Provisions and Events

IAS 37 applies to all provisions, contingent liabilities, and contingent assets EXCEPT those covered by other standards (e.g., financial instruments under IFRS 9, leases under IFRS 16, insurance contracts under IFRS 17, income taxes under IAS 12, employee benefits under IAS 19, onerous contracts that are covered by other standards).

Key definitions:

• Provision: A liability of uncertain timing or amount. Distinct from trade payables (no uncertainty) and accruals (certain timing/amount but not yet invoiced).
• Liability: A present obligation arising from past events, the settlement of which is expected to result in an outflow of economic benefits.
• Obligating event: An event creating a legal or constructive obligation that results in the entity having no realistic alternative to settling that obligation.
• Legal obligation: Derives from a contract (explicit or implicit), legislation, or other operation of law.
• Constructive obligation: Derives from the 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 parties that it will discharge those responsibilities.
• Contingent liability: Either (a) a possible obligation (depends on uncertain future events not wholly within the entity's control), OR (b) a present obligation where either outflow is NOT probable, or the amount cannot be measured reliably.
• Contingent asset: A possible asset that arises from past events, whose existence will be confirmed only by uncertain future events not wholly within the entity's control.

A provision is recognised when ALL THREE criteria are met:

1. Present obligation (legal or constructive) as a result of a past event — an obligating event has already occurred before the reporting date
2. Probable outflow of resources — "probable" means more likely than not (i.e., >50% probability)
3. Reliable estimate of the amount can be made — IAS 37 notes that only in extremely rare cases will a reliable estimate not be possible

IAS 37 decision tree:

1. Is there a present obligation as a result of an obligating event?
   • Yes → Is an outflow probable?
     • Yes → Can it be reliably estimated? If yes → Recognise provision. If no (rare) → Disclose as contingent liability.
     • No (but not remote) → Disclose as contingent liability. Remote → no action.
   • Possible obligation only → not remote → Disclose as contingent liability. Remote → no action.
   • No obligation → no action needed

"Past event" — the obligating event: The past event must have already given rise to the obligation. Expectations of future expenditure (even if legally required to incur) do NOT create a present obligation at the reporting date if the entity can still avoid them by its future actions. Example: A law requires installation of smoke filters by 31 December 20X3. At 31 December 20X2, no provision is recognised because the entity could still avoid the expenditure by shutting down the plant. The obligating event is the operation of the plant after the legal deadline — which hasn't happened yet at the 20X2 reporting date.

Best estimate: The amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligation at the reporting date. This is the amount a rational entity would pay to settle the obligation at the reporting date, or transfer it to a third party.

Methods of estimation:

• Single obligation: Use the most likely amount (most probable outcome). Consider other possible outcomes if they are significantly higher/lower, adjusting the most likely figure for a range of reasonably possible outcomes.
• Large population of items (e.g., warranty provisions on many products sold): Use expected value (probability-weighted outcomes). If 100,000 products are sold and historical data shows 5% will need minor repairs costing £10 and 1% will need major repairs costing £100: expected cost per product = (5% × £10) + (1% × £100) + (94% × £0) = £1.50. Total provision = 100,000 × £1.50 = £150,000.

Present value (discounting): Where the time value of money is material, the provision should be discounted to present value using a pre-tax rate reflecting current market assessments of time value and the risks specific to the liability. Subsequently, the discount unwinds each period — the unwinding is a finance cost in P/L.

Risks and uncertainties: Must be taken into account but must NOT be used to justify creating "excessive" provisions (e.g., "big bath" accounting, "cookie jar" reserves). Prudence does not justify deliberate overstatement.

Future events: Expected future events that may affect the amount required to settle should be reflected if there is sufficient objective evidence that they will occur (e.g., expected future technological improvements reducing clean-up costs).

Expected disposal of assets: Gains from the expected disposal of assets should NOT be taken into account in measuring a provision — even if expected to occur closely with the event giving rise to the provision.

Reimbursements: If some or all of the expenditure required to settle a provision is expected to be reimbursed by another party (e.g., insurance):

• Recognise the reimbursement as a separate asset ONLY when it is virtually certain to be received
• The reimbursement asset CANNOT exceed the amount of the provision
• In P/L, the expense relating to the provision may be presented net of the reimbursement

Changes in provisions: Reviewed at each reporting date and adjusted to reflect the current best estimate. If an outflow is no longer probable → reverse the provision. Changes in discount rate: remeasure the provision using the new rate (with the change going to P/L — except for some decommissioning provisions under IFRIC 1).

Use of provisions: A provision can only be used for expenditure for which the provision was originally recognised. Using a provision for unrelated expenditure would mask the effect of the other events on the current period's P/L.

Warranties:

• On sale of a product with a warranty: the sale creates a constructive obligation (and usually a legal one under the contract) that is probable to result in outflow (some proportion of products will be defective)
• Use expected value based on historical experience
• Note: under IFRS 15, "service-type" warranties (extended/enhanced warranties) are separate performance obligations and accounted for as revenue over the warranty period — not as provisions. Only "assurance-type" warranties (assurance the product complies with spec) are provisions under IAS 37.

Environmental restoration / decommissioning:

• Legal obligation to restore a site / decommission (e.g., oil well, nuclear plant, mine) arises as the damage is caused
• Provision recognised at PV of expected future costs (typically long-dated — discounting is material)
• Corresponding debit: increase the cost of the underlying non-current asset (IAS 16) — then depreciate over the useful life
• Each year: unwinding of discount → finance cost in P/L
• Constructive obligations also count — e.g., an entity with an established pattern of remediating environmental damage even where not legally required

Restructuring provisions:

"Restructuring" = a programme planned and controlled by management that materially changes either (a) the scope of business, or (b) the manner in which business is conducted. Examples: plant closures, relocations, fundamental reorganisations, disposal of a major line of business.

• A provision is recognised only when BOTH:
  1. Detailed formal plan identifying: the business/part affected, principal locations, the function, approximate number of employees to be compensated, expenditures to be undertaken, when the plan will be implemented; AND
  2. The entity has raised a valid expectation in those affected that it will carry out the restructuring — by starting to implement the plan OR by announcing its main features to those affected. A board decision alone is NOT sufficient.
• Included costs: only direct expenditures necessarily caused by the restructuring AND not associated with the ongoing activities of the entity. E.g., redundancy costs, contract termination costs, lease exit costs for onerous lease elements.
• Excluded costs: retraining/relocating continuing staff (these relate to future operations), marketing costs, investments in new systems/distribution networks (ongoing activities), future operating losses.

Onerous contracts:

• Definition: A contract where the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.
• Recognise a provision for the onerous element (the "present obligation" is the loss-making nature of the contract)
• Unavoidable costs: The LOWER of: (a) the cost of fulfilling the contract (direct and allocated costs of performance), and (b) any compensation or penalties arising from failure to fulfil. Amendment from 2022: unavoidable costs explicitly include allocation of overheads directly relating to fulfilling contracts, per the "costs that relate directly" principle.
• Before recognising an onerous contract provision: first impair any assets dedicated to the contract (e.g., equipment used solely for the loss-making contract)

Future operating losses: A provision is NEVER recognised for future operating losses (IAS 37.63). These do not meet the definition of a present obligation arising from past events. However, they may indicate that assets used in the operations are impaired — apply IAS 36.

Contingent liabilities:

A contingent liability may also be a present obligation where outflow is not probable OR the amount cannot be reliably estimated. In this (rare) case, the obligation exists but it is disclosed rather than recognised.

Contingent assets — conservative treatment:

Legal proceedings: The treatment depends on the company's role:

• Company is the defendant (potential outflow): assess as a liability/contingent liability using the criteria above. Legal advice is crucial.
• Company is the claimant (potential inflow): assess as a contingent asset. Typically disclosed at best if probable, recognised only if virtually certain (e.g., a court has ruled in the company's favour with no further appeals pending and payment is virtually certain).

Definitions:

• Events after the reporting period: Events (favourable or unfavourable) occurring between the reporting date and the date when the financial statements are authorised for issue
• Date of authorisation for issue: The date on which the FS are approved by the board of directors (or equivalent) and released. In some jurisdictions this is before shareholder approval; in others it is when the board finalises; the entity should disclose its policy.

Two categories of events:

Examples of adjusting events (ADJUST):

• Settlement of a court case after the reporting date that confirms a present obligation existed at the reporting date — adjust the provision to the settlement amount
• Bankruptcy of a customer after the reporting date — typically confirms that a receivable was already impaired at the reporting date — increase bad debt provision
• Sale of inventory at a price below cost after the reporting date — evidence that NRV at the reporting date was already below cost — write down inventory under IAS 2
• Discovery of fraud or errors showing the financial statements are incorrect — correct
• Determination after the reporting period of employee profit-sharing or bonus payments if the entity had a present obligation at the reporting date

Examples of non-adjusting events (DISCLOSE):

• Decline in market value of investments after the reporting date (conditions that caused the decline arose after)
• Major business combination or disposal of a major subsidiary after the reporting date
• Destruction of a major production plant by fire after the reporting date
• Abnormally large changes in asset prices or exchange rates after the reporting date
• Announcement of a major restructuring plan after the reporting date (but where the recognition criteria for a restructuring provision had not been met at the reporting date)
• Issue of shares or significant new borrowings after the reporting date
• Entering into significant commitments or contingent liabilities after the reporting date

Dividends declared after the reporting period:

• Dividends declared to holders of equity instruments AFTER the reporting date but BEFORE the FS are authorised for issue are NOT recognised as a liability at the reporting date
• Disclose the amount in the notes
• This is because at the reporting date there was no present obligation — the dividend must be declared (by the directors) before the obligation arises

Going concern:

• If, after the reporting period, management determines that it intends to liquidate the entity or cease trading, or that there is no realistic alternative but to do so, the FS should NOT be prepared on a going concern basis
• This applies even if the events occurred AFTER the reporting date — the going concern basis is assessed at the date of authorisation for issue
• Disclose the fact that the entity is not a going concern, the basis used, and the reasons why the entity is not regarded as a going concern