IAS 37: Provisions, contingent liabilities and contingent assets

Financial statements must include all the information necessary for an understanding of the company's financial position. Provisions, contingent liabilities and contingent assets are 'uncertainties' that must be accounted for consistently if we are to achieve this understanding. IAS 3 Provisions, contingent liabilities and contingent assets aims to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets and that sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount. !efore IAS 3 , there was no accounting standard dealing with provisions. "ompanies wanting to show their results in the most favourable light used to ma#e large 'one off$ provisions in years where a high level of underlying profits was generated. %hese provisions, often #nown as 'big bath' provisions, were then available to shield e&penditure in future years when perhaps the underlying profits were not so good. In other words, provisions were used for profit smoothing. 'ust as an e&ample, (orldcom had set aside )3.3bn reserves in order to be able to dip into them to boost profits in the future. %hese were brought into current year earnings in *++*. %he #ey aim of IAS 3 is to ensure that provisions are made only where there are valid grounds for them. IAS 3 views a provision as a liability. A provision is a liability of uncertain timing or amount. A liability is an obligation of an entity to transfer economic benefits as a result of past transactions or events. %he IAS distinguishes provisions from other liabilities such as trade payables and accruals. %his is on the basis that for a provision there is uncertainty about the timing or amount of the future e&penditure. (hilst uncertainty is clearly present in the case of certain accruals the, uncertainty is generally much less than for provisions. IAS 3 states that a provision should be recognised as a liability in the financial statements when,

An entity has a present obligation -legal or constructive. as a result of a past event It is probable that a transfer of economic benefits will be re/uired to settle the obligation A reliable estimate can be made of the obligation

Meaning of obligation It is fairly clear what a legal obligation is. 0owever, there can also be a constructive obligation. IAS 3 defines a constructive obligation as An obligation that drivers form an entity$s actions where.

!y an established pattern of past practice, published polices or a sufficiently specific current

statement the entity has indicated to other parties that will accept certain responsibilities, and

As a result, the entity has created a valid e&pectation on the part of those other parties that it will
discharge those responsibilities. In which circumstances might a provision be recognised1

a) 2n 33 4ecember *+56 the board of an entity decided to close down a division. %he accounting date
of the company is 33 4ecember. !efore 33 4ecember *+56 the decision was not communicated to any of those affected and no other steps were ta#en to implement the decision. 7o provision would be recognised as the decision has not been communicated and so could still be avoided.

b) %he board agreed a detailed closure plan on *+ 4ecember *+56 and details were given to customers
and employees. A provision would be made in the *+56 financial statements.

c) A company is obliged to incur clean up costs for environmental damage -that

has already been caused.. A provision for such costs is appropriate, because the obligation arises from a past event.

d) A company intends to carry out future e&penditure to operate in a particular way in the future.
7o present obligation e&ists and under IAS 3 no provision would be appropriate. %his is because the entity could avoid the future e&penditure by its future actions, maybe by changing its method of operation. Transfer of economic benefits For the purpose of the IAS, a transfer of resources embodying economic benefits is regarded as 'probable' if the event is more li ely t!an not to occur. %his appears to indicate a probability of more than 8+9. 0owever, the standard ma#es it clear that where there is a number of similar obligations the probability should be based on considering the population as a whole, rather than one single item. If a company has entered into a warranty obligation then the probability of transfer of resources embodying economic benefits may well be e&tremely small in respect of one specific item. 0owever, when considering the population as a whole the probability of some transfer of resources is /uite li#ely to be much higher. If there is a greater t!an "#$ probability of some transfer of economic benefits then a provision should be made for the e%pected amount& Measurement of provisions %he amount recognised as a provision should be the best estimate of the e&penditure re/uired to settle the present obligation at the end of the reporting period. %he estimates will be determined by the 'udgment of the entity's management supplemented by the e&perience of similar transactions. Allowance is made for uncertainty. (here the provision being measured involves a large population of items, the obligation is estimated by weighting all possible outcomes by their associated probabilities, ie e&pected value. (%ample A company sells goods with a warranty under which customers are covered for the cost of repairs of any manufacturing defect that becomes apparent within the first si& months of purchase. %he company's past e&perience and future e&pectations indicate the following pattern of li#ely repairs. 9 of goods sold 8 *+ 8 4efects 7one ;inor ;a<or "ost of repairs if all items suffered from these defects )m : 3.+ =.+

%he cost is found using 'e&pected values' - 89 & )nil. > -*+9 & )3.+m. > -89 & )=.+m. ? )=++,+++. (here the effect of the time value of money is material, the amount f a provision should be the present value of the e&penditure re/uired to settle the obligation. An appropriated discount rate should be used. %he discount rate should be a pre:ta& rate that reflects current mar#et assessments of the time value of money. %he discount rate-s. should not reflect ris#s for which future cash flow estimates have been ad<usted. (%ample A company #nows that when it ceases a certain operation in 8 years time it will have to pay environmental cleanup costs of )8m. %he provision to be made now will be the present value of )8m in 8 years time.

%he relevant discount rate in this case is 3+9. %herefore a provision will be made for, )8m & +.@*+6*A %he following year the provision will be, )8m & +.@B3+3AA Increase A%he discount rate for 8 year at 3+9 AA%he discount rate for = year at 3+9 %he increase in the liability in the second year of )33+,=8+ will be charged to profit or loss. It is referred to as the un)inding of the discount. %his is accounted for as a finance cost. *uture events which are reasonably e&pected to occur -eg new legislation, changes in technology. may affect the amount re/uired to settle the entity$s obligation and should be ta#en into account. Cains from the e&pected disposal of assets should not be ta#en into account in measuring a provision. +eimbursements Some or all of the e&penditure needed to settle a provision may be e&pected to be recovered from a third party. If so, t!e reimbursement s!ould be recognised only )!en it is virtually certain t!at reimbursement )ill be received if t!e entity settles t!e obligation& ) 3,3+=,@++ 3,=38,+8+ 33+,=8+

%he reimbursement should be treated as a separate asset, and the amount recognised should not
be greater than the provision itself.

%he provision and the amount recognised for reimbursement may be netted off in profit or loss.
,!anges in provisions Provisions should be reviewed at the end of each reporting period and ad<usted to reflect the current best estimate. If it is no longer probable that a transfer of resources will be re/uired to settle the obligation, the provision should be reversed. -se of provisions A provision s!ould be used only for e%penditures for )!ic! t!e provision )as originally recognised& Setting e&penditures against a provision that was originally recognised for another purpose would conceal the impact of two different events. *uture operating losses Provisions should not be recognised for future operating losses. %hey do not meet the definition of a liability and the general recognition criteria set out in the standard. .nerous contracts If an entity has a contract that is onerous, the present obligation under the contract should be recognised and measured as a provision. An e&ample might be vacant leasehold property. %he entity is under an obligation to maintain the property but is receiving no income from it. An onerous contract is a contract entered into with another party under which the unavoidable costs of fulfilling the terms of the contract e&ceed any revenues, e&pected to be received from the goods or services supplied or purchased directly or indirectly under the contract and where the entity would have to compensate the other party if it did not fulfill the terms of the contract. (%amples of possible provisions

a)

/arranties. %hese are argued to be genuine provisions as on past e&perience it is probable, ie more li#ely than not, that some claims will emerge. %he provision must be estimated, however, on the basis of the class as a whole and not on individual claims. %here is a clear legal obligation in this case.

b)

c)

d) e)

Ma'or repairs. In the past it has been /uite popular for companies to provide for e&penditure on a ma<or overhaul to be accrued gradually over the intervening years between overhauls. Dnder IAS 3 this is no longer possible as IAS 3 would argue that this is a mere intention to carry out repairs, not an obligation. %he entity can always sell the asset in the meantime. %he only solution is to treat ma<or assets such as aircraft, ships, furnaces etc as a series of smaller assets where each part is depreciated over shorter lives. %hus any ma<or overhaul may be argued to be replacement and therefore capital rather than revenue e&penditure. Self insurance. A number of companies have created a provision for self insurance based on the e&pected cost of ma#ing good fire damage etc instead of paying premiums to an insurance company. Dnder IAS 3 this provision is no longer <ustifiable as the entity has no obligation until a fire or accident occurs. 7o obligation e&ists until that time. (nvironmental contamination& If the company has an environmental policy such that other parties would e&pect the company to clean up any contamination or if the company has bro#en current environmental legislation then a provision for environmental damage must be made. 0ecommissioning or abandonment costs. (hen an oil company initially purchases an oilfield it is put under a legal obligation to decommission the site at the end of its life. Prior to IAS 3 most oil companies set up the provision gradually over the life of the field so that no one year would be unduly burdened with the cost. +estructuring& %his is considered in detail below.

f)

1 Provisions for restructuring %he IAS 3 defines a restructuring as, A programme that is planned and is controlled by management and materially changes one of two things.

%he scope of a business underta#en by an entity %he manner in which that business is conducted
%he IAS gives the following e&amples of events that may fall under the definition of E restructuring.

%he sale or termination of a line of business %he closure of business locations in a country or region or the relocation of business activities
from one country region to another

,!anges in management structure, for e&ample, the elimination of a layer of management *undamental reorgani2ations that have a material effect on the nature and focus of the entity's
operations %he /uestion is whether or not an entity has an obligation : legal or constructive : at the end of the reporting period. For this to be the case,

An entity must have a detailed formal plan for the restructuring It must have raised a valid e&pectation 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 A mere management decision is not normally sufficient& ;anagement decisions may sometimes trigger off recognition, but only if earlier events such as negotiations with employee representatives and other interested parties have been concluded sub<ect only to management approval. (here the restructuring involves the sale of an operation then IAS 3 states that no obligation arises until the entity has entered into a binding sale agreement. %his is because until this has occurred the entity will be able to change its mind and withdraw from the sale even if its intentions have been announced publicly.

"osts to be included within a restructuring provision

%he IAS states that a restructuring prevision should include only the direct e&penditures arising from the restructuring, which are those that are both,

3ecessarily entailed by the restructuringF and 7ot associated with the ongoing activates of the entity.

%he following costs should specifically not be included within a restructuring provision.

+etraining or relocating continuing staff Mar eting Investment in ne) systems and distribution networ#s

0isclosure
4isclosures for provisions fall into two parts.

4isclosure of details of the c!ange in carrying value of a provision from the beginning o the end of the year 4isclosure of the bac ground to the ma#ing of the provision and the uncertainties affecting its outcome

3 contingent liabilities and contingent assets

IAS 3 defines a contingent liability as, A possible obligation that arises from past events and whose e&istence 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, or A present obligation that arises for past events but is not recognised because, It is not probable that an outflow of resources embodying economic benefits will be re/uired to settle the obligation or %he amount of the obligation cannot be measured with sufficient reliability. As a rule of thumb, probable means more than 8+9 li#ely. If an obligation is probable, it is not a contingent liability G instead, a provision is needed. Treatment of contingent liabilities "ontingent liabilities should not be recognised in financial statements but they should be disclosed. %he re/uired disclosures are,

A brief description of the nature of the contingent liability An estimate of its financial effect An indication of the uncertainties that e&ist %he possibility of any reimbursement

,ontingent assets IAS 3 defines a contingent asset as, A possible asset that arises from past events and whose e&istence will be confirmed by the occurrence or non:occurrence of one or more uncertain future events no wholly within control of the entity. A contingent asset must not be recognised& .nly )!en t!e realisation of t!e related economic benefits is virtually certain s!ould recognition ta e place& At that point, t!e asset is no longer a contingent asset4 0isclosure "ontingent assets must only be disclosed in the notes if they are probable. In that case a brief description of the contingent asset should be provided along with an estimate of its li#ely financial effect. '5et out' IAS 3 permits reporting entities to avoid disclosure re/uirements relating to provisions, contingent liabilities and contingent assets if they would be e&pected to seriously pre'udice the position of the entity in dispute with other parties. 0owever, this should only be employed in e%tremely rare cases. 4etails of the general nature of the provisionHcontingencies must still be provided, together with an e&planation of why it has not been disclosed.