Provisions, ContingentLiabilities and Contingent

Assets: IAS 37

Wiecek and Young

IFRS PrimerChapter 5

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Provisions, Contingent Liabilities and Contingent Assets

Related standards IAS 37 Current GAAP comparisons Looking ahead End-of-chapter practice

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Related Standards

FAS 5 Accounting for Contingencies FAS 143 Accounting for Asset Retirement

Obligations FAS 146 Accounting for Costs Associated with

Exit or Disposal Activities CON 5 Recognition and Measurement in

Financial Statements of Business Enterprises CON 6 Elements of Financial Statements CON 7 Using Cash Flow Information and

Present Value in Accounting Measurements

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Related Standards

Framework for the Preparation and Presentation of Financial Statements

IFRS 4 Insurance Contracts IAS 1 Presentation of Financial Statements IAS 11 Construction Contracts IAS 12 Income Taxes IAS 17 Leases IAS 19 Employee Benefits

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IAS 37 – Overview

Objective and scope Recognition Measurement Reimbursements Changes in and use of provisions Application of the recognition and

measurement rules Disclosures

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IAS 37 – Objective and Scope

Standard seeks to ensure that provisions and contingencies are appropriately dealt with in terms of recognition, measurement, and disclosure

It does not cover:– Executory contracts unless they are onerous– Provisions or contingencies that are covered by other standards– Depreciation and impairments

The key thing that separates a provision from other liabilities is the uncertainty associated with it, including:

• Uncertainty of the timing of a future expenditure, and/or

• Uncertainty of measurement

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IAS 37 – Objective and Scope

The standard defines provisions, contingent liabilities, and contingent assets as follows: A provision is a liability of uncertain timing or amount

A contingent liability is

(a) A possible obligation 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 or

(b) A present obligation that arises from past events but is not recognized because

(i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation, or

(ii) the amount of the obligation cannot be measured with sufficient reliability

A contingent asset is 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

IAS 37 – Objective and ScopeHow are provisions differentiated from contingencies?

Both have significant uncertainty associated with them, although contingencies have considerably more - relating either to the outcome of a future event or the measurement of the element

The terms contingent assets/liabilities are used to refer to assets/liabilities that are not recognized in the financial statements because of significant uncertainty

Provisions, by contrast, are recognized. They reflect an existing obligation that is measurable and probable

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IAS 37 – Recognition

PROVISIONS:

Provisions are recognized only when all of the following criteria are met:

(a) An entity has a present obligation (legal or constructive) as a result of a past event

(b) It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation and

(c) A reliable estimate can be made of the amount of the obligation

The above definition is essentially the definition of a liability, including

recognition criteria

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IAS 37 – RecognitionPresent Obligation Resulting from a Past Event, Which Is Independent of

an Entity’s Future Actions

To determine whether we should recognize a liability or not depends on whether an obligation exists at the present time

This is differentiated from a future commitment, although the latter may create a present obligation if there are significant negative consequences

The obligation must also result from a past event (sometimes referred to as an obligating event) and according to IAS 37.17, there is no realistic alternative to settling the obligation (there is little or no discretion to avoid settlement)

The standard notes that this would be the case, for instance:

• Where the obligation is enforceable by law (known as a legal obligation), or

• Where a valid expectation has been created that the entity will discharge the

obligation (known as a constructive obligation)

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IAS 37 – RecognitionConstructive and legal obligations are specifically defined as follows:

A constructive obligation is an obligation that derives from an entity’s actions where:

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

(b) As a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities

A legal obligation is an obligation that derives from:

(a) A contract (through its explicit or implicit terms)

(b) Legislation or

(c) Other operation of law.

An entity should take care to avoid accruing provisions for things that it can

avoid through future actions

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IAS 37 – Recognition

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IAS 37 – RecognitionProbable Outflow of Resources Embodying Economic Benefits For recognition, the potential outflow of resources must be probable (more

likely than not) If it is not probable, then note disclosure is required, unless the probability is

remote

Reliable Estimates of an Obligation Provisions, by definition, are very uncertain and therefore may be difficult to

measure In general, the standard presumes that the entity should be able to

determine a reliable range of outcomes; however, if the provision is not estimable (in rare situations), then note disclosure is required

CONTINGENT LIABILITIES AND ASSETS: Note disclosure only, unless the probability of occurrence is remote, in

which case note disclosure is not required

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IAS 37 – MeasurementBEST ESTIMATE AND RISKS/UNCERTAINTIES:

According to IAS 37, an entity must accrue the best estimate of the amount for the provision

Best estimate is defined as follows:– The amount that an entity would rationally pay to settle the obligation

at the end of the reporting period or to transfer it to a third party at that time

Entities must gather evidence to support the assessment of best estimate, which may require market data and the use of independent experts

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IAS 37 – MeasurementThere are differing methodologies for measuring the provision, and the technique chosen depends upon the nature of the item that the provision relates to

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IAS 37 – MeasurementPRESENT VALUE: Where the time value is material, the present value of the cash

flows must be used in estimating the amount The discount rate shall

– Be a pre-tax rate (or rates) that reflect(s) current market assessments of the time value of money and the risks specific to the liability

– Not reflect risks for which future cash flow estimates have been adjusted Since IAS 37 gives little guidance as to how to discount, the

following approaches would be acceptable:1. Adjust the discount rate to reflect the riskiness of the cash flows

This is sometimes referred to as the traditional present value technique or a discount rate adjusted approach

2. Use a risk-free rate as the discount rate but consider multiple cash flow scenarios that reflect differing outcomes and their probability of occurrence

This method is referred to as the expected present value technique

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IAS 37 – Measurement Either the discount rate or the cash flows are adjusted for risk but not both Recall that IAS 37 gives little guidance and thus leaves it to professional judgment

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IAS 37 – MeasurementFUTURE EVENTS:

In estimating the provision, entities may consider future events if there is sufficient evidence regarding the occurrence of the events

EXPECTED DISPOSAL OF ASSETS:

No gains are taken into income for assets that are expected to be sold– Since they are not realized

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IAS 37 – Reimbursements In some cases, some of the cash outflows will be reimbursed

This should be assessed separately and recognized when the receipt of cash inflows is virtually certain

In terms of presentation, the cost and the reimbursement may be offset in the statement of profit and loss

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IAS 37 – Changes In and Use of Provisions

The provisions should be continually assessed, at a minimum, at the end of each reporting period

If the amount of the provision is discounted, then borrowing costs are recognized

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IAS 37 – Application of the Recognition and Measurement Rules

FUTURE OPERATING LOSSES: Future operating losses are not accrued since they represent future events

that an entity may be able to get out of– However, future losses may be indicative of asset impairment

ONEROUS CONTRACTS: According to IAS 37.10, an onerous contract is

“. . . a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it”

Present obligations under onerous contracts are recognized as provisions in the financial statements

– Onerous contracts are often purchase commitments, where the entity is locked in and must settle the contract according to terms that are unfavourable to it

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IAS 37 – Application of the Recognition and Measurement Rules

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IAS 37 – Application of the Recognition and Measurement Rules RESTRUCTURING: Restructuring includes termination of a line of business,

closure or relocation of business, changes in management structure, and fundamental reorganizations

As a general rule, a restructuring provision should be recognized when the criteria for recognizing a provision is met:• The entity has a present obligation (legal or constructive) as

a result of a past event • It is probable that an outflow of resources will be necessary

to settle the obligation and• The restructuring is measurable (a reliable estimate can be

made)

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IAS 37 – Application of the Recognition and Measurement Rules

Additionally, the following criteria must also be met in order to argue that a constructive obligation exists:(a) [The entity] has a detailed formal plan for the restructuring, identifying at least

(i) The business or part of a business concerned(ii) The principal locations affected(iii) The location, function, and approximate number of employees who will be compensated for terminating their services(iv) The expenditures that will be undertaken and(v) When the plan will be implemented and

(b) [The entity] has raised a valid expectation 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

The provision under the standard includes only direct costs that meet both of the following criteria:• The costs are necessarily entailed by the restructuring, and• They are not associated with the ongoing activities of the entity

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IAS 37 – Disclosures

Appropriate detail regarding the nature of the provisions and uncertainties should be disclosed

In rare cases where the information to be disclosed may prejudice the outcome of a dispute with other parties, there is not a requirement to disclose, other than the general nature of the dispute and the reason why full disclosure is not being made

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Current GAAP Comparisons

Pages 90 & 100 ofhttp://www.kpmg.co.uk/pubs/IFRScomparedtoU.S.GAAPAnOverview(2008).pdf

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Looking Ahead

The IASB originally decided to review IAS 37 as part of its short-term convergence project with FASB

– It became apparent that the issues being discussed were quite foundational in terms of the entire body of knowledge

The IASB issued an Exposure Draft in 2005 and plans to issue a new standard in 2009

The standard proposes that all liabilities be recognized unless they cannot be reliably measured, and that uncertainty relating to the amount and timing of cash flows be reflected in the measurement of the liability

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Looking Ahead

Some of the items being proposed/clarified are as follows:

1. Scope: Performance obligations will not be covered by the standard

2. Definitions: – Provision will not be a defined term due to its ambiguity– The terms contingent liability and assets will be deleted– Differentiation of a business risk from a present obligation will be more explicit

3. Recognition: Probability recognition criteria will be deleted

4. Measurement: More guidance on measuring expected values and reimbursement rights will be included

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End-of-Chapter Practice

5-1 The concept of contingency is different under IFRS.

InstructionsContrast and compare the definitions of contingencies and contingent liabilities under both IFRS and U.S. GAAP. How does the accounting differ? Start by looking up the respective definitions under the respective standards.

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End-of-Chapter Practice

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End-of-Chapter Practice

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End-of-Chapter Practice

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