7.ias 37 provision

IAS 37
Provisions, Contingent
Liabilities and Contingent
Assets
Tuesday, December 14,
2021 AAUSC IFRS Project Office 1

Objective
2
 This Standard prescribes rules regarding
◦ the recognition and measurement of
 provisions,
 contingent liabilities, and
 contingent assets and
◦ also mandates
 disclosures in footnotes
 that would enable users of financial
statements to understand their nature, timing,
and amount.
AAUSC IFRS Project Office
2021
IAS
37

Definitions of Key Terms
3
 Liability: is a present obligation of an entity
arising from past events, the settlement of which
is expected to result in an outflow of resources
embodying economic benefits.
 Provision: is a liability of uncertain timing or
amount.
 Contingent Liability.
a) A possible obligation arising from past events
whose existence will be confirmed only by the
occurrence or nonoccurrence of one or more
uncertain future events that are not completely within
the control of the entity; or
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37

Definitions (Cont’d…)
4
b)A present obligation that arises from past
events but is not recognized because either
• it is not possible to measure the amount
of the obligation with sufficient reliability or
• it is not probable that an outflow of
resources will be required to settle the
obligation.
 Contingent Asset: is possible asset arising
from past events and whose existence will be
confirmed only by the occurrence or
nonoccurrence of one or more uncertain future
events that are not completely within the control
of the entity. AAUSC IFRS Project Office
2021
IAS
37

5
 An Obligating Event is
◦ an event
 that creates a legal or constructive
obligation
 that results in an entity having no realistic
alternative but to settle that obligation.
2021
Definitions (Cont’d…)
IAS
37

Recognition - Provisions
6
 Provisions should be recognized when, and
only when, all of these conditions are met:
a) An entity has a present legal or constructive obligation
resulting from a past event;
b) It is probable that an outflow of resources embodying
economic benefits would be required to settle the
obligation; and
c) A reliable estimate can be made of the amount of the
obligation.
 Creditors (Trade Payables) and Accrued
Expenses are not considered “provisions” by this
Standard
◦ because they do not entail either uncertain timing or
amount.
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7
 An obligation could either be
a) a legal obligation or
b) a constructive obligation.
 A legal obligation is an obligation that
could
a) Be contractual; or
b) Arise due to a legislation; or
c) Result from other operation of law.
Provisions (Cont’d…)
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37

8
 A Constructive Obligation, however, is an
obligation that results from an entity’s actions
where
a) By an established pattern of past practice,
published policies, or a sufficiently specific
current statement, the entity has indicated to
other (third) parties that it will accept certain
responsibilities; and
b) As a result, the entity has created a valid
expectation in the minds of those parties that it
will discharge those responsibilities.
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9
 It should be
◦ “probable that the outflow of resources
embodying economic benefits would
occur.”
 The term “probable” is interpreted, for
the purposes of this Standard, as
◦ “more likely than not”
◦ (i.e., the chances of occurrence are
more than 50%).
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37

Case Study 1_10 Minutes
10
Facts
 Excellent Inc. is an oil entity that is exploring oil off the shores of Excessoil
Islands. It has employed oil exploration experts from around the globe.
Despite all efforts, there is a major oil spill that has grabbed the attention of
the media. Environmentalists are protesting and the entity has engaged
lawyers to advise it about legal repercussions. In the past, other oil entities
have had to settle with the environmentalists, paying huge amounts in out-of-
court settlements. The legal counsel of Excellent Inc. has advised it that there
is no law that would require it to pay anything for the oil spill; the parliament of
Excessoil Islands is currently considering such legislation, but that legislation
would probably take another year to be finalized as of the date of the oil spill.
However, in its television advertisements and promotional brochures,
Excellent Inc. often has clearly stated that it is very conscious of its
responsibilities toward the environment and will make good any losses that
may result from its exploration. This policy has been widely publicized, and
the chief executive officer has acknowledged this policy in official meetings
when members of the public raised questions to him on this issue.
Required
 Does the above give rise to an obligating event that requires Excellent Inc. to
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Solution
11
a) Present obligation as a result of a past obligating
event. The obligating event is the oil spill. Because
there is no legislation in place yet that would make
cleanup mandatory for any entity operating in
Excessoil Islands, there is no legal obligation.
However, the circumstances surrounding the issue
clearly indicate that there is a constructive obligation
since the company, with its advertised policy and
public statements, has created an expectation in the
minds of the public at large that it will honor its
environmental obligations.
b) An outflow of resources embodying economic benefits
in settlement. Probable.
c) Conclusion. A provision should be recognized for the
best estimate of the cost to clean up the oil spill.
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Measurement-Provisions
12
 The amount to be recognized as a provision is
◦ the best estimate of the expenditure
◦ required to settle the present obligation at the balance sheet date.
 “Best Estimate”
◦ is a matter of judgment and is usually based on
 past experience with similar transactions,
 evidence provided by technical or legal experts, or
 additional evidence provided by events after the balance sheet
date.
 Risks and uncertainties surrounding events and circumstances
should be considered in arriving at the best estimate of a provision.
◦ If a group of items is being measured, it is the “expected value.”
◦ If a single obligation is being measured, it is the “most likely
outcome.”
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• Entity A has manufactured and delivered a custom-designed ship and has a
warranty obligation to repair any faults in the next 12 months
• management estimates the following two possible outcomes, their
associated probability and cost:
o no faults: 20% probability, zero cost
o normal faults: 80% probability, cost CU10,000.
Provisions – measurement of a
single obligation
Example 1

• Entity B has manufactured and delivered a custom-designed ship and has a
warranty obligation to repair any faults in the next 12 months
• management estimates the following three possible outcomes, their
associated probability and cost:
o no faults: 25% probability, zero cost
o normal faults: 40% probability, cost CU10,000
o major faults: 35% probability, cost CU100,000.
Provisions – measurement of
a single obligation
Example 2

15
Facts
 A car dealership also owns a workshop that it uses for servicing cars
under warranty. In preparing its financial statements, the car
dealership needs to ascertain the provision of warranty that it would
be required to provide at year-end. The entity’s past experience with
warranty claims is
• 60% of cars sold in a year have zero defects.
• 25% of cars sold in a year have normal defects.
• 15% of cars sold in a year have significant defects.
 The cost of rectifying a “normal defect” in a car is Birr 10,000. The
cost of rectifying a “significant defect” in a car is Birr 30,000.
Required
Compute the amount of “provision for warranty” needed at year-end.
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Solution
16
 The expected value of the provision for
warranty needed at year-end is:
(60% × Birr 0) + (25% × Birr 10,000) + (15% × Birr 30,000) = Birr
7,000.
Note
 Where the effect of time value is
material, the amount of provision is to
be discounted to its present value using
a pretax discount rate that reflects
current market assessments of time
value of money and the risks specific to
the liability.
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Common Types:
Common Types of Provisions
1. Lawsuits
2. Warranties
3. Environmental
4. Onerous contracts
5. Restructuring
IFRS requires extensive disclosure related to provisions in the notes to
the financial statements, however companies do not record or report in
the notes general risk contingencies inherent in business operations
(e.g., the possibility of war, strike, uninsurable catastrophes, or a
business recession).

Litigation Provisions
Companies must consider the following in
determining whether to record a liability with
respect to pending or threatened litigation.
1. Probability of an unfavorable outcome.
2. Ability to make a reasonable estimate of the amount of
loss.
Accountants must generally rely on attorneys’ assessments
concerning the likelihood of such events

Example: Scorcese Inc. is involved in a lawsuit at December 31,
2010. (a) Prepare the December 31 entry assuming it is probable that
Scorcese will be liable for $900,000 as a result of this suit. (b) Prepare
the December 31 entry, if any, assuming it is not probable that
Scorcese will be liable for any payment as a result of this suit.
(a) Lawsuit loss 900,000
Provision for Lawsuit 900,000
(b) No entry is necessary. The loss is not accrued because it
is not probable that a liability has been incurred at
12/31/10. Only disclosure of the fact , no recognition

BE13-13: Streep Factory provides a 2-year warranty with one of its
products which was first sold in 2010. In that year, Streep spent
$70,000 servicing warranty claims. At year-end, Streep estimates that
an additional $400,000 will be spent in the future to service warranty
claims related to 2010 sales. Prepare Streep’s journal entry to record
the $70,000 expenditure, and the December 31 adjusting entry.
2010 Warranty expense 70,000
Cash 70,000
12/31/10 Warranty expense 400,000
Provision for warranty claim 400,000
Warranty Provisions

“The unavoidable costs of meeting the obligations exceed
the economic benefits expected to be received.”
The expected costs should reflect the least net cost of
exiting from the contract, which is the lower of
1. the cost of fulfilling the contract, or
2. the compensation or penalties arising from failure to
fulfill the contract.
Onerous Contract Provisions

Illustration: Sumart Sports operates profitably in a factory that it
has leased and on which it pays monthly rentals. Sumart decides to
relocate its operations to another facility. However, the lease on the
old facility continues for the next three years. Unfortunately, Sumart
cannot cancel the lease nor will it be able to sublet the factory to
another party. The expected costs to satisfy this onerous contract
are €200,000. In this case, Sumart makes the following entry.
Loss on lease contract 200,000
Lease contract liability 200,000

Assume the same facts as above for the Sumart example and the
expected costs to fulfill the contract are €200,000. However,
Sumart can cancel the lease by paying a penalty of €175,000. In
this case, Sumart should record the liability as follows.
Loss on lease contract 175,000
Lease contract liability 175,000

24
Facts
 XYZ Inc. is getting ready to move its factory from its
existing location to a new industrial free zone specially
created by the government for manufacturers. To avail
itself of the preferential licensing offered by the local
governmental authorities as a reward for moving into
the free trade zone and the savings in costs that would
ensue (since there are no duties or taxes in the free
trade zone), XYZ Inc. has to move into the new location
before the end of the year. The lease on its present
location is non cancelable and is for another two years
from year-end. The obligation under the lease is the
annual rent of Birr 100,000.
Required
 Advise XYZ Inc. what amount, if any, it needs to provide
at year-end toward this lease obligation.
2021
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Solution
25
 The lease agreement is an executory onerous
contract because after moving to the new
location, XYZ Inc. would derive no economic
benefits from the existing factory building but
would still need to pay rent under the agreement
since the lease is non-cancelable. Thus the
unavoidable costs exceed the benefits
expected under the lease contract.
 Based on the annual lease obligation under the
lease agreement, the total amount needed to be
provided at year-end is the present value of the
total commitment under the lease = PV of [Birr
100,000 × 2 (years)]. AAUSC IFRS Project Office
2021
IAS
37

Provisions for Restructuring
Restructuring is a program that is planned
and is controlled by management and
materially changes one of two things
1. The scope of a business undertaken by an
entity.
2. The manner in which that business is
conducted.

Examples of restructuring events:
1. The sale or termination of a line of business.
2. The closure of business locations in a
country or region or the relocation of
business activities from one country region to
another.
3. Changes in management structure, for
example, the elimination of a layer of
management.
4. Fundamental reorganizations that have a
material effect on the nature and focus of
the entity's operations 27
IAS
37
2021 AAUSC IFRS Project Office

 A restructuring provision should include
only the direct expenditures arising from
the restructuring, which are those that are
both:
1. Necessarily entailed by the restructuring;
and
2. Not associated with the ongoing
activities of the entity.
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IAS
37

Disclosures Related To Provisions
A company must provide a reconciliation of its beginning
to ending balance for each major class of provisions,
identifying what caused the change during the period.
In addition,
► Provision must be described and the expected timing
of any outflows disclosed.
► Disclosure about uncertainties related to expected
outflows as well as expected reimbursements
should be provided.

Contingent liability
An entity should not recognise a contingent liability
Disclosure only (unless possibility of outflow is remote)
A contingent liability is:
1. a
obligation that
arises from past
events
2. its existence will be
confirmed only by the
occurrence/non-occurre
nce of uncertain future
events not wholly
within the control of
the entity
1. a
obligation that
arises from past
events
2. is not recognised
because it is not
probable that an
outflow of economic
benefits will be
required
1. a
obligation that
arises from past
events
2. is not recognised
because the
amount of the
obligation cannot
be reliably
measured
OR OR

IAS 37 : Contingent Liabilities
31
 They should not be recognized in F/S but they
should be disclosed unless they are remote.
 Once recognized as a contingent liability, an
entity should continually assess the probability
of the outflow of the future economic benefits
relating to that contingent liability.
 If the probability of the outflow of the future
economic benefits changes to more likely
than not, then the contingent liability may
develop into an actual liability and would need to
be recognized as a provision.
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Disclosures
32
 The required disclosures are:
1. A brief description of the nature of the
contingent liability.
2. An estimate of its financial effect.
3. An indication of the uncertainties that exist.
4. The possibility of any reimbursement.
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Provisions and contingent liabilities
Decision tree
Present obligation
as a result of
an obligating event
Possible
obligation
Probable
outflow
Remote
Reliable estimate
Yes
Yes
Yes
Yes
Yes
No
No
No
No (rare)
No
PROVIDE DISCLOSE
Contingent
Liability
DO NOTHING

Contingent Assets
1. Possible asset that arises from past events and
2. whose existence will be confirmed only by the
occurrence or non-occurrence of uncertain future
events not wholly within the entity’s control
virtually
certain?
Recognis
e under
applicabl
e IFRS
Disclose
only
probable but not
virtually certain?
Not probable?
Do
nothing
Contingent asset Actual asset
How likely is realisation of income?

IAS 37 : Example of Contingent Asset & Liability
 A legal dispute which the outcome is not yet
known, a number of possibilities arise:
1. It expects to have to pay about $100,000. A provision
is recognized.
2. Possible damages are $100,000 but it is not
expected to have to pay them. A contingent liability
is disclosed.
3. The company expects to have to pay damages but is
unable to estimate the amount. A contingent liability
is disclosed.
4. The company expects to receive damages of
$100,000 and this is virtually certain. An asset is
recognized.
5. The company expects to probably receive damages of
$100,000. A contingent asset is disclosed.
6. The company thinks it may receive damages, but it is
not probable. No disclosure.
35

Case Study _10 Minutes
36
Facts
 A Singapore-based shipping company lost an
entire shipload of cargo valued at Birr 5 million on a
voyage to Australia. It is, however, covered by an
insurance policy. According to the report of the
surveyor the amount is collectible, subject to the
deductible clause (i.e., 10% of the claim) in the
insurance policy. Before year-end, the shipping
company received a letter from the insurance
company that a check was in the mail for 90% of
the claim.
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37
 The international freight forwarding company that
entrusted the shipping company with the delivery of the cargo
overseas has filed a lawsuit for Birr 5 million, claiming the
value of the cargo that was lost on high seas, and also
consequential damages of Birr 2 million resulting from the
delay. According to the legal counsel of the shipping
company, it is probable that the shipping company would have
to pay the Birr 5 million, but it is a remote possibility that it
would have to pay the additional Birr 2 million claimed by the
international freight forwarding company, since this loss was
specifically excluded in the freight forwarding contract.
Required
◦ What provision or disclosure would the shipping
company need to make at year-end?
Case Study 5 Cont’d…
2021
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37

Solution
38
 The shipping company would need to recognize
an asset of Birr 4.5 million (the amount that is
virtually certain of collection).
 Also it would need to make a provision for Birr 5
million toward the claim of the international freight
forwarding company.
 Because the probability of the claim of Birr 2
million is remote, no provision or disclosure
would be needed for that.
2021
IAS
37

7.ias 37 provision

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