1. IAS 37 Provision and Contigencies
Provisions
A provision is an uncertain future obligation that the business may or may not have to settle.
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2. IAS 37 Provision and Contigencies
Examples of possible provisions
a) Warranties b) Environmental contamination c) Decommissioning or abandonment costs d) Restructuring
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3. IAS 37 Provision and Contigencies
Recognition
You can only recognize the provision if these 3 criteria are met:
P: probable that resources will be transferred to settle the liability(asset/other resources);
O: present obligation whether it’s legal (law) or constructive (published information) from past event;
R: reliable estimate of the amount of payment can be made.
If any of these conditions are not met then the enterprise should show a contingentliability unless the probability of an outflow is remote in which case nothing should be disclosed.
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4. IAS 37 Provision and Contigencies
Provisions
Present obligation
A provision may be necessary as a result of a legal or a constructive obligation.
A legal obligation is an obligation that derives from:
A contract
Legislation
other operation of law
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5. Topic 7 Provisions, contingent liabilities, and contigent assets
IAS 37 Provision and Contigencies
Provisions
A constructive obligation is an obligation that derives from an entity's action where:
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
as a result, the entity has created a valid expectation onthe part of those other parties that it will discharge those responsibilities.
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6. IAS 37 Provision and Contigencies
Probable transfer of resources
For the purpose of the IAS, a transfer of resources
embodying economic benefits is regarded as
'probable' if the event is more likely than not to occur.
This appears to indicate a probability of more than 50%.
However, the standard makes it clear that where there
is a number of similar obligations the probability
should be based on considering the population as a
whole, rather than one single item.
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7. IAS 37 Provision and Contigencies
Example1:
Target Co is preparing its financial statements for the year
ended 30 September 20X7. The company is facing a number
of legal claims from its customers with regards to a faulty
product sold. The total amount being claimed is $3.5 million.
The company's lawyers say that the customers have an 80%
chance of being successful.
What amount, if any, should be recognized in respect of
the above in Target Co’s statement of financial position
as at 30 September 20X7?
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8. IAS 37 Provision and Contigencies
Example1:
Answer $3,500,000
Per IAS 37, the amount payable relates to a past event (the
sale of faulty products) and the likelihood of payout is
probable (i.e. more likely than not). Hence, the full amount of
the payout should be provided for.
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9. IAS 37 Provision and Contigencies
Example
Answer $3,500,000
Per IAS 37, the amount payable relates to a past event (the
sale of faulty products) and the likelihood of payout is
probable (i.e. more likely than not). Hence, the full amount of
the payout should be provided for.
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10. IAS 37 Provision and Contigencies
Measurement of provisions
The amount recognised as a provision should be the best
estimate of the expenditure required to settle the present
obligation at the end of the reporting period.
The estimates will be determined by the judgement of the
entity's management supplemented by the experience of
Similar transactions
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11. IAS 37 Provision and Contigencies
Measurement of provisions
Where the provision being measured involves a large
population of items, the obligation is estimated by weighting
all possible outcomes by their associated probabilities, ie
expected value.
Where the provision involves a single item, such as the
outcome of a legal case, provision is made in full for the
most likely outcome.
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12. IAS 37 Provision and Contigencies
Example2:
Hermione has sold 100,000 machines that are covered by a
warranty agreement as at the reporting date. If a machine
develops a major fault then the average cost to Hermione of
repairing it is $100. If a machine develops a minor fault then
the average cost to Hermione of repairing it is $30. It is
believed that 6% of the machines under warranty will
develop major faults and that 8% will develop minor faults.
The time value of money can be ignored.
What amount should be recognised as a warranty
provision in the year ended 31 December 20X4?
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13. IAS 37 Provision and Contigencies
Example 2:
Answer $840,000
The provision being measured involves a large population of
items, so an expected value must be calculated:
(100,000 x 6% x $l00) + (100,000 x 8% x $30) = $840,000
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14. IAS 37 Provision and Contigencies
Example 3:
Hermione was informed that it was being sued by an
employee in respect of a workplace accident that took place
in October 20X4. Legal advisors advise that Hermione is
certain to lose the case. They have provided the following
information: Estimated pay-out Probability of payment occurring $1 million % $2 million % $3 million %
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15. IAS 37 Provision and Contigencies
Example 3:
What amount should be recognised as a provision in
respect of the workplace accident claim in the year
ended 31 December 20X4?
Nil
$1.8 million
$2 million
$3 million
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16. IAS 37 Provision and Contigencies
Decommissioning or abandonment costs
Time value
Where the effect of the time value of money is material, the
amount of a provision should be the present value of the
expenditure required to settle the obligation. An appropriate
discount rate should be used.
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17. IAS 37 Provision and Contigencies
Example
A company knows that when it ceases a certain operation in
five years time it will have to pay environmental cleanup
costs of $5m.
The provision to be made now will be the present value of
$5m in five years time. The relevant discount rate in this
case is 10%
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18. IAS 37 Provision and Contigencies
Example
Therefore a provision will be made for: $
$5m × * ,104,600
*The discount rate for 5 years at 10%.
The following year the provision will be: $5m × ** ,415, ,540 **The discount rate for four years at 10%
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19. IAS 37 Provision and Contigencies
Example
The original provision of $3,104,600 will be added to the cost
of the assets involved in the operation and depreciated over
five years.
The increase in the second year of $310,450 will be charged
to profit or loss. It is referred to as the unwinding of the
discount. This is accounted for as a finance cost.
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20. IAS 37 Provision and Contigencies
Question1:
On 1 July 20X4, Experimenter opened a chemical
reprocessing plant. The plant was due to be active for five
years until 30 June 20X9, when it would be decommissioned.
At 1 July 20X4, the costs of decommissioning the plant were
estimated to be $4 million in 5 years time. The company
considers that a discount rate of 12% is appropriate for the
calculation of a present value, and the discount factor at 12%
For Year 5 is
What is the total charge to the statement of profit or loss
in respect of the decommissioning for the year ended 30
June 20X5?
A. $453, C. $800,000
B. $725, D. $2,268,000
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21. IAS 37 Provision and Contigencies
Answer B
The cost of the decommissioning is assumed to be an
obligation for the company. An amount should be included in
the cost of the asset when it is first recognised (1 July 20X4).
The amount to include in the cost of the asset for
decommissioning costs is the present value of the expected
future decommissioning costs. The present value is
calculated by multiplying the expected future cost by a
discount factor, which in this case is the discount factor for
Year 5 (20X9) at 12%. $4 million x = $2.268 million.
The asset is depreciated on a straight-line basis over five
years.
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22. IAS 37 Provision and Contigencies
Answer B
In addition, the decommissioning cost should be increased to
$4 million by the end of Year 5. This is done by making a
finance charge each year. This is charged at the cost of
capital (12%) and applied to the balance on the provision
account. The finance charge for the year to 30 June 20X5 is
12% x $2.268 million = $272, $
Depreciation charge ($2,268 million/5 years) ,600
Finance charge ,160
Total charge ,760
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23. IAS 37 Provision and Contigencies
Question2:
On 1 October 20X3, Xplorer commenced drilling for oil from
an undersea oilfield. The extraction of oil causes damage to
the seabed which has a restorative cost (ignore discounting)
of $10,000 per million barrels of oil extracted. Xplorer
extracted 250 million barrels of oil in the year ended 30
September 20X4. Xplorer is also required to dismantle the
drilling equipment at the end of its five-year licence. This has
an estimated cost of $30 million on 30 September 20X8.
Xplorer’s cost of capital is 8% per annum and $1 has a
present value of 68 cents in five years' time.
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24. IAS 37 Provision and Contigencies
Question2:
What is the total provision (extraction plus dismantling)
which Xplorer would report in its statement of financial
position as at 30 September 20X4 in respect of its oil
operations?
$34,900,000
$24,532,000
$22,900,000
D. $4,132,000
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25. IAS 37 Provision and Contigencies
Answer B
Extraction provision at 30 September 20X4 is $2.5 million
(250 x 10).
Dismantling provision at 1 October 20X3 is $20.4 million
(30,000 x 0.68).
This will increase by an 8% finance cost by 30 September
20X4 = $22,032,000.
Total provision is $24,532,000.
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26. IAS 37 Provision and Contigencies
Restructuring
Recognition
The question is whether or not an entity has an obligation
legal or constructive – at the end of the reporting period. For
this to be the case:
An entity must have a detailed formal plan for the
restructuring &
It must have 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.
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27. IAS 37 Provision and Contigencies
Restructuring
Example:
ABC Co has a year end of 31 December 20X4. On 15th
December 20X4 the directors publicly announced their
decision to close an operating unit and make a number of
employees redundant. Some of the employees currently
working in the unit will be transferred to other operating units
within ABC.
The estimated costs of the closure are as follows: $000
Redundancy costs
Lease termination costs
Relocation of continuing employees to new locations
Retraining of continuing employees ,700
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28. IAS 37 Provision and Contigencies
Specific example
Future events
Future events which are reasonably expected to occur (eg
new legislation, changes in technology) may affect the
amount required to settle the entity's obligation and should
be taken into account.
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29. IAS 37 Provision and Contigencies
Future events
The Beth Group operates in the oil industry ancontamination
of land occurs including the pollution of seas and rivers. The
Group only cleans up the contamination if it is a legal
requirement in the country where it operates. The following
information has been produced for Beth by a group of
environmental consultants for the year ended 30 November
20X7:
Cost to clean up contamination Law existing in country $m No
To come into force in December 20X7
Yes
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30. IAS 37 Provision and Contigencies
Example:
Fauberg Co owns a number of offices in country Y and is in
the process of finishing its financial statements for the year
ended 31 December 20X4. In December 20X4, country Y
announced changes to health and safety regulations
meaning that Fauberg's air conditioning units will have to be
replaced by 30 June 20X5. This is estimated to cost Fauberg
$500,000. Fauberg has a history of compliance with
regulations and intends to do the work by June 20X5.
Which of the conditions for a provision will be met at 31
December 20X4?
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31. IAS 37 Provision and Contigencies
Answer:
Yes/No
There is a present obligation from a past event
A reliable estimate can be made
There is a probable outflow of economic benefits
Whilst there is an estimate of $500,000 and it is probable that
Faubourg Co will make the changes, there is no present
obligation at 31 December 20X4. If Faubourg Co changes its
mind and sells the building prior to June 20X5, no obligation
would arise. Future obligations are not accounted for as
provisions.
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32. IAS 37 Provision and Contigencies
Expected disposal of assets
Gains from the expected disposal of assets should not be
taken into account in measuring a provision.
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33. IAS 37 Provision and Contigencies
Reimbursements
Some or all of the expenditure needed to settle a provision
may be expected to be recovered from a third party. If so, the
reimbursement should be recognised only when it is virtually
certain that reimbursement will be received if the entity
settles the obligation.
The reimbursement should be treated as a separate asset,
and the amount recognised should not be greater than the
provision itself. The provision and the amount recognised for
reimbursement may be netted off in profit or loss.
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34. IAS 37 Provision and Contigencies
Future operating losses
Provisions should not be recognised for future operating
losses. They do not meet the definition of a liability and the
general recognition criteria set out in the standard.
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35. IAS 37 Provision and Contigencies
Onerous contracts
An onerous contract is a contract entered into with another
party under which the unavoidable costs of fulfilling the
terms of the contract exceed any revenues expected to be
received from the goods or services supplied or purchased
directly or indirectly under the contract and where the entity
would have to compensate the other party if it did not fulfil
the terms of the contract.
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36. IAS 37 Provision and Contigencies
Contingent liability
IAS 37 defines a contingent liability as:
A possible obligation that arises from past events and whose
existence will be confirmed only by the occurrence or
nonoccurrence of one or more uncertain future events not
whollynwithin the control of the entity; or
A present obligation that arises from past events but is not
recognised because:
– It is not probable that an outflow of resources embodying
economic benefits will be required to settle the obligation; or
– The amount of the obligation cannot be measured with sufficient reliability
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37. IAS 37 Provision and Contigencies
Contingent assets
IAS 37 defines a contingent asset as:
A possible asset that arises from past events and whose
existence will be confirmed by the occurrence or non
occurrence of one or more uncertain future events not wholly
within control of the entity.
A contingent asset must not be recognised. Only when the
Realisation of the related economic benefits is virtually
certain should recognition take place. At that point, the asset
is no longer a contingent asset!
Contingent assets must only be disclosed in the notes if they
are probable. In that case a brief description of the
contingent asset should be provided along with an estimate
of its likely financial effect.
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38. IAS 37 Provision and Contigencies
Example:
AP has the following two legal claims outstanding:
A legal action claiming compensation of $500,000 filed
against AP in March 20X4.
A legal action taken by AP against a third party, claiming
damages of $200,000 was started in January 20X3 and is
nearing completion.
In both cases, it is more likely than not that the amount
claimed will have to be paid.
How should AP report these legal actions in its financial
Statements for the year ended 31 March 20X5?
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39. IAS 37 Provision and Contigencies
Answer:
Legal action against AP
Legal action by AP
Provision
Contingent Asset
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40. Topic 7 Provisions, contingent liabilities, and contigent assets
IAS 37 Provision and Contigencies
To sum up
Liability (outflow)
Asset (inflow)
Probable(>50%)
Provide (provision)
Disclose
Possible(20%-50%)
Ignore
Remote(<20%)
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41. Topic 7 Provisions and Events after the reporting period
Exercise
18 Which TWO of the following events which occur after the reporting date of a company but before the financial statements are authorized for issue are classified as ADJUSTING events in accordance with IAS 10 Events after the Reporting Period?
i) A change in tax rate announced after the reporting the current tax liability
ii) The discovery of a fraud which has occurred during the year
iii) The determination of the sale proceeds of an item of plant sold before the year end
iv) The destruction of a factor by fire
A i and ii C ii and iii
B i and iii D iii and iv
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