IAS 37

• IAS37 defines a provision as "a liability of uncertain timing or amount ", and states that a provision should be recognised
when all of the following conditions are satisfied:

a) the 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.
c) a reliable estimate can be made of the amount of the obligation.
• If any of these conditions are not satisfied, a provision must not be recognised.
• This reinforces the point that a provision is a kind of liability and the only difference between a provision and any other
liability is the degree of uncertainty involved.
• Although many liabilities involve uncertainty (e.g. the amount of an accrued expense) this will generally be much greater
in the case of a provision.
• IAS37 also states that the amount of a provision should be equal to "the best estimate of the expenditure required to
settle the present obligation at the end of the reporting period".

 To understand provisions better, let’s break down the definition of a liability in IAS 37:
- A liability is a present obligation arising from 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 event can create 2 types of obligation:

• Legal obligation that arises from legislation, a contract or other legal act.

• Constructive obligation that arises from some business practice or customs and created an expectation in other
parties to fulfil the obligation (in other words, people simply expect some company to fulfil the obligation even if
it’s not in the law or any contract).

Example: A company gives warranties at the time of sale to customers who buy the company’s products. These warranties
commit the company to make good any manufacturing defects that become apparent within three years from the date of sale.
On past experience, it is probable that some valid warranty claims will arise. When preparing its financial statements for the
year to 30 June 2020, should the company make a provision for warranty claims? If so, how should this be measured?
Solution
It is clear that the company is obliged at 30 June 2020 to meet any valid claims which arise under warranties given in the
previous three years. Therefore, there is a present obligation arising from a past event. It is also clear that such claims will
probably occur and so it is probable that an outflow of resources will be required to settle this obligation. If the amount and
timing of the claims were certain, a liability could be recognized in the usual way. But there is considerable uncertainty with
regard to both the timing and the amount of this liability and therefore a provision is required. The amount of the provision
should be the company's best estimate of the cost of meeting warranty claims arising in relation to products sold in the last
three years. This estimate will presumably be based on past experience.

Recognition criteria: Obligating events

A past event which leads to a present obligation is known as an "obligating event".

For a past event to be an obligating event, the business entity involved must have no realistic alternative but to settle the
obligation created by the event. This will be the case if:

a) The obligation is legally enforceable, or

b) The entity has a "constructive obligation", which occurs when an entity has indicated that it will accept an obligation and
has created a valid expectation in other parties that it will discharge that obligation, even though this is not legally
enforceable.
For instance, a business entity which operates in a country with environmental legislation may have a legal obligation to
decontaminate land which it has contaminated by its past actions. An entity which operates in a country with no such
legislation may nonetheless have a widely-published policy of cleaning up all contamination which it causes and a record of
honoring this policy, in which case there is a constructive obligation.

Recognition criteria: Probable outflow of economic benefits

 As stated above, a provision cannot be recognized unless it is probable that an outflow of economic benefits will be
required to settle the obligation in question. For this purpose, the word "probable" means "more likely than not".

 If a number of similar obligations (e.g. Product warranties) exist at the end of a reporting period, IAS37 requires that the
probability of an outflow of benefits should be assessed by considering the class of obligations as a whole.
 Even though it may not be probable that any one obligation will result in an outflow of benefits, it may indeed be
probable that an outflow will be needed to settle the entire class of obligations.
 If an entity is involved in a lawsuit at the end of a reporting period, the entity should consider all available evidence
(possibly including expert opinion) and then:
a) If it is more likely than not that a present obligation exists at the end of the reporting period (and if the other
recognition criteria are met) a provision should be recognized.
b) If it is more likely that there is no present obligation at the end of the reporting period, a contingent liability should
be disclosed unless there is only a remote possibility of an outflow of economic benefits.

Recognition criteria: Reliable estimate of the obligation

The final condition which must be satisfied in order for a provision to be recognized is that a reliable estimate can be made of
the amount of the obligation.
 IAS37 takes the view that it will usually be possible to determine a range of possible outcomes and then make an
estimate that is sufficiently reliable for this purpose.
 If (rarely) a reliable estimate cannot be made, a liability exists but a provision cannot be recognized. This liability must
be disclosed as a contingent liability.

When to recognize a provision?

 The standard IAS37 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)
• The amount of economic benefits required to satisfy the obligation must be reliably estimated.
If all 3 criteria are met, then you should recognize a provision.
 If just one of them is not met, then you should either:

Provisions
o Disclose ain specificliability,
contingent circumstances
or
o Do nothing if the outflow of economic benefits is remote.
Standard IAS 37 specifies the treatment of provisions in a few specific situations:
• Future operating losses
o You should not make a provision for future operating loss. Why?
Because there is no past event. The future operating losses can be avoided by some future actions, for example –
by selling a business. However, you should test your assets for impairment under IAS 36 Impairment of Assets.
• Onerous contracts
o Onerous contract is a contract in which unavoidable costs of fulfilling exceed the benefits from the contract.
o In other words, it is a loss contract that cannot be avoided.

You should make a provision in the amount lower of:

 Unavoidable costs of fulfilling the contract and
 Penalty for not meeting your obligations from the contract

• Restructuring
o Restructuring is a plan of management to change the scope of business or a manner of conducting a business.
o You 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 in the affected parties.

Examples:
The following information relates to a company which prepares financial statements to 31 December each year:

(a) On 1 January 2019, the company acquired new plant costing £10 million. This plant will require a complete overhaul after five
years of use, at an estimated cost of £1 million. Accordingly, the company wishes to make a provision of £200,000 for plant
overhaul costs in its financial statements for the year to 31 December 2019 and then to increase this provision by £200,000 in
each of the next four years. This will have the effect of spreading the overhaul costs evenly over the years 2019 to 2023.

Solution: At 31 December 2019, there is no present obligation to undertake the overhaul that is due in four years’ time. The
plant could in fact be sold before the overhaul is required. Therefore, no provision can be made for the overhaul costs.
International standard IAS16 Property, Plant and Equipment prescribes the accounting treatment of this type of expenditure.

(b) On 1 August 2019, the company took out a 12-month lease on factory premises at a monthly rental of £10,000. However,
these premises are now surplus to requirements and will stand empty until the lease comes to an end. The lease is non-
cancellable and the premises cannot be sub-let. The company wishes to make a provision of £70,000 in its financial statements
for the year to 31 December 2019.

Solution: In general, IAS37 does not apply to leases. But this is an example of a short-term lease and IAS37 does apply to such
leases if they become onerous. The obligation of £70,000 (£10,000 per month from 1 January 2020 to 31 July 2020) is
unavoidable and should be provided for.

(c) In November 2019, the company decided to sell off one of its operations. No buyer has been found at 31 December 2019, but
the sale is expected to result in a loss of £500,000 when it occurs. The company wishes to provide for this loss in the financial
statements for the year to 31 December 2019.

Solution: There is no binding sales agreement in existence at 31 December 2019 and so there is no present obligation on that
date. A provision cannot be made. However, depending on the circumstances, the non-current assets of the operation might be
Contingent
classified liabilities
as "held for sale" and measured in accordance with the requirements of IFRS 5 (IFRS 5 — Non-current Assets Held for
Sale and Discontinued Operations). Assets of the operation that are not classified as held for sale should be tested for
impairment under IAS36 (IAS 36 — Impairment of Assets).
• Except for provisions, we can deal both with contingent liabilities and contingent assets.
• A contingent liability is either:
o A possible obligation (not present) from past event that will be confirmed by some future event; or

o A present obligation from 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 (this is very rare, in fact).

An example when an entity is involved in a legal case and will be required to pay damages if the case is lost. If it is probable that
the case will be lost, the entity should recognise a provision. But if it is merely possible that the case will be lost, the entity
should treat the obligation as a contingent liability. IAS37 requires that contingent liabilities should not be recognised in the
statement of financial position but should instead be disclosed in the notes, unless the possibility of an outflow of economic
benefits is remote.
For example, you might face a lawsuit, but your lawyers estimate the probability of losing the case at 30% – in this case, it’s not
probable that you will have to incur any expenditures to settle the claim and you should not book a provision. It’s typical
contingent liability.
• If you identify you have a contingent liability, you do NOT recognize it – no journal entry. You should only make
appropriate disclosures in the notes to the financial statements.

Example:
In May 2019, ABC plc (which prepares financial statements to 31 December) guaranteed a £100,000 bank loan provided to DEF
Ltd. DEF Ltd was in a strong financial position at 31 December 2019, but this had worsened by 31 December 2020 and it
seemed likely on that date that ABC plc would be required to honour its guarantee. Explain how this guarantee should be
treated in the financial statements of ABC plc at 31 December 2019 and 2020.

Solution: At 31 December 2019, there is a present obligation arising from a past event. However, an outflow of economic
benefits does not seem probable, so no provision can be made. The guarantee falls within the definition of a contingent
liability and should be disclosed in the notes to the financial statements, unless the possibility of an outflow of benefits is
judged to be remote.

At 31 December 2020, there is still a present obligation arising from a past event, but now it seems probable that there will be
an outflow of economic benefits. As long as a reliable estimate of the obligation can be made (which will almost certainly be
the case) a provision should be made in relation to this obligation.

CASES:
 Briefly discuss the accounting treatment for each of the following situation under IAS 37. All the entities in the question have 31 December year-ends. In all
cases, it is assumed that a reliable estimate can be made of any outflows expected.

a) A manufacturer gives warranties at the time of sale to purchasers of its product. Under the terms of the contract for sale the manufacturer undertakes
to make good, by repair or replacement, manufacturing defects that become apparent within three years from the date of sale. On past experience, it
is probable (i.e. more likely than not) that there will be some claims under the warranties.

b) An entity in the oil industry causes contamination and operates in a country where there is no environmental legislation. However, the entity has a
widely published environmental policy in which it undertakes to clean up all contamination that it causes. The entity has a record of honoring this
published policy.

c) An entity operates an offshore oilfield where its licensing agreement requires it to remove the oil rig at the end of production and restore the seabed.
Ninety per cent of the eventual costs relate to the removal of the oil rig and restoration of damage caused by building it, and 10 per cent arise through
the extraction of oil. At the end of the reporting period, the rig has been constructed but no oil has been extracted.

d) A retail store has a policy of refunding purchases by dissatisfied customers, even though it is under no legal obligation to do so. Its policy of making
refunds is generally known.

e) Under new legislation, an entity is required to fit smoke filters to its factories by 30 June 20X1. The entity has not fitted the smoke filters. What is
impact of this at 31 December 20X0, the end of the reporting period?

f) Under new legislation, an entity is required to fit smoke filters to its factories by 30 June 20X1. The entity has not fitted the smoke filters. What is
impact of this at 31 December 20X1, the end of the reporting period?

g) The government introduces a number of changes to the income tax system. As a result of these changes, an entity in the financial services sector will
need to retrain a large proportion of its administrative and sales workforce in order to ensure continued compliance with financial services regulation.
At the end of the reporting period, no retraining of staff has taken place.

h) After a wedding in 20X0, ten people died, possibly as a result of food poisoning from products sold by the entity. Legal proceedings are started seeking
damages from the entity but it disputes liability. Up to the date of authorization of the financial statements for the year to 31 December 20X0 for issue,
the entity's lawyers advise that it is probable that the entity will not be found liable.

i) Consider the same facts as given in (h) above. However, when the entity prepares the financial statements for the year to 31 December 20X1, its
lawyers advise that, owing to developments in the case, it is probable that the entity will be found liable.

j) A furnace has a lining that needs to be replaced every five years for technical reasons. At the end of the reporting period, the lining has been in use for
three years.

k) An airline is required by law to overhaul its aircraft once every three years.

Example:
Identify, whether each of the following would be a liability, a provision or a contingent liability, or none of the above, in the
financial statements of the entity as at the end of its reporting period (provide brief explanation to your answers).
a) As a result of its plastics operations, Company G has contaminated the land on which it operates. There is no legal
requirement to clean up the land, and Company G has no record of cleaning up land that it has contaminated.

b) Damages awarded against Company A resulting from a court case decided on 26 June 2016. The judge has announced
that the amount of damages will be set at a future date, expected to be in September 2016. Company A has received
advice from its lawyers that the amount of the damages could be anything between $20 000 and S7 million.

c) Long service leave, estimated to be $500 000, owing to employees in respect of past services.

d) At 31 March 2020, the company owns a fleet of motor lorries, all of which require an annual service. This servicing work
is expected to occur in the first few months of the year to 31 March 2021, at an estimated cost of £50,000.

e) the board of directors decided to close down one of the company's operations. This decision had been announced to the
workforce and a detailed plan had been drawn up for its implementation. The closure would involve redundancy
payments of £375,000.

How to measure a provision?

• The amount of the provision should be measured at the best estimate of the expenditures required to satisfy the
obligation at the end of the reporting period.
• As you can see, here’s some judgement and estimates involved. Management should really incorporate all available
information in their estimates and they must not forget about:
o Risks and uncertainties (like inflation),
o Time value of money (discounting when the settlement is expected in the long-term future)
o Some probable future events, etc.

There are 2 basic methods of measuring a provision:

 Expected value method: You would use this method when you have a range of possible outcomes or you measure the
provision for large amount of items. In this case, you need to weight each outcome by its probability. (for example,
warranty repair costs for 10,000 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 the court case).

EXAMPLE: A company sells goods under warranty. If all of the goods covered by warranties at the end of the reporting period
had minor defects, the company would incur repair costs of £1m. If all of these goods had major defects, repair costs would be
£4m. Experience shows that 75% of goods sold have no defects, 20% have minor defects and the remaining 5% have major
defects. What is the expected value of the cost of repairs under warranties?

Solution: The expected value is (75% × £nil) + (20% × £1m) + (5% × £4m) = £400,000.

How to account for a provision?

There are several events associated with the accounting for provisions:
• Recognition of a provision: In most cases, you 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.
Don’t forget to split the provision in the current and non-current part for the presentation purposes in your 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 you need to present it in its present value. In each reporting period, you account for an interest on the opening
balance of the provision and this is called “unwinding the discount “. You should recognize the interest in profit or loss and
it also increases the amount of a provision.
• Utilization of a provision: When you incur expenditures associated with the settlement of your obligation, you should
„utilize a provision. In most cases, you simply recognize this utilization directly with incurring the invoices from suppliers or
any related payments (e.g. Debit Provision / Credit Cash).
• Reimbursement: Sometimes, entities have right to reimbursement 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 you can net off the expenses for provision with the income from reimbursement in the profit or loss.

Accounting Treatment for Warranty

• Many entities sell goods or provide a service and grant their customers a guarantee against the defects that may appear in
the goods sold or service provided in the period following the sale or service, which is usually free of charge.

• warranty period is usually fixed in years or in other units such as vehicle mileage, specified working hours for machinery
and equipment, and so on.

• IAS (37) requires the recognition of the after-sale guarantee provision, the warranty costs of sold items are estimated
based on the prior experience of the entity.

Example:
1. The Jordanian Company sells computers and customers are given guarantees for one year from the date of sale. During
2018, the Jordanian Company sold 400 computers. Based on the company’s experience:

- 40% of the computers sold are not returned by customers for maintenance within the warranty period.

- 50% of the computers sold undergo simple maintenance within the warranty period.

- 10% of the sold computers undergo substantial maintenance within the warranty period.

The cost of simple maintenance of the device is $50, and the cost of material maintenance is $100.

Required: Calculate the amount warranty provision that shall be recognized on 31/12/2018.

Solution: Expected value of guarantees = (400 × 40% x 0) + (400 x 50% x 50) + (400 x 10% x 100) = $14,000

2. The Jordanian Computers Company sells computers and gives its customers a warranty for one year. The
company's sales during the year totaled $70000. Based on the company’s experience, it estimated maintenance
costs at 4% of the sales value. During 2019, maintenance expenses incurred for computers sold during 2018
totaled $2500. Required: record all necessary journal entries related to the warranty of computers sold.

3. During 2017, the International Trading Company sold 60 cars at a price of $12000/ car. The company offers free
car maintenance for two years from the date of sale.
 - According to the company estimates, the cost of maintenance for each car during the warranty period is $300 on
average, including repairs and spare parts.

- The actual maintenance costs incurred by the company with respect to the sold cars amounted to $4000, $5000
and $8300 for the years 2017, 2018 and 2019, respectively.

Required: journalize necessary entries relating to the sale and guarantee during the periods 2017-2019 (ignoring
the time-value for money) in accordance with the requirements of IAS 37.

Accounting Treatment for Litigations Provision

• IAS 37 establishes guidance for measuring a provision as the best estimate of the expenditure required to settle the
present obligation at the balance sheet date.
• The best estimate is the probability-weighted expected value when a range of estimates exists or the midpoint within a
range if all estimates are equally likely.
• Provisions must be discounted to present value . Provisions also must be reviewed at the end of each accounting period
and adjusted to reflect the current best estimate.

Example:
1. Former employees of Dreams Unlimited Inc. filed a lawsuit against the company in Year 1 for alleged age discrimination.
At December 31, Year 1, external legal counsel provided an opinion that it was 60 percent probable that the company
would be found liable, which would result in a total payment to the former employees between $1,000,000 and
$1,500,000, with all amounts in that range being equally likely.

Assume that in Year 2, Dreams Unlimited settled with the former employees, making a total payment of $1,100,000. As a
result, the company would prepare the following journal entry:

2. In Year 1, Better Sleep Company began to receive complaints from physicians that patients were experiencing
unexpected side effects from the company’s sleep apnea drug. The company took the drug off the market near the end
 of Year 1. During Year 2, the company was sued by 1,000 customers who had had a severe allergic reaction to the
company’s drug and required hospitalization.
- At the end of Year 2, the company’s attorneys estimated a 60 percent chance the company would need to make
payments in the range of $1,000 to $5,000 to settle each claim, with all amounts in that range being equally likely.
- At the end of Year 3, while none of the cases had been resolved, the company’s attorneys now estimated an 80
percent probability the company would be required to make payments in the range of $2,000 to $7,000 to settle
each claim.
- In Year 4, 400 claims were settled at a total cost of $1.2 million. Based on this experience, the company believes 30
percent of the remaining cases will be settled for $3,000 each, 50 percent will be settled for $5,000, and 20 percent
will be settled for $10,000.
Required: Prepare journal entries for Years 1–4 related to this litigation (ignore time value for money).

Accounting Treatment for Onerous Contracts

• IAS 37 requires the recognition of a provision for the present obligation related to an “onerous contract”, that is a contract
in which the unavoidable costs of meeting the obligation of the contract exceed the economic benefits expected to be
received from it.
• When an onerous contract exists, a provision should be recognized for the unavoidable costs of the contract, which is the
lower of the cost of fulfillment and the penalty that would result from non-fulfillment under the contract.

Example:
1. Delicious Chocolate Company produces chocolate candies. It has a non-cancelable lease on a building in Ridgeway, South
Carolina, that it uses for production. The lease expires on December 31, Year 2, and is classified as an operating lease for
accounting purposes. The annual lease payment is $120,000. In October, Year 1, the company closed its South Carolina
facility and moved production to Mexico. The company does not believe it will be possible to sublease the building
located in South Carolina.

2. On June 1, Year 1, Charley Horse Company entered into a contract with Good Feed Company to purchase 1,000 bales of
organic hay on January 30, Year 2, at a price of $30 per bale. The hay will be grown especially for Charley Horse and is
needed to feed the company’s herd of buffalos. On December 1, Year 1, Charley Horse sells its herd of buffalos. As a
result, the company no longer has a need for the organic hay that will be delivered on January 30, Year 2, and the
company does not believe it will be able to sell the hay to a third party. Charley Horse is able to cancel the contract with
Good Feed for a cancellation fee of $20,000. Required: Determine what accounting entries, if any, Charley Horse
Company should make on December 31, Year 1, related to the contract to purchase 1,000 bales of hay on January 30,
Year 2.

Contingent assets
• 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.
o An example of such an asset may arise if an entity is involved in a legal case and will receive damages if the case is won. If
it is virtually certain that the case will be won, the entity should treat the damages as an asset in the usual way.
Otherwise, the entity should treat the damages as a contingent asset.
• Similarly, as with contingent liabilities, you should not book anything in relation to contingent assets, but you make
appropriate disclosures.