IAS37 Provisions, contingent

liabilities and contingent assets

Basic concept
A provision is a liability of uncertain timing or
amount.

Dr Expense
Cr Provision
 Examples of possible provisions

a) Warranties
b) Environmental contamination
c) Decommissioning or abandonment costs
d) Restructuring
Recognition
 Recognition
IAS 37 states that a provision should be recognised as a
liability in the financial statements 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
A reliable estimate can be made of the amount of the
obligation
 Meaning of obligation
It is fairly clear what a legal obligation is. However, you may
not know what a constructive obligation is.
IAS 37 defines a constructive obligation as
'An obligation that derives from an entity's actions 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 on
the part of those other parties that it will discharge those
responsibilities.'
 Ex1
There is no legal obligation for Promoil to remove the oil platform, but
has a published environmental policy which it has a hisotry of
honouring.
Which of the following is correct regarding Promoil’s proposed
accounting treatment?
A. No provision should be recorded as there is no legal obligation
B. Promoil should recognise a provision as there is a constructive
obligation
C. No provision should be made but a contingent liability should be
recorded
D. If Promoil make a provision, the present value of the costs will be
expensed in the statement of profit or loss for the year to 30
September 20X8
 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%.
 Ex2
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.
Per IAS 37 Provisions, Contingent Liabilities and Contingent
Assets, what amount, if any, should be recognised in respect of
the above in Target Co’s statement of financial position as at 30
September 20X7?
$ .
 Ex2
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.
 Probable transfer of resources
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.
 Example: warranty
If a company has entered into a warranty obligation then the
probability of transfer of resources embodying economic
benefits may well be extremely small in respect of one specific
item.
However, when considering the population as a whole the
probability of some transfer of resources is quite likely to be
much higher. If there is a greater than 50% probability of
some transfer of economic benefits then a provision should be
made for the expected amount.
Measurement of provisions
 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.
 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.
 Ex3
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.
 Ex3
What amount should be recognised as a warranty provision in
the year ended 31 December 20X4?
$ 000
 Ex3
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
 Ex4
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 30%
$2 million 60%
$3 million 10%
 Ex4
What amount should be recognised as a provision in respect of the
workplace accident claim in the year ended 31 December 20X4?
A. Nil
B. $1.8 million
C. $2 million
D. $3 million
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.
 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%
 Example

Therefore a provision will be made for:

$
$5m × 0.62092* 3,104,600
*The discount rate for 5 years at 10%.

The following year the provision will be:

$5m × 0.68301** 3,415,050
310,540

**The discount rate for four years at 10%

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.
 Ex5
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 0.567.
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. $453,600
B. $725,760
C. $800,000
D. $2,268,000
 Ex5
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 0.567 = $2.268 million.
Therefore:
Debit: Cost of asset $2.268 million
Credit: Provision for decommissioning costs $2.268 million
The asset is depreciated on a straight-line basis over five years.
 Ex5
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 = $272,160.
Debit: Finance charge (expense) $272,160
Credit: Provision for decommissioning costs $272,160
$
Depreciation charge ($2,268 million/5 years) 453,600
Finance charge 272,160
Total charge 725,760
If you selected A, you have included the depreciation without the finance cost. If you
selected C, you have just spread the present value of the dismantling over 5 years. If
you selected D, you have expensed the whole asset value.
 Ex5
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.
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?
A. $34,900,000
B. $24,532,000
C. $22,900,000
D. $4,132,000
 Ex5
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.
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
 Ex6
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 800
Lease termination costs 200
Relocation of continuing employees to new locations 400
Retraining of continuing employees 300
1,700
Ex6
What is the closure provision that should be recognised?
A. $800,000
B. $1,000,000
C. $1,400,000
D. $1,700,000
Specific example 1
 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.
 Question
The Beth Group operates in the oil industry and contamination 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
5 No
7 To come into force in December 20X7
4 Yes
 Ex7
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?
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
 Ex7
Answer
Yes/No
There is a present obligation from a past event No
A reliable estimate can be made Yes
There is a probable outflow of economic benefits Yes

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.
 Expected disposal of assets

Gains from the expected disposal of assets

should not be taken into account in measuring
a provision.
 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.
 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.
 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.
Contingent liabilities and
contingent assets
 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 non-
occurrence of one or more uncertain future events not wholly
within 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.
 Treatment of contingent liabilities

Contingent liabilities should not be recognised in financial

statements but they should be disclosed. The required
disclosures are:
 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.
 Ex8
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?
 Ex8
Drag the items into the appropriate category

Legal action against AP Legal action by AP

Options:
Contingent Liability
Contingent Asset
Provision
Asset
 Ex8
Answer

Legal action against AP Legal action by AP

Provision Contingent Asset

The legal action against AP has a probable outflow, so AP should

make a provision. The legal action taken by AP is a contingent
asset. As it is probable, it should be disclosed in a note. Assets
should only be recognised when there is a virtually certain inflow.
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OT1
 B166
Candel is being sued by a customer for $2 million for breach of contract
over a cancelled order. Candel has obtained legal opinion that there is a
20% chance that Candel will lose the case. Accordingly Candel has
provided $400,000 ($2 million × 20%) in respect of the claim. The
unrecoverable legal costs of defending the action are estimated at
$100,000. These have not been provided for as the case will not go to
court until next year.
What is the amount of the provision that should be made by Candel
in accordance with IAS 37 Provisions, contingent liabilities and
contingent assets ?
A. $2,000,000
B. $2,100,000
C. $500,000
D. $100,000 (2 marks)
 B166
Answer D
Loss of the case is not 'probable', so no provision is made, but the legal
costs will have to be paid so should be provided for.
 B167
During the year Peterlee acquired an iron ore mine at a cost of $6 million. In
addition, when all the ore has been extracted (estimated ten years' time) the
company will face estimated costs for landscaping the area affected by the
mining that have a present value of $2 million. These costs would still have
to be incurred even if no further ore was extracted.
How should this $2 million future cost be recognised in the financial
statements?
A. Provision $2 million and $2 million capitalised as part of cost of mine
B. Provision $2 million and $2 million charged to operating costs
C. Accrual $200,000 per annum for next ten years
D. Should not be recognised as no cost has yet arisen (2 marks)
 B167
Answer A
$2 million should be provided for and capitalised as part of the cost of the
mine. It will then be depreciated over the useful life.
 B168
Which one of the following would not be valid grounds for a provision?
A. A company has a policy has a policy of cleaning up any environmental
contamination caused by its operations, but is not legally obliged to do
so.
B. A company is leasing an office building for which it has no further use.
However, it is tied into the lease for another year.
C. A company is closing down a division. The Board has prepared detailed
closure plans which have been communicated to customers and
employees.
D. A company has acquired a machine which requires a major overhaul
every three years. The cost of the first overhaul is reliably estimated at
$120,000. (2 marks)
 B168
Answer D
The cost of the overhaul will be capitalised when it takes place. No
obligation exists before the overhaul is carried out. The other options would
all give rise to valid provisions.
 B170
Which of the following statements are correct in accordance with IAS 37
Provisions, contingent liabilities and contingent assets?
(i) Provisions should be made for both constructive and legal obligations.
(ii) Discounting may be used when estimating the amount of a provision.
(iii) A restructuring provision must include the estimated costs of retraining
or relocating continuing staff.
(iv) A restructuring provision may only be made when a company has a
detailed plan for the restructuring and has communicated to interested
parties a firm intention to carry it out.
A. All four statements are correct
B. (i), (ii) and (iv) only
C. (i), (iii) and (iv) only
D. (ii) and (iii) only (2 marks)
 B170
Answer B
A restructuring provision must not include the costs of retraining or
relocating staff.
 B171
Tynan's year end is 30 September 20X4 and the following potential liabilities have
been identified:
Which TWO of the above should Tynan recognise as liabilities as at 30
September 20X4?
The signing of a non-cancellable contract in September 20X4 to supply goods in the
following year on which, due to a pricing error, a loss will be made
The cost of a reorganisation which was approved by the board in August 20X4 but
has not yet been implemented, communicated to interested parties or announced
publicly
An amount of deferred tax relating to the gain on the revaluation of a property
during the current year. Tynan has no intention of selling the property in the
foreseeable future.
The balance on the warranty provision which related to products for which there are
no outstanding claims and whose warranties had expired by 30 September 20X4
(2 marks)
 B171
Answer
The correct answers are:
The signing of a non-cancellable contract in September 20X4 to supply goods in the
following year on which, due to a pricing error, a loss will be made.
An amount of deferred tax relating to the gain on revaluation of a property during the
current year.
Tynan has no intention of selling the property in the foreseeable future.
The reorganisation does not meet the criteria for a provision and a provision is no
longer needed for the warranties.
 B172
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 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.
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?
$ (2 marks)
 B172
Answer $24,532,000
$'000
Restoration of seabed (10,000 × 250) 2,500
Dismantling of equipment (30m × 0.68) 20,400
Unwinding of discount (20,400 × 8%) 1,632
24,532
 B173
Hopewell sells a line of goods under a six-month warranty. Any defect
arising during that period is repaired free of charge. Hopewell has calculated
that if all the goods sold in the last six months of the year required repairs
the cost would be $2 million. If all of these goods had more serious faults
and had to be replaced the cost would be $6 million.
The normal pattern is that 80% of goods sold will be fault-free, 15% will
require repairs and 5% will have to be replaced.
What is the amount of the provision required?
$ (2 marks)
 B173
Answer $0.6 million
$m
$2 million × 15% 0.3
$6 million × 5% 0.3
0.6
OT2
 Information relevant to questions B175-B179
Rainbird decided to reorganise a manufacturing facility
during November 20X1 and commissioned a consulting
engineer to carry out a feasibility study. A provision for the
reorganisation was created at 31 December 20X1.
Staff functions will change following the reorganisation, so
in December 20X1 Rainbird contracted with a training
company to provide retraining to take place in January 20X2.
A provision for this expenditure was created at 31 December
20X1.
 Information relevant to questions B175-B179
Rainbird hopes that reorganising its manufacturing facility will
improve quality control. It gives a one-year warranty with all
products and the rate of returns under warranty is 12%. 5% of
the returned items can be repaired at a cost of $5 (free of charge
to the customer). The other 95% are scrapped and a full refund
of $30 is given. Rainbird sold 525,000 units during the year to
31 December 20X1.
In five years' time Rainbird will have to dismantle its factory
and return the site to the local authority. A provision was set up
for the present value of the dismantling costs when the factory
was first acquired. The opening balance on the provision at 1
January 20X1 was $2.63 million. Rainbird has a cost of capital
of 8%.
 B175
Rainbird's accountant is preparing the financial statements for
the year to 31 December 20X1 and is not too sure about the
provisions set up for the reorganisation of the facility and the
staff training.
Which of these is a correct provision under IAS 37?
A. The reorganisation
B. The staff training
C. The reorganisation and the staff training
D. Neither the reorganisation nor the staff training
 B175
Answer D
The reorganisation cannot be provided for because it has only
gone as far as a feasibility study.
Staff training is not a valid provision.
 B176
Rainbird's finance director is checking some of the financial
estimates involved. In accordance with IAS 37 if the reporting
entity is presently obliged to transfer economic benefit to
another party, the occurrence is probable but the amount cannot
be measured with sufficient reliability, this should give rise to:
A. A provision
B. A contingent liability
C. A long-term liability
D. A contingent asset
 B176
Answer B
This is a contingent liability. The outcome is probable but
cannot be reliably measured.
 B177
What is the amount of the provision that should be created
at 31 December 20X1 for returns under warranty?
A. $1,890,000
B. $1,811,250
C. $1,795,500
D. $1,575,000
 B177
Answer B $1,811,250
Total returns = 525,000 × 12% = 63,000
Expected cost:
$
63,000 × 95% × 30 1,795,500
63,000 × 5% × 5 15,750
1,811,250
 B178
What is the amount of the provision that should be carried
forward at 31 December 20X1 for the dismantling of the
factory?
A. $2,630,000
B. $2,419,600
C. $2,435,185
D. $2,840,400
 B178
Answer D
$2.63 million × 108% = $2,840,400. This is the unwinding of
the discount.
 B179
During January 20X2, before the financial statements for the year ended 31
December 20X1 had been finalised, a number of events took place.
Which one of these events would require an adjustment to the financial
statements as at 31 December 20X1 in accordance with IAS 10 Events after the
reporting period?
A. Rainbird's board announced a plan to discontinue one of its operations and
dispose of the plant. The loss on disposal is estimated at $2 million.
B. The employees of the operation to be discontinued commenced a case against
the company for constructive dismissal. The total cost could be $3 million.
C. A legal case for which Rainbird had provided $1.7 million at 31 December 20X1
to cover possible damages was unexpectedly settled in its favour.
D. One of Rainbird's warehouses was destroyed by fire and half of the inventory on
hand at 31 December 20X1, valued at $2.5 million, was destroyed.
 B179
Answer C
This is a favourable event after the reporting period because it provides evidence
regarding conditions that existed at the end of the reporting period ie the legal case
that was ongoing.
The other events have all taken place after the reporting period.
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