold, returned by the customers under warranty claims with the minor faults, it would result in repair cost of $200,000, the repair cost will be $800,000 if all the goods sold were returned with major faults.
The sales department of AB Ltd has commented that on the basis of past experience, in the coming year, 70% of the product sold will be having no faults and will not be returned under warranty claims, however 25% of the product sold will have minor faults and 5% of the products sold will be returned with major faults.

Required
Determine the amount of warranty provision which is required to be recognized by AB Ltd in its financial statements?

Solution:

Under IAS 37 a provision is recognized when all of the following conditions are satisfied:

a) It is a present obligation (legal or constructive) which arises from a past obligating event;

b) Which requires probable outflow of economic resources of the entity to settle the obligation and

c) The amount of obligation is reliably measurable.

• In the above scenario, the past obligating event is the sale of products with warranty which gives rise to the legal obligation for AB ltd.
• It is probable that entity will be found liable as on the basis of past experience it is expected that there will be some claims under warranty terms, the settlement of which will require the probable outflow of economic resources of the entity
• Therefore, the entity should recognize a provision with a reliable estimate as follows:

	Provision
	$'000
70% of the goods will not be returned	-
25% of the goods with minor faults ($200 × 25%)	50
5% of the goods with major faults ($800 × 25%)	200
Total Amount of provision	250

Example 2

AB Ltd was sued by its major customer for the compensation of loss suffered because of the supply of sub-standard products in the last consignment. Legal proceedings have been started but the liability is in disputes yet.

At the yearend of 31 March 2009 up to the date of authorization of financial statements, the entity’s lawyers have commented that it is probable that AB Ltd will not be found liable for the compensation of the loss claimed by the customer. However, at the year end of 31 March 2010 when AB Ltd is preparing its financial statements, the lawyers clearly stated that because of developments in the case, it is now probable that the entity will be found liable to compensate the loss.

Required:

Discuss as per the requirements of IAS 37, how the event above will be accounted for in the financial statements of AB Ltd for the year to 31 March 2009 and 31 March 2010

Solution:

1) At 31 March 2009

• The past obligating event is the supply of sub-standard products by AB Ltd under the contract which gives rise to legal obligation
• There is no present obligation at the year end of 31 March 2009, as it is probable that entity will not be found liable
• Therefore, no provision will be recognized at the year end of 31 March 2009 and the matter will be disclosed in the notes to the accounts as a contingent liability unless the probability of any outflow is considered as remote

2) At 31 December 2010

• As at the year end of 31 March 2010, it is probable that AB Ltd will be found liable and settlement of this obligation will require probable outflow of economic resources of the entity
• Therefore, a provision will be recognized for the reliable estimate of the amount to settle the obligation.