The International Accounting Standard (“IAS 37”) Provisions, Contingent Liabilities and Contingent assets sets the criteria for the recognition and measurement of: -
- Contingent liabilities;
- Contingent assets; and,
requires a number of disclosures about these items in order to understand them better.
What is a provision?
A Provision is a liability of uncertain timing or amount.
The word “uncertain” is very important, because if timing and amount are certain or almost certain, then the entity does not deal with the provision but with a payable or an accrual.
To understand provisions better, it is necessary to look at the definition of a liability in IAS 37:
A liability is a present obligation arising from a past event that is expected to be settled by an outflow of economic benefits from an entity.
In other words, if there is no past event, then there is no liability and no provision should be recognized.
Past events can create 2 types of obligation being:
- Legal obligation that arises from legislation, a contract or other legal act; or
- Constructive obligation that arises from some business practice or custom which creates an expectation in other parties to fulfill the obligation.
It does not really matter what type of obligation the entity deals with – whichever it is, it leads to a provision. However, if the entity identifies the obligation, it can help the entity to decide whether to recognize a provision or not.
When to recognize a provision?
The IAS standard sets 3 criteria for recognizing a provision:
- There must be a present obligation as a result of a past event ;
- The outflow of economic benefits to satisfy the obligation must be probable (i.e. more than 50% probable); and,
- The amount of economic benefits required to satisfy the obligation must be reliably estimated.
If all 3 criteria are met, then the entity should recognize a provision.
If one of them is not met, then the entity should either:
- Disclose a contingent liability, or
- Do nothing if the outflow of economic benefits is remote.
If the entity is unsure whether to recognize a provision in a particular situation or not, it is necessary to consider the below question:
Can the obligation be avoided by some future actions?
If yes, then the entity should NOT book a provision.
For example, if a government introduces new tax legislation, does the tax consulting company need to spend cash for training its employees and thus recognize a provision for that training?
No, it does not have to as the Tax consulting company can avoid the training and decide to stop its activities.
If the entity cannot avoid the obligation by some future action, then the entity has to recognize a provision.
For example, when a company provides a free warranty service for defective products at the point of sale, then the company has a present obligation. If the entity’s past statistics indicate that the entity has needed to spend some cash for warranty repairs, then the entity needs to make a provision.
How to measure a provision?
The amount of the provision should be measured as the best estimate of the expenditures required to satisfy the obligation at the end of the reporting period.
This will involve some judgement and estimation. The management should incorporate all available information in their estimates and must include the below matters when doing this:
- Risks and uncertainties (like inflation);
- Time value of money (discounting when the settlement is expected in the long-term future), and;
- Some probable future events.
There are 2 basic methods of measuring a provision:
- Expected value method: The entity would use this method when the entity has a range of possible outcomes or the entity measures the provision for a large amount of items. In this case, the entity needs to weight each outcome by its probability (for example, warranty repair costs for 200,000 products).
- The most likely outcome: This method is suitable in the case of a single obligation or just 1 item (for example, provision for loss in a court case action).
How to account for a provision?
There are several events associated with accounting for provisions:
- Recognition of a provision: In most cases, the entity should recognize a provision in profit or loss. Sometimes, a provision is recognized in the cost of another asset, for example, provision for removing the asset and restoring the site after its use. The entity should split the provision to current and non-current parts for presentation purposes in the entity’s statement of financial position.
- Unwinding the discount: When a provision has a long-term nature (beyond 12 months), then there’s some discounting involved as the entity needs to present at its present value. In each reporting period, the entity should account for an interest on the opening balance of the provision and this is called “unwinding the discount”. The entity should recognize the interest in profit or loss and it must also increase the amount of the provision.
- Utilization of a provision: When the entity incurs expenditure associated with the settlement of the its obligation, the entity should utilize a provision. In most cases, the entity simply recognizes this utilization directly with incurring the invoices from suppliers or any related payments (e.g. Debit Provision / Credit Cash).
- Reimbursement: Sometimes, entities have rights to reimbursements of related expenditures by the third party (e.g. from an insurance company). In this case, a right to reimbursement is recognized as a separate asset (no netting off with the provision itself), but the entity can net off the expenses for the provision with the income from reimbursement (indemnity) in the profit or loss.
Provisions in specific circumstances
Standard IAS 37 specifies the treatment of provisions in a few specific situations:
Future operating losses
The entity should not make a provision for a future operating loss since there is no past event. The future operating losses can be avoided by some future actions, for example – by selling a business.
However, the entity should test the entity’s assets for impairment under IAS 36 Impairment of Assets.
An onerous contract is a contract in which unavoidable costs of fulfilling exceed the benefits from the contract.
In other words, it is a loss contract that cannot be avoided.
The entity should make a provision in the amount being the lower of:
- Unavoidable costs of fulfilling the contract and
- Penalty for not meeting the entity’s obligations from the contract
Restructuring is a management plan to change the scope of a business or the manner of conducting business.
The entity should recognize a provision for restructuring only when the general criteria for recognizing provisions are met.
In the case of restructuring, an obligation to restructure arises only if:
- There is a detailed formal plan for restructuring with relevant information in it (about business, location, employees, time schedule and expenditures)
- A valid expectation related to restructuring has been raised by the affected parties.
A contingent liability is either:
- A possible obligation (not present) from a past event that will be confirmed by some future event; or
- A present obligation from a past event, but either:
- The outflow of economic benefits to satisfy this obligation is not probable (less than 50%), or
- The amount of obligation cannot be reliably measured.
For example, the entity might face a lawsuit, but the entity’s lawyers estimate the probability of losing the case at 30% – in this case, it’s not probable that the entity will have to incur any expenditures to settle the claim and the entity should not book a provision which is a typical contingent liability.
If the entity identifies that it has a contingent liability, the entity does NOT need to recognize it by way of a journal entry. The entity should only make appropriate disclosures in the notes to the financial statements.
A contingent asset is a possible asset arising from past events that will be confirmed by some future events not fully under the entity’s control.
Similarly, as with contingent liabilities, the entity should not book anything in relation to contingent assets, but the entity should make appropriate disclosures.
This article was compiled by Khun Surachai Damnoenwong who is the Director Head of RSM Audit Services Thailand Limited and who has over 25 years of experience in audit services Thailand as well as Laos. As mentioned earlier, this article is based on Silvia’s one reported on CPD Box. Should you have any queries about the article or require the services of an audit firm in Thailand, please contact [email protected]