IAS 37 - Provisions and Contingencies

Purpose of IAS 37

To prescribe rules for the recognition and measurement of provisions, contingent liabilities and contingent assets.

Key Definitions within IAS 37

Provision: a liability of uncertain timing or amount - which therefore excludes creditors and accruals.

Liability: a present obligation of an entity arising from past events, the settlement of which is expected to result in an outflow of resources embodying economic benefits.

Executory contract: contract under which neither party has performed its obligations OR both parties have performed their obligations partially to an unequal extent. 

Onerous contract: a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under the contract. 

Key Definitions (Continued)

Restructuring: programme planned and controlled by the management of the entity and materially changes either the scope of a business undertaking or the manner in which the business is conducted.

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

Contingent asset: a possible asset arising from a past event whose existence will only be confirmed by the occurrence or non-occurrence of one or more uncertain future events that are not completely in control of the entity. 

What items can a provision be made for?

• reorganisation costs
• warranties
• environmental costs
• major refits/refurbishments
• decommissioning costs
• legal cases against the company
• deferred taxation
• losses on contracts

Provisions - Recognition

Provisions should be recognised if all of the following apply:

• There is a present obligation from a past event;
• It is probable that there will be an outflow of resources representing economic benefits which are required to settle the obligation;
• A reliable estimate can be made of the amount of the obligation. 

Not all obligations require a provision - there must be a past obligating event, 

Obligation can either be legal or constructive. 

Legal obligation: 

• Contractual
• Arises due to legislation
• Results from the operation of law

Constructive obligation:

Arises from an entity's actions rather than legal basis - 

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

Recognition - Probablity of outflow of resources

For a provision to be recognised there has to be a probability of the outflow of resources - a level greater than possibility.

For the purposes of the standard the eventuality has to be "more likely than not".

Recognition - Best Estimate

Amount to be included is the best estimate of the expenditure required to settle the present obligation at the balance sheet date.

If a reliable estimate is not possible then the item will be shown as a contingent liability and not a provision. 

Best estimate is a matter of judgement:

• Past experience
• Professional, technical, legal advice
• Additional evidence provided by events after the balance sheet date but before the date the accounts are approved. 

Provision should be discounted where the effect of the time value of money is material.

Future events likely to affect the measurement of the provision should be taken into account if sufficient objective evidence exists that the future event(s) is/are likely to occur.

Review of Provisions

• Provisions should be reviewed at each balance sheet date.
• Amount of provision should be adjusted if necessary to reflect any changes in the best estimate.
• If discounted, then any unwinding of the discount will be taken to income statement.
• Where it is no longer probable that a future outflow of economic benefits would be required to settle the obligation, the provision should be reversed.
• A provision should only be used for the purpose for which it was originally established. 

Provision may not be made for future operating losses:

• Past practices have included such provisions as a means of 'smoothing' profits.
• Provision would not meet the recognition criteria - do not arise from past events and can be avoided by the actions of the entity. 
• However, considerations of future losses could lead to the possibility of impairment of assets and these should be re-examined to establish whether there has been any element of impairment (IAS 36). 

Executory contracts are outside the scope of IAS 37.

Under IAS 37 it is permissible to recognise an executory contract which fulfils the definition of being an onerous contract:

• Arises where the unavoidable costs exceed the benefits expected from the contract.
• Arises from an agreement that the entity cannot rescind legally. 

Previous practice of providing lump sum amounts for future restructuring has led to manipulation and creative accounting. 

Provisions for restructuring now restricted to a structured programme:

• Which is planned and controlled by management 
• Which materially changes either the scope of an entity or the manner in which that business is conducted. 

IAS 37 Examples:

• Sale or termination of a line of business
• Closure of business locations in a region or relocation of business activities from one location to another
• Changes in management structure, such as the elimination of a layer of management
• Fundamental reorganisation of the entity such that it has a material and significant impact on its operations

In general, material restructuring plans and costs would warrant inclusion in the notes to the accounts.

Recognition of a restructuring provision must still fulfil the general definition of a provision before it can be included in the body of the accounts.

A constructive obligation only exists where:

• There is a detailed plan - locations, employees affected, timing, etc.
• Valid expectations have been raised in the minds of those affected that it will be carried out - i.e. it has been made public. 

Restructuring provision that is recognised should only show direct expenditures arising from the restructuring:

• Necessarily incurred by the restructuring
• Not associated costs from the ongoing activities of the entity

Specific exclusions:

• Costs of retraining or relocating continuing staff
• Marketing
• Investment in new systems and distribution networks

For each class of provision, the following should be disclosed:

• Carrying amount at beginning and end of period
• Additional provisions made in the period including increases to existing provisions
• Amounts utilised in the period
• Unused amounts reversed during the period
• Increase during the period in the discounted amount arising fromthe passage of time and the effect of any changes in the discount rate
• Brief description of the nature of the obligation and the expected timing to any resulting outflows of economic benefits
• An indication about the uncertainties relating to the amount and timing of those outflows and where necessary major assumptions about future events
• Amount of any expected reimbursement, stating the amount of any asset that has been recognised for that expected reimbursement
• In certain rare circumstances disclosure can be reduced where it may be seriously prejudicial to the entity. 

If a potential liability does not fulfil all of the conditions for a provision, it will often then be a contingent liability.

Contingent liabilities are not recognised in the financial statements but are disclosed in the notes to the accounts, unless the probability of the outflow of future economic benefits is remote (then non-disclosure).

Definition: a possible obligation arising from past events the outcome of which will only be confirmed by the occurrence or non-occurrence of one or more uncertain future events. 

Once identified, a contingent liability should continually be re-assessed with regard to the possibility/probability of the future outflow of economic benefits.If the possibility changes to more likely than not then the contingency may change to fulfil the definition of a provision, and recognised as such or ultimately to that of an actual liability requiring full recognition as such. 

Disclosure

For each class of contingent liability (unless the possibility of outflow of resources is too remote):

• An estimate of the financial effect
• An indication of the uncertainties relating to the amount or timing of any outflow
• The possibility of any reimbursement

Where any disclosure is impracticable that fact should be disclosed.

In rare cases, information may not be disclosed if to do so would be seriously prejudicial to the entity - and that fact must be disclosed. 

Definition: contingent assets are possible assets that arise from a past event and whose existence is confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity. 

A contingent asset is not recognised in the financial statements (the income from the asset may never be realised).

A contingent asset is disclosed in the notes where an inflow of economic beenfits is probable (and reviewed regularly).

Disclosure

Where an inflow of economic benefits is probable:

• A brief description of the nature of the contingent assets at the balance sheet date
• Where practicable an estimate of their financial effect.

If disclosure of any information is impracticable that fact should be disclosed.

Rare circumstances - seriously prejudicial provisions apply as before.