Provisions, Contingent Liabilities

and Contingent Assets

IAS 37
Introduction
Liabilities are obligations arising from a past event that will lead to an outflow of economic
resources.
Most liabilities can be measured accurately. For example, if you take out a bank loan then you
know exactly how much you have to repay, and when the repayments are due. Provisions,
however, involve more uncertainty.
Definition of Provision
According to IAS 37 Provisions, Contingent Liabilities and Contingent Assets (para 10), 'a
provision is a liability of uncertain timing or amount'.
Recognition
A provision is recognised when (IAS 37: para. 14):
a) An entity has a present obligation (legal or constructive) as a result of a past event;
b) It is probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; and
c) A reliable estimate can be made of the amount of the obligation.
Measurement
General rule
The amount recognised is the best estimate of the expenditure required to settle the present
obligation at the end of the reporting period (IAS 37: para. 36). Allowing for uncertainties
a) Where the provision being measured involves a large population of items
◦ use expected values.

b) Where a single obligation is being measured

◦ The individual most likely outcome may be the best estimate.
Discounting of provisions
Where the time value of money is material, the provision is discounted. The discount rate
should:
◦ Be a pre-tax rate
◦ Appropriately reflect the risk associated with the cash flows

The unwinding of the discount is recognised in profit or loss.

Reimbursements
Some or all of the expenditure needed to settle a provision may be expected to be recovered
from a third party, eg an insurer. This reimbursement should be recognised only when it is
virtually certain that reimbursement will be received if the entity settles the obligation (IAS
37: para. 53).
Recognising an asset when creating a
provision
An asset can only be recognised where the present obligation recognised as a provision gives
access to future economic benefits (eg decommissioning costs could be an IAS 16 component
of cost).
Derecognition
If it is no longer probable that an outflow of resources embodying economic benefits will be
required to settle the obligation, the provision should be reversed (IAS 37: para. 59).
Example
Clean sells domestic appliances such as washing machines.
On 31 December 20X1, Clean decides to start selling washing machines with a warranty.
Under the terms of the warranty, Clean will repair washing machines at no charge to the
customer if they break within the warranty period. The entity estimates, based on past-
correspondence with customers, that 20% of the washing machines sold will require repair
within the warranty period at an average cost to Clean of $50 per machine.
Clean sold 200 washing machines on 31 December 20X1.
The time value of money should be ignored.
Required:
◦ Calculate the warranty provision required.
Solution
A provision is required.
A past event (the sale) has created a legal obligation to spend money on repairing machines
in the future. The best estimate can be determined using an expected value: 200 machines ×
20% × $50 = $2,000.
Specific types of provision
Future operating losses
Provisions are not recognised for future operating losses. They do not meet the definition of
a liability and the general recognition criteria set out in the standard (IAS 37: para. 63).

Onerous contracts
IAS 37 defines an onerous contract as one in which unavoidable costs of completing the
contract exceed the benefits expected to be received under it (IAS 37: para. 10).
Unavoidable costs of meeting an obligation are the lower of:
◦ Cost of fulfilling the contract
◦ Penalties from failure to fulfil the contract

An example may be a fixed price supply contract related to a particular product that, due to
inflation, now costs more to manufacture than the fixed sale price agreed in the contract. If
an entity has a contract that is onerous, the present obligation under the contract must be
recognised and measured as a provision (IAS 37: para. 66).
Specific types of provision
Future repairs to assets
Some assets need to be repaired or to have parts replaced every few years. For example, an
airline may be required by law to overhaul all its aircraft every three years.
Provisions cannot normally be recognised for the cost of future repairs or replacement parts.
This is because there is no current obligation to incur the expense – even if the future
expenditure is required by law, the entity could avoid it by selling the asset.
Example
Danboy is a company that owns several shops and which has a year end of 31 December
20X1.
One of the shops is loss-making. At 31 December 20X1, Danboy forecasts that this shop will
make a loss of $50,000 in the year ended 31 December 20X2.
As at 31 December 20X1, one of the shop buildings requires repair. The cost has been reliably
estimated at the reporting date at $10,000. The repair is made in the following accounting
period at a cost $12,000.
Required:
◦ Discuss the accounting treatment of the above in the financial statements for the year ended 31
December 20X1.
Solution
IAS 37 states that no provision should be made for future operating losses. Therefore, no
provision should be made for the $50,000 forecast losses.
No provision should be made for future repairs despite it being probable and capable of
being reliably measured. This is because there is no obligation at the year end. The repairs
expenditure of $12,000 is expensed to profit or loss as it is incurred.
Example
Under new legislation, an entity is required to fit smoke filters to its factories by 31
December 20X7. At the reporting date of 30 June 20X7, the entity has not fitted the smoke
filters.
Required:
◦ Should a provision be made at the reporting date for the estimated cost of fitting the filters?
Solution
No provision should be made for this future expenditure despite it being probable and
capable of being reliably measured. There has been no obligating past event (the fitting of
the filters).
Environmental provisions
Environmental provisions are often referred to as clean-up costs because they usually relate
to the cost of decontaminating and restoring an industrial site after production has ceased.
A provision is recognised if a past event has created an obligation to repair environmental
damage:
◦ A provision can only be set up to rectify environmental damage that has already
happened. There is no obligation to restore future environmental damage because the
entity could cease its operations.
◦ Merely causing damage or intending to clean-up a site does not create an obligation.
➢An entity may have a constructive obligation to repair environmental damage if it
publicises policies that include environmental awareness or explicitly undertakes to
clean up the damage caused by its operations
Environmental provisions
The full cost of an environmental provision should be recognised as soon as the obligation
arises.
◦ The effect of the time value of money is usually material. Therefore, an environmental
provision is normally discounted to its present value.
◦ If the expenditure results in future economic benefits then an equivalent asset can be
recognised. This is depreciated over its useful life, which is the same as the ‘life’ of the
provision.
Example
a) An entity has a policy of only carrying out work to rectify damage caused to the
environment when it is required to do so by local law. For several years the entity has
been operating an overseas oil rig which causes environmental damage. The country in
which the oil rig is located has not had legislation in place that required this damage to
be rectified.
A new government has recently been elected in the country. At the reporting date, it is
virtually certain that legislation will be enacted that will require damage rectification.
This legislation will have retrospective effect.
b) Under a licence granted by a local government, an entity has constructed a rock-crushing
plant to process material mined from the surrounding area. Mining activities have
already started. Under the terms of the licence, the entity must remove the rock-
crushing plant when mining activities have been completed and must landscape the
mined area, so as to create a national park.
Required:
◦ For each of the situations, explain whether a provision should be recognised.
Solution
For each situation, ask two questions.
a) Is there a present obligation as the result of a past event?
b) Is an outflow of economic benefits probable as a result?
A provision should be recognised if the answer to both questions is yes. In the absence of
information to the contrary, it is assumed that any future costs can be estimated reliably.
a) Present obligation? Yes. Because the new legislation with retrospective effect is virtually
certain to be enacted, the damage caused by the oil rig is the past event that gives rise to a
present obligation.
◦ Outflow of economic benefits probable? Yes.
◦ Conclusion – Recognise a provision.
b) Present obligation? Yes. There is a legal obligation under the licence to remove the rock-
crushing plant and to make good damage caused by the mining activities to date (but not any
that may be caused by these activities in the future, because mining activities could be
stopped and no such damage caused).
◦ Outflow of economic benefits probable? Yes.
◦ Conclusion – Recognise a provision for the best estimate of the eventual costs of rectifying the damage
caused up to the reporting date.
Example
On 1 January 20X6, Scrubber spent $5m on erecting infrastructure and machinery near to an
area of natural beauty. These assets will be used over the next three years. Scrubber is well-
known for its environmentally friendly behaviour and is therefore expected to restore the
site after its use.
The estimated cost of removing these assets and cleaning up the area on 1 January 20X9 is
$3m.
The pre-tax, risk-specific discount rate is 10%. Scrubber has a reporting date of 31 December.
Required:
◦ Explain how the above should be treated in the financial statements of Scrubber.
Solution
Scrubber has a constructive obligation to restore
the area to its original condition as a result of a past
event (erecting the infrastructure). Therefore, it
should recognise a provision at 1 January 20X6. The
best estimate of the expenditure is $3m, but this
must be discounted to its present value of
$2,253,000 ($3m × 0.751). Movement on provision 20X6 20X7 20X8 20X9
Scrubber could not carry out its operations without Opening balance 2,253 2,478 2,727 3,000
incurring the clean-up costs. This means that Finance cost at 10% 225 249 273 -
incurring the costs gives it access to future
economic benefits. The estimated clean-up costs Utilisation - - - (3000)
are therefore included in the cost of the property,
plant and equipment (PPE): Closing balance 2,478 2,727 3,000 -

Dr PPE $2,253,000
Cr Provisions $2,253,000
Each year, the discount unwinds and the provision
increases. The unwinding of the discount is charged
to the statement of profit or loss as a finance cost.
Solution Continued
Initial cost of PPE $000
Cash paid 1 January 20X6 5,000
PV of clean-up costs 2,253
Total 7,253

20X6 20X7 20X8 20X9

$000 $000 $000 $000
Operating costs
Depreciation ($7,253/3 years) 2,418 2,418 2,417 -
Finance costs
Unwinding of discount 225 249 273 -
Restructuring
Restructuring is a programme that is planned and is controlled by management and
materially changes either the scope of a business undertaken by an entity, or the manner in
which that business is conducted (IAS 37: para. 10).
Examples of restructuring include (IAS 37: para. 70):
◦ The sale or termination of a line of business
◦ The closure of business locations or the relocation of business activities
◦ Changes in management structure
◦ Fundamental reorganisations that have a material effect on the nature and focus of the
entity's operations
Restructuring - Recognition
One of the main purposes of IAS 37 was to target abuses of provisions for restructuring by
introducing strict criteria about when such a provision can be made. A provision for
restructuring is recognised only when the entity has a constructive obligation to restructure.
Such an obligation only arises where an entity:
a) Has a detailed formal plan for the restructuring; and
b) Has raised a valid expectation in those affected that it will carry out the restructuring by
starting to implement that plan or announcing its main features to those affected by it.

Where the restructuring involves the sale of an operation, no obligation arises until the entity
has entered into a binding sale agreement.
Restructuring costs
A restructuring provision includes only the direct expenditures arising from the restructuring,
which are those that are both (IAS 37: para. 80):
a) Necessarily entailed by the restructuring; and
b) Not associated with the ongoing activities of the entity.

The provision should not include (IAS 37: para. 81):

◦ Retraining or relocating continuing staff
◦ Marketing
◦ Investment in new systems and distribution networks
◦ future operating losses (unless these arise from an onerous contract)
◦ profits on disposal of assets

The amount recognised should be the best estimate of the expenditure required and it
should take into account expected future events. This means that expenses should be
measured at their actual cost, where this is known, even if this was only discovered after the
reporting date (this is an adjusting event after the reporting period per IAS 10).
Example
Trailer, a public limited company, operates in the manufacturing sector. During the year
ended 31 May 20X5, Trailer announced two major restructuring plans. The first plan is to
reduce its capacity by the closure of some of its smaller factories, which have already been
identified. This will lead to the redundancy of 500 employees, who have all individually been
selected and communicated with. The costs of this plan are $9 million in redundancy costs,
$4 million in retraining costs and $5 million in lease termination costs. The second plan is to
re-organise the finance and information technology department over a one-year period but
it does not commence for two years. The plan results in 20% of finance staff losing their jobs
during the restructuring. The costs of this plan are $10 million in redundancy costs, $6 million
in retraining costs and $7 million in equipment lease termination costs.
Required
◦ Discuss the treatment of each of the above restructuring plans in the financial statements of Trailer
for the year ended 31 May 20X5.
Solution
Plan 1:
A provision for restructuring should be recognised in respect of the closure of the factories in
accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets. The plan has
been communicated to the relevant employees (those who will be made redundant) and
factories have already been identified. A provision should only be recognised for directly
attributable costs that will not benefit ongoing activities of the entity. Thus, a provision should be
recognised for the redundancy costs and the lease termination costs, but none for the retraining
costs:
$m
Redundancy costs 9
Retraining -
Lease termination costs 5
Liability 14

Dr Profit or loss (retained earnings) $14m

Cr Current Liabilities $14m
Solution - Continued
Plan 2
No provision should be recognised for the reorganisation of the finance and IT department.
Since the reorganisation is not due to start for two years, the plan may change, and so a valid
expectation that management is committed to the plan has not been raised. As regards any
provision for redundancy, individuals have not been identified and communicated with, and
so no provision should be made at 31 May 20X3 for redundancy costs.
Example
A company was awarded a licence to quarry limestone in an area of outstanding natural beauty.
As part of the agreement, the company was required to build access roads as well as the
structures necessary for the extraction process. The total cost of these was $50 million. The
quarry came into operation on 31 December 20X3 and the operating licence was for 20 years
from that date. Under the terms of the operating licence, the company is obliged to remove the
access roads and structures and restore the natural environmental habitat at the end of the
quarry's 20-year life. At 31 December 20X3, the estimated cost of the restoration work was $10
million, and this estimate did not change by 31 December 20X4. An additional cost of $500,000
per annum the quarry is operated (at 31 December 20X4 prices) will also be incurred at the end
of the licence period to clean up further progressive environmental damage that will arise
through the extraction of the limestone.
An appropriate discount rate reflecting market assessments of the time value of money and risks
specific to the operation is 8%.
Required Explain the treatment of the cost of the assets and associated obligation relating to the
quarry:
a) As at 31 December 20X3
b) For the year ended 31 December 20X4.
Work to the nearest $1,000.
Solution
At 31 December 20X3
At 31 December 20X3, a provision should be
recognised for the dismantling costs of the
structures already built and restoration of the
environment where access roads to the site
have been built. This is because the
construction of the access roads and Non-current assets $m
structures, combined with the requirement Quarry structures and access roads at cost
under the operating licence to restore the site
and remove the access roads, create an Construction cost 50.0
obligating event at the end of the period. As
the time value of money is material, the Provision for dismantling and restoration costs 2.145
amount must be discounted resulting in a ($10m x 1/1.08 ^20)
provision of $2.145 million ($10m x 1/1.08 ^20
). 52.145
As undertaking this obligation gives rise to
future economic benefits (from selling
limestone), the amount of the provision should
be included in the initial measurement of the
assets relating to the quarry as at 31 December
20X3:
Solution - Continued
Year ended 31 December 20X4
The overall cost of the quarry structures and access roads (including the discounted
provision) would be depreciated over the quarry's 20 year life resulting in a charge for the
year of $52.145m/20 = $2.607m recognised in profit or loss and a carrying amount of
$52.145m – $2.607m = $49.538m.
The provision would begin to be compounded resulting in an interest charge of $2.145m x
8% = $0.172m in profit or loss.
The obligation to rectify damage to the environment incurred through extraction of
limestone arises as the quarry is operated, requiring a new provision and a charge to profit
or loss of $0.116m ($500,000 x 1/1.08 ^ 19 ) in 20X4.
Solution - Continued
Therefore the outstanding provision in the statement of financial position as at 31
December 20X4 is made up as follows:

$m
Provision for dismantling and restoration costs b/d 2.145
Interest ($2.145m x 8%) 0.172
New provision for restoration costs at year end prices ($500,000 x 1/1.08 ^19) 0.116
Provision for dismantling and restoration costs c/d at 31 December 20X4 2.433
The overall charge to profit or loss for the year is:
Depreciation 2.607
New provision for restoration costs 0.116
Finance costs 0.172
Provision for dismantling and restoration costs c/d at 31 December 20X4 2.895
Example
On 15 January 20X5, the Board of Directors of Shane voted to proceed with two
reorganisation schemes involving the closure of two factories. Shane’s reporting date is 31
March, and the financial statements will be authorised for issue on 30 June.
Scheme 1
◦ The closure costs will amount to $125,000. The closure will be announced in June, and will
commence in August.

Scheme 2
◦ The costs will amount to $45,000 (after crediting $105,000 profit on disposal of certain machines).
The closure will take place in July, but redundancy negotiations began with the staff in March.

Required:
◦ For each of the two schemes discuss whether a provision should be recognised and, if so, at what
amount.
Solution
Scheme 1
◦ The obligating event is the announcement of the plan, which occurs in June. This is after the year-
end, so there can be no provision. However, the announcement in June should be disclosed as a
non-adjusting event after the reporting date.

Scheme 2
◦ Although the closure will not begin until July, the employees will have had a valid expectation that
it would happen when the redundancy negotiations began in March. Therefore, a provision should
be recognised. The provision will be for $150,000 because the expected profit on disposal cannot
be netted off against the expected costs.
Example
On 30 June 20X2, the directors of Delta decided to close down a division. This decision was
announced to the employees affected on 15 July 20X2 and the actual closure occurred on
31 August 20X2, prior to the 20X2 financial statements being authorised for issue on 15
September.
Expenses and other items connected with the closure were as follows:

$m
Redundancy costs (estimated) 22
Staff retraining (actual) 10
Operating loss for the 2 months to 31 August 20X2 (estimated at 30 June) 12
Profit on sale of property 5

The actual redundancy costs were $20 million and the actual operating loss for the two
months to 31 August 20X2, was $15 million.
Required:
◦ What is the amount of the restructuring provision to be recognised in the financial statements of
Delta plc for the year ended 31 July 20X2?
Solution
The only item which can be included in the provision is the redundancy costs, measured at
their actual amount of $20 million.
IAS 37 prohibits the recognition of future operating losses, staff retraining and profits on
disposals of assets.
Contingent liabilities
A contingent liability is defined by IAS 37 as:
◦ a possible obligation that arises from past events and whose existence will be confirmed by the
outcome of uncertain future events which are outside of the control of the entity, or
◦ a present obligation that arises from past events, but does not meet the criteria for recognition as
a provision. This is either because an outflow of economic benefits is not probable or (more rarely)
because it is not possible to make a reliable estimate of the obligation.

A contingent liability is disclosed, unless the possibility of a future outflow of economic

benefits is remote.
If an outflow of economic benefits becomes probable then contingent liabilities must be
reclassified as provisions.
Contingent assets
IAS 37 defines a contingent asset as a possible asset that arises from past events and whose
existence will be confirmed by uncertain future events that are outside of the entity's
control.
A contingent asset should not be recognised:
◦ A contingent asset should be disclosed if the an inflow of future economic benefits is at least
probable
◦ If the future inflow of benefits is virtually certain, then it ceases to be a contingent asset and
should be recognised as a normal asset.