IAS 37 vs. liabilities and provisions for liabilities

Paulina PRUSIK
Audit Assistant at RSM Poland

The consequences of applying the prudence principle and the matching principle involve recognising provisions and disclosing contingent liabilities. In practice, these areas stir a lot of controversy because of the danger of being subjective, so typical for any decision-making under uncertainty.​

In this article, I would like to present some problematic aspects of provisions for liabilities, accruals and contingent liabilities according to IAS 37.

According to the standard, a provision is a specific type of liability of an uncertain amount or timing. In line with IAS 37, provisions are liabilities and must have all the characteristics of liabilities as being a balance sheet item. What is more, an entity recognises a provision if, and only if, all of the following conditions are met:

• the entity has a present (legal or constructive) payment obligation resulting from a past event,
• it is probable that an outflow of resources will be required to settle this obligation,
• the amount of the obligation can be estimated reliably.

According to the standard, the entity should review and adjust provisions at each balance sheet date. If an outflow necessary to meet the obligation is no longer probable, the entity should reverse the provision. In line with IAS 37, provisions should only be used for the purpose for which they were originally recognised.

Zdarzenia warunkowe w sprawozdaniu finansowym

It should be noted that liabilities can be classified as those that shall be recognised in the balance sheet (like e.g. provisions) and those that shall not, namely contingent liabilities. The information about contingent liabilities is presented in the notes to the financial statement.

In order to have a full picture of what provisions and contingent liabilities are, we are going to analyse the following case:

Example:

The “ALFA” production company employs 20 people: they all work full-time under a contract of employment. The remuneration of employees is paid by the 10th day of the following month.

At the balance sheet date, the company’s accountant must decide if there is a need for provisions or contingent liabilities to be made as a result of the fact that the company has employees. Let us consider the following elements of liabilities:

1. Unpaid employees’ remuneration is a liability for the company: the obligation, amount and timing of payment are certain.
2. Under the company’s policy, the employees receive high one-time retirement benefits. The accountant should recognise a provision for one-time retirement benefit, because this is a future obligation resulting from past events, even though the amount and timing are uncertain.
3. Furthermore, when employing under a contract of employment, the employer is obliged to grant the employee an appropriate number of holiday leave days or a payment in lieu of holiday leave. Given the fact that the service (employee’s work) has been performed, and the employee has not yet taken all the days off which they are entitled to by the end of the fiscal year, the accountant should recognise a provision for holiday leave, which is an element of liabilities different from a typical provision, namely an accrual, because – in contrast to provisions – this amount can be determined and the uncertainty of an outflow is much lower than in the case of provisions.

Moreover, continuing our example, this year one of the employees filed a wrongful termination suit against the “ALFA” company claiming a compensation of PLN 50,000. The company asked a lawyer for an opinion on the probability of the company winning the lawsuit.

How should the company disclose the risk in their financial statements?

Option I: The lawyer and the management board of the “ALFA” company assessed that the entity would most probably win the lawsuit.

• It is highly probable that the “ALFA” company will win the lawsuit and will not have to pay the claim amount to the employee.
• The amount of possible costs the company would have to bear in case of losing the lawsuit can be estimated.

Decision:

In the notes to the financial statements, the chief accountant of the ”ALFA” entity should disclose a contingent liability for the amount of the compensation, because winning the lawsuit was determined as more likely than not. The liability will result from future events: if the court rules against the company, the contingent liability will be changed into a liability (and included in the balance sheet).

Option II: The lawyer and the management board of the “ALFA” company assessed that the entity would most probably lose the lawsuit.

• It is highly probable that the “ALFA” company will lose the lawsuit and will have to pay the claim amount to the employee.
• The amount of the provision can be estimated.
• The liability results from past events (wrongful termination).

Decision:

The chief accountant of the “ALFA” entity should make a decision on recognising a provision for the amount of PLN 50,000 being the claim amount.

Option II – future consequences:

• If the entity loses the lawsuit, they will be obliged to cover the court costs in the future.
• Both the timing and amount of a possible liability will be certain.

Decision:

Upon the settlement of the lawsuit, the chief accountant of the ”ALFA” entity should recognise a liability for the amount of costs resulting from a court ruling.

What should be also noted is that the standard has not only separated provisions from contingent liabilities, but also distinguished between provisions and other liabilities, such as trade payables or accruals. In contrast to provisions:

• trade payables are amounts payable for goods and services that have been purchased/availed and have been invoiced or formally agreed with the vendor,
• accruals are amounts payable for goods and services that have been purchased/availed, but have not been paid, invoiced or formally agreed with the vendor, including amounts payable to staff.

What is more, accruals are recognised as part of trade payables or other payables, whereas provisions are recognised separately.

The table below presents relations between genuine liabilities, provisions, accruals and contingent liabilities according to IAS 37.

Provisions and liabilities on the balance sheet: an expert analysis

As you can see, economic entities that want to include risks and uncertainties in their financial statements must go for a deeper analysis of certain situations. Since the Accounting Act offers only some general information on this subject, it is a good idea to have a look at IAS 37, where you can find more details. We encourage you to read more articles we have written on (international) financial reporting, and should you have any questions, please contact our experts.