IAS 37 provisions explained

When is a provision recognised under IAS 37?

• Present obligation from a past event: an obligating event that leaves the company no realistic alternative but to settle. It may be legal, from a contract or law, or constructive, from an established practice, published policy or specific statement that has created a valid expectation.
• Probable outflow: more likely than not. For many similar obligations, such as warranties, the test is applied to the class as a whole.
• Reliable estimate: almost always possible; only in extremely rare cases can no estimate be made.

No provision is recognised for future operating losses or for costs the company could avoid by its future actions, such as planned repairs or future fines it could avoid by changing how it operates.

How is a provision measured?

At the best estimate of the expenditure required to settle the present obligation at the reporting date: the amount the company would rationally pay to settle it or transfer it to a third party.

• Large populations: expected value, weighting all possible outcomes by their probabilities.
• Single obligations: the most likely outcome, adjusted if other outcomes are mostly higher or lower.
• Time value: discounted at a pre-tax rate when the effect is material; the unwinding is a finance cost.
• Future events: reflected where there is sufficient objective evidence, such as new technology that will reduce clean-up costs.

A worked example: a warranty provision

A manufacturer sells 10,000 appliances with a one-year warranty. Experience shows 5% have minor defects costing 20 each to repair and 1% have major defects costing 200 each.

Entry: Dr Warranty expense, Cr Warranty provision 30,000. As repairs are made, the provision is used; at each year end it is re-estimated, and any unused amount is reversed.

How does discounting work?

A company must clean up a site in five years at an estimated cost of 100,000. At a pre-tax discount rate of 5%, the provision is 100,000 / 1.05^5 = 78,353. Each year it grows by the unwinding of the discount, 3,918 in the first year, recognised as a finance cost, until it reaches 100,000 when the work is done.

Common mistakes

• Providing for future operating losses or for costs the company could avoid.
• Building up "general" provisions in good years to release in bad ones, which IAS 37 does not allow.
• Netting an expected insurance recovery against the provision instead of recognising it separately when virtually certain.

What about reimbursements?

If an insurer or supplier will reimburse part of the cost, the reimbursement is recognised as a separate asset only when it is virtually certain, and never above the provision. The expense may be shown net of the reimbursement in profit or loss.

How do provisions differ from contingent liabilities?

A contingent liability is a possible obligation whose existence depends on uncertain future events, or a present obligation where an outflow is not probable or cannot be measured reliably. It is not recognised but is disclosed unless the possibility of an outflow is remote. Contingent assets are disclosed only when an inflow is probable and recognised only when virtually certain.

Which provisions have their own guides?

Loss-making contracts are covered in onerous contracts, and dismantling obligations in decommissioning costs. Uncertain income taxes follow IFRIC 23, not IAS 37; see IFRIC 23.

This guide is general information. It is not tax or legal advice for your situation.