Provisions and Contingencies – IAS 37

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CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Provisions and Contingencies – IAS 37

Provision:- A liability of uncertain timing or amount.

Contingent liability :- A possible obligation arising from past events whose existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events that are not completely within the control of the entity.

Contingent asset. A possible asset arising from past events and whose existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events that are not completely within the control of the entity.

Executory contract:- A contract under which neither party (to the contract) has performed its obligations or both the parties (to the contract) have performed their obligations partially to an equal extent.

Onerous contract. Onerous Contract is a contract where the costs involved with fulfilling the terms and conditions of the contract are higher than the amount of economic benefit received.

Restructuring A program that is planned and controlled by the management and materially changes either the scope of a business undertaking by an entity or the manner in which that business is conducted.

Replies (42)

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Provision against assets

The word ‘provision’ is often used to describe amounts that are deducted from assets to arrive at their balance sheet carrying amount. Example:- provisions are made for depreciation or amortisation or impairment of assets and provisions are made for bad and doubtful debts. These types of provisions do not fall within the scope of IAS 37, because they relate to the measurement of assets and are merely adjustments made to arrive at the asset’s appropriate carrying value.

Example :- Entity A has some long outstanding receivables and management has determined that some of them are impaired. In addition, the fall in demand of entity’s production has caused a decline in utilization. Management has estimated that the recoverable amount of the factory is below the carrying amount.

The impairment loss on the receivables is not a provision in accordance with IAS 37. it should be presented as a reduction of the financial asset either directly or through the use of an allowance account.

In accordance with IAS 36 PPE should be presented net of the impairment charge. An impairment charge is not a probable outflow of economic resources, but a reduction in the cash flows expected from the asset. An impairment charge is not within the scope of IAS 37.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Recognition of Provisions

Provisions should be recognized if, and only if, all of these conditions are met:

§ An entity has a present obligation resulting from a past event;

§ It is probable that an outflow of resources embodying economic benefits would be required to settle the obligation; and

§ A reliable estimate can be made of the amount of the obligation.

Only present obligations resulting for a past obligating event give rise to a provision. An obligation could either be a legal obligation or a constructive obligation.

A legal obligation is an obligation :- Be contractual; or, Arise due to a legislation; or Result from other operation of law.

A constructive obligation, is an obligation that results from an entity’s actions

§ By an established pattern of past practice, published policies, or a sufficiently specific current statement, the entity has indicated to other (third) parties that it will accept certain responsibilities; and

§As a result, the entity has created a valid expectation in the minds of those parties that it will discharge those responsibilities.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Example :- XYZ Inc. is an oil entity that is exploring oil. Environmentalists are protesting and the entity has engaged lawyers to advise it about legal matter. In the past, other oil entities have had to settle with the environmentalists, paying huge amounts in out-of-court settlements. The legal counsel of XYZ Inc. has advised it that there is no law that would require it to pay anything for the oil spill.

However, in its television advertisements and promotional brochures, XYZ Inc. often has clearly stated that it is very conscious of its responsibilities toward the environment and will make good any losses that may result from its exploration and the chief executive officer has acknowledged this policy in official meetings when members of the public raised questions to him on this issue.

§Present obligation as a result of a past obligating event. The obligating event is the oil spill. Because there is no legislation in place yet that would make cleanup mandatory for any entity. However, the circumstances surrounding the issue clearly indicate that there is a constructive obligation since the company, with its advertised policy and public statements, has created an expectation in the minds of the public at large that it will honor its environmental obligations.

§ An outflow of resources embodying economic benefits in settlement.

§ A provision should be recognized for the best estimate of the cost to clean up.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Example :- An entity entered into a 10 year lease of a building. The annual rent under the lease agreement is 36 minr. The entity has decided to relocate its head office with 5 years still to run on the original lease. The entity is permitted to sublet the building and believes that, although market rentals have decreased, it should be able to sublet the building for the full 5 years. The expected rental is Rs. 24 minr

A provision should be recognised for the excess costs under the lease contract above the expected benefits to be received. The obligating event was the signing of the lease agreement and 36 minr is required to be paid in each of the remaining 5yr.

A provision for the following amount should be recognised:

§Annual outflow 36 minr

§Annual expected inflow 24 minr

§Excess annual outflow expected 12 minr

§A provision of 60, minr (12 minr x 5 years) should be recognised.

Note: all other costs and the time value of money have been ignored.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

No Reliable Estimate

Probable is often taken to mean the chance of occurrences is likely. ‘More likely than not’ would seem to suggest more than 50%.

In extremely rare cases, there will be situation where it will not be possible for even an expert to make a reliable estimate of the obligation such that a provision can be made. In this case, because of the uncertainty in the measurement of the obligation, only a contingent liability should be disclosed.

The standard emphasis that in nearly all cases an entity will be able to determine a range of possible outcomes and will generally be competent to make an estimate of an obligation that will be sufficiently reliable to use in recognition a provision.

The standard doesn't, however, elaborate further on the type of situations where a provision would not be made. Clearly, in circumstances where the amount is uncertain it will be necessary to make a judgment about the appropriate amount to provided.

In many situation, this judgment will be relatively easy to make by using a variety of estimation techniques.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Changes in Provisions

Once a provision has been established, it should be reviewed at each subsequent year end and adjusted if necessary to reflect the current best estimate. If uncertainty is removed, the provision should be reclassified as a creditor and disclosed as current or non current as appropriate until its paid.

Where a provision has been set up in the past, the circumstances of the obligation might change from one year to the next. Where, for example, in a subsequent year it becomes no longer probable that an outflow of economic benefits will arise, the provision should be reversed.

Example:- During 2007, 15 Customers of a XYZ Inc. suffered from food poisoning allegedly from products the entity sold. Management has withdraw the product from the market. During the year legal action was brought against the entity. On 31st Dec 07 lawyer advised to management that it was not likely than not to loose the court case. Accordingly management has recognised the provisions in the books.

At 31st Dec 08 the entity’s lawyer advised management that the chances of losing the court case where now negligible as a result of a decision made in a similar case. Lawyer now believe that its no longer probable that the entity will be found liable.

In this case, Management should reverse the provision and recognise the reversal in the P/L. Management should explain the reason for the change in the assessment of the legal action and disclose the amount of the reversal.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Contingent Liabilities

In order to recognize a provision, certain conditions need to be satisfied. However, when one of the prescribed conditions is not satisfied, then a provision cannot be recognized. It is then a contingent liability and needs to be disclosed in footnotes, unless the probability of the outflow embodying economic benefits is remote.

A contingent liability is a possible obligation arising from past events, the outcome of which will be confirmed only on the occurrence or nonoccurrence of one or more uncertain future events. A contingent liability is also a present obligation that is not recognized, either because it is not probable that an outflow of resources will be required to settle an obligation or the amount of the obligation cannot be measured with sufficient reliability.

Once recognized as a contingent liability, an entity should continually assess the probability of the outflow of the future economic benefits relating to that contingent liability. If the probability of the outflow of the future economic benefits changes to more likely than not, then the contingent liability may develop into an actual liability and would need to be recognized as a provision.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Example:- Amazon Inc. has been sued for following 3 alleged infringements of law:

§ Unauthorized use of a trademark; the claim is for 100 minr

§ Nonpayment of end-of-service severance pay and gratuity to 5,000 employees who were terminated without Amazon Inc. giving any reason; the class action lawsuit is claiming 3 minr

§ Unlawful environmental damage for dumping waste in the river near its factory; environmentalists are claiming unspecified damages as cleanup costs

Legal counsel is of the opinion that not all the legal cases are tenable in law and has communicated to Amazon Inc. this assessment of the three lawsuits:

Lawsuit 1: The chances of this lawsuit are remote.

Lawsuit 2: It is probable that Amazon Inc. would have to pay the displaced employees, but the best estimate of the amount that would be payable if the plaintiff succeeds against the entity is 2 minr.

Lawsuit 3: There is no current law that would compel the entity to pay for such damages. There may be a case for constructive obligation, but the amount of damages cannot be estimated with any reliability.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Required

What should be the provision that Amazon Inc. should recognize or the contingent liability that it should disclose in each of the lawsuits, based on the assessments of its legal counsel?

Solution

Lawsuit 1: Because the probability of an outflow of economic benefits is remote, no provision or disclosure is required.

Lawsuit 2: Because it is probable (“more likely than not”) that Amazon Inc. would ultimately have to pay the dues to the displaced employees and the best estimate of the settlement is 2 minr (as against the claim of 3 minr), Amazon Inc. would have to make a provision for 2 minr.

Lawsuit 3: There is no legal obligation, but there is a constructive obligation. However, an estimate of the obligation with reasonable reliability is not possible. Hence this qualifies for disclosure as a contingent liability because it cannot be recognized as a provision (as it does not meet all the prescribed conditions for recognition of a provision).

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Contingent Assets

Under IAS 37, Contingent assets are not recognised – just as contingent liabilities are not recognised. Contingent assets are required to be disclosed by IAS 37, but only where an inflow of economic benefits is probable.

Contingent assets generally only arise from unplanned or other unexpected events that give rise to the possibility of an inflow of resources embodying economic benefits to the entity. Contingent assets are defined as …………

“ 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 entity”

§ An inflow of economic benefit is not probable – do not mention in the financial statements.

§ An inflow of economic benefit is probable – disclose as a contingent asset.

§ An inflow of economic benefits is virtually certain – recognise an asset and the related income in the financial statements.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Reimbursements

Where some or all of the expenditure required to settle a provision is expected to be reimbursed by another party, the reimbursement should be recognised only when it is virtually certain that reimbursement will be received if the entity settles the obligation. Reimbursements of this nature are required to be treated as separate assets and the standard also comments that the amount recognised for reimbursement should not exceed the amount of the related provision.

Example :- An entity had a provision for a legal case that was in progress at the year end. Also at the year end it was negotiating with its insurance company for reimbursement of the amount to be paid out in the legal case, although there was agreement, in principle, with the insurance company that reimbursement would be made if company lost the legal case.

The asset should be recognised in the financial statement provided it is virtually certain at the balance sheet date that reimbursement will be received if the entity settles the obligation. The post year end settlement of the court, confirms the amount of the liability that should be recognised at the balance sheet date. The related reimbursement asset should be recognised if its virtually certain to be received.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Measurement of Provision

The amount to be recognized as a provision is the best estimate of the expenditure required to settle the present obligation at the balance sheet date. While a reliable estimate is usually possible, in rare circumstances, it may not be possible to obtain a reliable estimate. In such cases, the liability is to be disclosed as a contingent liability

“Best estimate” is a matter of judgment and is usually based on past experience with similar transactions, evidence provided by technical or legal experts, or additional evidence provided by events after the balance sheet date.

Example :- A car dealership owns a workshop that it uses for servicing cars under warranty. The entity’s past experience with warranty claims is

§ 60% of cars sold in a year have zero defects.

§ 25% of cars sold in a year have normal defects.

§ 15% of cars sold in a year have significant defects.

The cost of rectifying a “normal defect” in a car is Rs.10,000. The cost of rectifying a “significant defect” in a car is Rs. 30,000. Compute the amount of “provision for warranty” needed at year-end.

The expected value of the provision for warranty needed at year-end is:

(60% × 0) + (25% × Rs.10,000) + (15% × Rs. 30,000) = Rs.7,000.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Estimation techniques
There are number of different techniques that can be used to arrive at the best estimate of the amount of a provision, where the creditor does not wish to settle and where there is no market in obligation of the kind for which provision is being made. Assuming that is possible to specify all the possible outcome and their associated probabilities, the amount to be provided for an obligation could be estimated as :

§The mostly likely outcome:- This method, ignores other possible outcomes and where its nil can lead to the wrong conclusion and the entity has no obligation.

§The maximum amount :- This can lead to excessive provisions where the possibility of that outcome is remote.

§ Minimum amount in the Range :- This might result in a wide range of possible estimates and could impair comparability between financial statements.

§ The expected value :- This method provides an estimate that reflects the entire probability distribution, all the possible outcomes weighted by their probabilities. Its particularly suited to situation where there is a large population of similar claims

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Discounting
The standard suggest that where the effect of the time value of money is material the amount of a provision should be the present value of the expenditures expected to be required to settle the obligation.

The PV of a provision should be determined based on a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the liability.

The discount rate should not reflect risks for which future cash flow estimates have been adjusted. Estimation of cash flows to be paid in the future will be subject to the following factors, which may all have an impact on the discount rate to be used in establishing the obligation’s present value.

§ Inflation

§ Other risks and uncertainties concerning the amount to be settled.

§ The effects of taxation