International Accounting Standard 37 (IAS 37) defines a provision as “a liability of uncertain timing or amount”.
From the definition of a provision, the first thing to notice is that it is a liability. A liability is a present obligation which arises as a result of some past event or events and it is expected that it will be settled by outflow of economic resources. Therefore, a provision is an obligation which will be settled by outflow of economic resources.
The second important thing to notice about a provision is that it is of uncertain nature. Uncertainty can either pertain to timing or amount. By uncertain timing we mean that the company is not sure at which point of time the obligation will be settled. By uncertain amount we mean that the company is not sure how much of the economic resources will be needed to settle the liability.
Those liabilities which are of uncertain timing and amount are called provisions according to IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Therefore trade payables and accrued expenses are not considered provisions by this IAS 37 because they do not meet the above criteria. They are not uncertain in timing and amount therefore they cannot be classified as provisions.
In some countries the term “provision” is used in the context of “doubtful debts” and depreciation. But IAS 37 does not consider them as provisions because they do not meet the criteria because they are not liabilities.
Provisions should be recognized only if all the following three conditions are satisfied:
1. There is a present obligation
2. Outflow of economic resources will be probable
3. Amount of the obligation can be reasonably estimated
An obligation can be either a legal obligation or constructive obligation. Legal obligation can arise by contract, due to legislation, or by law. Constructive obligation arises from the company’s actions whereby it has indicated that it will accept certain responsibilities and it has created valid expectations in the minds of other parties that it will discharge such responsibilities.
The term “probable” is interpreted to mean “more likely than not”. In other words the chances of outflow of economic resources are more than 50%.