IAS 37 and liabilities, provisions and contingent liabilities

This article answers the following questions:

• How do international standards define liabilities, provisions and contingent liabilities?
• How should contingent liabilities be recognised in financial statements in accordance with IAS 37?
• What can be considered an entity’s liability?

The prudence principle and the matching principle are – as fundamental accounting concepts – well known to all accountants. Their proper application, however, requires, among other things, the creation of liabilities or provisions (and sometimes also the disclosure of contingent liabilities). Unfortunately, this often leads to problems, as it requires the correct interpretation of events and carries the risk of subjectivity. What should the employees of finance departments of Polish and foreign companies take into account in order to make decisions compliant with international standards, even under uncertain conditions?

How are liabilities, provisions and contingent liabilities defined under International Accounting Standard 37 (IAS 37)?

• A liability is 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.
• A provision is a liability of uncertain timing or amount.

When comparing the definitions of a liability and a provision, particular attention must be paid to the degree of uncertainty associated with a given economic event. In accordance with IAS 37, if there is uncertainty regarding either the amount of the obligation or the timing of its settlement, then we are dealing with a provision.

Moreover, IAS 37 imposes specific conditions that must be met in order for a provision to be recognised. A provision is recognised when:

1. the entity has a present obligation (legal or constructive) resulting from past events,
2. it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation,
3. a reliable estimate of the amount of the obligation can be made.

If the above conditions are not met, a provision should not be created in the given case.

According to the international standard, the level of provisions recognised by an entity should be reviewed and adjusted at the end of each reporting period. If, as a result of any events, it is no longer probable that an outflow of resources will be required to settle the obligation, the provision previously recognised must be reversed. Under IAS 37, a provision may be used only for the purpose for which it was originally created.

Contingent liabilities in financial statements under IAS 37

Liabilities are divided into those that are recognised in the balance sheet (including provisions) and those that are not recognised in the balance sheet (referred to as contingent liabilities). Information on contingent liabilities is presented in the notes to the financial statements.

According to IAS 37, a contingent liability is:

1. a possible obligation – arising from past events, 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,
2. a present obligation – arising from past events, but not recognised in the financial statements because:
   1. it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation, or
   2. the amount of the obligation cannot be measured with sufficient reliability.

Differences between a provision and a contingent liability in practice

Example:

The manufacturing company “ALFA” employs 20 full‑time employees under employment contracts. Salaries are paid by the 10th day of the following month. The company’s policy provides for high retirement severance payments for its employees. 

As at the balance sheet date, ALFA’s accountant must determine whether, given the company’s employment of staff, there is a need to recognise provisions or contingent liabilities. The following key points should be analysed:

1. Unpaid salaries constitute a liability of the company – the obligation to pay them, together with the amount and the date of settlement, is certain.
2. The finance department should recognise a provision for retirement severance payments, as these are future obligations arising from past events. Even though the amount and timing of the severance payments are uncertain, the estimate of such a provision must include the probability that a given employee will remain with the employer until retirement. 

Now consider that during the current year, one employee sues ALFA for PLN 50,000 in compensation for unlawful dismissal, prompting the company to seek legal advice on the likelihood of winning the case. How should the company disclose this risk in its financial statements? Two scenarios are possible. 

Scenario I: ALFA’s lawyer and management assess that the company is highly likely to win the case

This approach may be taken if:

• there is significant probability that ALFA will win the case and will not have to pay the compensation claimed,
• the potential costs that the company would incur if it lost the case can be estimated.

Proposed decision for Scenario I:

The accounting department should disclose, in the notes to the financial statements, a contingent liability equal to the potential compensation costs, as the probability of winning the case is assessed as greater than the probability of losing. The liability arises from future events – if the court decision were unfavourable to the company, the contingent liability would have to be converted into a liability and recognised in the balance sheet.

Scenario II: ALFA’s lawyer and management assess that the company is highly likely to lose the case

This approach should be taken if:

• there is significant probability that ALFA will lose the case and will have to pay the amount claimed,
• the amount of the provision can be reliably estimated,
• the obligation arises from past events (unlawful dismissal).

Proposed decision for Scenario II:

The accounting department should recognise a provision for the claim amounting to PLN 50,000.

Proper application of standards is key to accurate financial reporting

Recognising provisions and liabilities is an extremely broad topic. Here we have only outlined the general issues, using simplified examples. In economic practice, however, much more complex problems and situations often arise. Bearing this in mind – and in the interest of proper bookkeeping – it is advisable, when necessary, to seek consultation with a statutory auditor or, when arranging the audit of financial statements, choose an audit firm offering comprehensive support in evaluating financial processes.

If this is the case, we encourage you to contact our experts, who will be happy to learn about the challenges faced by your entity in order to respond to its needs as effectively as possible.