Advanced Financial Accounting

AQ054-3-2

IAS 37 Provisions, Contingent

Liabilities and Contingent
Assets
 Learning outcomes

After you have studied this chapter, you should be

able to:
• define provisions, contingent liabilities and
contingent assets.
• recognise and measure provisions.
• disclose contingent liabilities and contingent
assets.

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 Why is an accounting on
provision necessary ?
Before IAS 37, there was no accounting standard
dealing with provisions. Companies wanting to
show their results in the most favourable light
used to make large 'one off' provisions in years
where a high level of underlying profits was
generated. These provisions were then available
to shield expenditure in future years when
perhaps the underlying profits were not as good.
In other words, provisions were used for profit
smoothing. Profit smoothing is misleading.

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 Definitions

A provision is a liability of uncertain timing or amount.

A liability is a present obligation of the entity arising

from past events, the settlement of which is expected
to result in an outflow from the entity of resources
embodying economic benefits.

Provisions are quite different from other liabilities such

as accruals and payables. In the case of provisions,
there is uncertainty as to the timing or amount of the
future expenditure.
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 Recognition (general recognition
criteria)

A provision shall be recognised when:

• an entity has a present obligation (legal or
constructive) as a result of a past event;
• it is probable that an outflow of resources
embodying economic benefits will be required to
settle the obligation; and
• a reliable estimate can be made of the amount of
the obligation.

If these conditions are not met, no provision shall be

recognised.
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 Meaning of obligation
a) Legal obligation. A legal obligation is an obligation that
derives from a contract, legislation, or other operation
of law.
b) Constructive obligation. A constructive obligation is an
obligation that derives from an entity’s actions where:
i. by an established pattern of past practice,
published policies or a sufficiently specific
current statement, the entity has indicated to other
parties that it will accept certain responsibilities; and
ii. as a result, the entity has created a valid
expectation on the part of those other parties that it
will discharge those responsibilities.

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 Past events
A past event that leads to a present obligation is called an
obligating event. For an event to be an obligating event, it
is necessary that the entity has no realistic alternative to
settling the obligation created by the event.

A provision must arise out of a past event so the event must

already have happened at the statement of financial
position date. If the event has not yet occurred then, there
is no provision as the entity may be able to avoid it.

For example, if the entity has polluted the environment

(the obligating event), it has to pay penalties
(obligation).
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 Probable outflow of resources

For a liability to qualify for recognition, there must

be not only a present obligation but also probable
outflow of resources to settle that obligation.

For the purpose of IAS 37, outflow of resources

or other event is regarded as probable if the event
is more likely than not to occur, ie the probability
that the event will occur is greater than the
probability that it will not. This appears to indicate
probability of more than 50%.
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 Reliable estimate

• The amount recognised as a provision

should be the best estimate of expenditure
required to settle the present obligation of
similar transactions. If no reliable estimate
can be made, then the liability is not
accrued but disclosed as a contingent
liability.

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 Contingencies
Contingencies are classified into:

a) Contingent liability; and

b) Contingent asset

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 Contingent liability
A contingent liability is:
a) a possible obligation that arises from past events and whose
existence will be confirmed only by the occurrence or non-
occurrence of one or more uncertain future events not wholly
within the control of the entity; or
b) a present obligation that arises from past events but is not
recognised because:
i. it is not probable that an outflow of resources
embodying economic benefits will be required to settle
the obligation; or (probability of the outflow of
economic benefits is less than 50+%)
ii. the amount of the obligation cannot be measured with
sufficient reliability.

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 Contingent liability

Recognition/Accounting treatment
• An entity shall not recognise a contingent liability
but it should be disclosed in the financial
statements, unless the possibility of an outflow
of resources embodying economic benefits is
remote.
• The entity has to determine if an obligation is
probable or possible. This involves judgement.

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 Comparison: Provision versus
Contingent Liabilities
Provision
• Provisions are liabilities of uncertain timing or
amount that should be recognised where there
is a present obligation (as a result of past
events), it is probable (assumed to be more than
a 50% chance) that there will be an outflow of
economic benefits (to settle the obligation) and
the amounts can be estimated reliably.
• The obligation may be legal or constructive.

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 Comparison: Provision versus
Contingent Liabilities
Contingent liabilities
• A contingent liability has more uncertainty in that it is a
possible obligation (assumed to be less than a 50% chance)
whose existence will be confirmed only by one or more future
uncertain events that are not wholly within the control of the
entity.
• A present obligation where it is not probable that an outflow of
resources embodying economic benefits will be required to
settle the obligation or the amount cannot be reliably
measured is also treated as a contingent liability.
• An entity shall not recognise a contingent liability but it should
be disclosed in the financial statements, unless the possibility
of an outflow of resources embodying economic benefits is
remote.
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 Contingent asset

• A contingent asset is a possible asset that

arises from past events and whose
existence will be confirmed only by the
occurrence or non-occurrence of one or
more uncertain future events not wholly
within the control of the entity.

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 Contingent asset
Recognition/Accounting treatment
• An entity shall not recognise a contingent
asset. A contingent asset is disclosed
where an inflow of economic benefits is
probable.
• Contingent assets are not recognised in
financial statements since this may result
in the recognition of income that may
never be realised.
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 Contingent asset
Recognition/Accounting treatment
• However, when the realisation of income is
virtually certain, then the related asset is
not a contingent asset and its recognition
is appropriate.
• In practice, virtual certainty is interpreted
as being at least 95% likely to occur.

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 Summary

Likelihood of Accounting Accounting

outcome treatment: treatment:
Contingent liability Contingent asset
Virtually certain Not a contingent Not a contingent asset
liability but a liability is but an asset
recognised
Probable Not a contingent Disclose
liability but a provision
is recognised
Possible but not Disclose No disclosure
probable permitted
Remote No disclosure No disclosure
permitted permitted

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 Measurement of a provision

In determining the amount of provisions to

be recognised, the following matters need to
be considered:
a) Best estimate
b) Risks and uncertainties
c) Present value
d) Future events
e) Expected disposal of assets
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 Changes in provisions

• Provisions should be reviewed at each

SOFP date.
• Any changes in the provision will be
adjusted in profit or loss.

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 References

• The Board, 2017. IAS 37 Provisions,

Contingent Liabilities and Contingent
Assets. London: IFRS Foundation.

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