Accounting for Provisions and

Contingencies
(IAS 37)
 Definition and effect of provisions

Provision:
A liability that is of uncertain timing or
amount .

Contrast with other liabilities!

 Significance of provisions

 Accounting treatment:
Recognition of a provision
Debit income statement
Credit liabilities

Derecognition reverses these entries

 Misuse of provisions

 Big bath provisions

 Profit smoothing
 Principles of recognition

1. Present obligation (legal or constructive) as a

result of past obligating event

2. Probable transfer of economic benefits to

settle the obligation

3. A reliable estimate can be made of the amount

 Definitions

1) Present obligation (legal or constructive)

Constructive obligation arises from past actions through

 An established pattern of practice, policies or statements

confirming the acceptance of responsibilities
and
 As a result an expectation is created to outside parties

that they can rely on the organisation to discharge their

responsibilities
 Definitions
2) Past Event:

An obligating event is created i.e. no

realistic alternative to settling the obligation

The event may be initiated internally or

externally to the organisation
 Definitions

3) Probable transfer of economic benefits

will occur as a result of the obligating event

Probable is more likely than not (more than 50%

Chance of occurrence)

If it is only possible (less than 50%) disclose by

way of note (contingent liability)

If remote possibility then ignore

 Dividends

 How do proposed dividends fit with the provision

definition?

 Test against – probable transfer of economic benefits

 Past event
 Present obligation
 Class and single obligations

1. For large population of items, probability times cost

can be used e.g. 1,000 items sold, probable that 40%
will need repairs at a cost of £1,000 each.

2. For single item, 40% probability of a claim for £50,000

no provision will be made because it is less than 50%.
Future operating losses should not be recognised, because
there is
 No past obligating event

 The company has a realistic alternative to settling the

obligation (company could dispose of business)

Unless the company has an onerous contract defined as:

‘A contract in which the unavoidable costs of meeting the

obligations under it exceed the economic benefits
expected to be received under it’
 Onerous contracts
Examples:
1. Long term contracts where as loss is foreseen (costs of
meeting obligations are more than economic benefits
expected to be received)

2. Rentals in respect of unused or under-utilised assets

Amount recognised:
The present value of the obligation
 Restructuring
Recognition;

Where a legal or constructive obligation exists

Constructive obligation is the creation of valid

expectations

A formal plan including timescale must be drawn

up

Management intentions alone are not enough to

create a provision
 The following expenditures are excluded from
provisions for restructuring:
1. Costs of staff retraining or relocating existing
staff
2. Marketing
3. Investment in new systems and distribution
networks
 Disclosure
 Changes in provisions in the course of the year
(including changes through discounts i.e.
timing or rates)

 For each class of provision:

1. Description of nature of obligation and timing
of outflows
2. Indication of uncertainties of timing and
amount and any major assumptions
3. Any expected re-imbursements
 Liabilities related to long-life assets
Oilfield example:

Initial capitalised cost of £100m

Useful life of 10 years
Re-instatement costs of £10m
Company has a cost of capital of 8%

Therefore the cost to the company includes the £100m

spent already and the £10m to be spent in 10 years, the
present value of which is £4.63m
(£10 X .463)
The cost of the oilfield in the balance sheet becomes
£104.63 and is depreciated over 10 years.

(debit asset credit provision with p.v. of future cost)

The provision increases every year (up to £10m)

As this increases there is a charge to the profit and
loss account equivalent to the change in the provision
i.e. the annual charge becomes:
PVt – PVt-1

This is known as unwinding the discount

Where part of abandonment costs relate to production:

Costs incurred at end of life consist of two types

1. Removal of plant
2. Restoration of site damage which has occurred
progressively over time

Obligation 1 occurs at the beginning of the project

Obligation 2 occurs as work progresses

The second provision should be charged to the profit and

loss account annually as work is carried out
 Contingent liabilities and assets

Where a provision is not made because of failing

to satisfy one criteria of a provision;
 Obligating event

 Probable transfer

 Reliable estimate

This should be disclosed, as a contingent liability can

become a provision or a liability
Contingent liabilities are not recognised, but are disclosed
by way of a note where one or more of the three
recognition criteria for a provision is not met.

1. Possible obligation from past event

2. Outflow is not probable

3. Unable to measure
 Contingent assets
A possible asset that arises from past events and whose
existence will be confirmed only by the occurrence of one
or more uncertain future events not wholly within the
entity’s control

However in exceptional cases where virtually certain, then

recognition is appropriate

Disclosure should be made if inflow is probable

 External events causing provisions and
contingencies

 Actions by the entity

 Actions by other entities
 New legislation especially:
1. Environmental
2. Social
 Possible loopholes in creation of provisions

1. Although future losses may not be recognised,

impairment of assets may take place instead

2. Onerous contracts rely on estimates and on the future

intent of management

3. On acquisition of another entity, a condition of

acquisition could be the commitment for re-
organisation leading to an overstatement of goodwill.