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IAS 37 — Provisions, Contingent Liabilities and Contingent Assets Objective: The objective of IAS 37 is to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets and that sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount. The key principle established by the Standard is that a provision should be recognised only when there is a liability i.e. a present obligation resulting from past events. The Standard thus aims to ensure that only genuine obligations are dealt with in the financial statements – planned future expenditure, even where authorised by the board of directors or equivalent governing body, is excluded from recognition. A mere ‘management intention’ is no longer sufficient. Before IAS 37 there was no standard which govern Provisions. Companies used to recognize Provisions in good economy times and used to reverse them in bad economy times. As unsettled liabilities are Income. This practice was carried on by many companies just to book profits in bad economy time. This practice is exercise of creative accounting and which is also known as cherry picking. To stop this Practice IASB issued the standard IAS 37.

Scope: IAS 37 excludes obligations and contingencies arising from: • Financial instruments that are in the scope of IFRS 9 Financial Instruments. • Non-onerous executory contracts • Insurance contracts (IFRS 4 Insurance Contracts), but IAS 37 does apply to other provisions, contingent liabilities and contingent assets of an insurer • Income taxes (IAS 12) • Leases (IFRS 16), but IAS 37 does apply to any lease that becomes onerous before the commencement date of the lease as defined in IFRS 16 and to short-term leases and leases for which the underlying asset is of low value accounted for in accordance with paragraph 6 of IFRS 16 and that have become onerous; • Employee benefits (IAS 19) • Revenue from Contracts with Customers (IFRS 15)

Introduction: Liabilities are obligations arising from a past event that will lead to an outflow of economic resources. Most liabilities can be measured accurately. For example, if you take out a bank loan then you know exactly how much you have to repay, and when the repayments are due. Provisions, however, involve more uncertainty.

According to IAS 37 Provisions, Contingent Liabilities and Contingent Assets, 'a provision is a liability of uncertain timing or amount'. As liabilities, provisions are included in the statement of financial position and increases or reductions in provisions are reported in profit and loss. Recognition: IAS 37 requires that a provision should be recognised when and only 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'.

Obligating event (Present Obligation): An event which creates a legal or constructive obligation which results in an entity having no realistic alternative to settle down that obligation. An obligation is something that cannot be avoided. There must be an obligation already in existence. Mere intention is not sufficient. The obligation may be legal or constructive: • A legal obligation is one arising from a contract, or some other aspect of the law. For example, a company may sell goods with a two-year warranty if any defect arises after the date of sale. The company now has legal obligation (a contractual obligation) to make good by repair or replacement, any defects that arise. Where details of a proposed new law have yet to be finalised, an obligation only arises when the legislation is virtually certain to be introduced (‘enacted’). • A constructive obligation is one arising from the entity’s actions, whereby  Through established past practice, published policies, or a 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 that it will discharge those responsibilities. For example, a retail store may have a policy of refunding purchases made by dissatisfied customers, even though it is only legally obliged to issue a refund if the goods are faulty. Its policy of making refunds is widely known. As a result of its conduct, the company has created a valid expectation amongst its customers that it will refund purchases. A constructive obligation therefore exists. In rare cases, for example in a lawsuit, it may not be clear whether an entity has a present obligation. In those cases, a past event is deemed to give rise to a present obligation if, taking account of all available evidence, it is more likely than not that a present obligation exists at the balance sheet date. A provision should be recognised for that present obligation if the other recognition criteria described above are met. If it is more likely than not that no present obligation exists, the entity should disclose a contingent liability, unless the possibility of an outflow of resources is remote. A contingent liability is disclosed but not accrued. However, disclosure is not required if payment is remote. Past event: The event leading to the present obligation must be past, and must have occurred before the reporting date (end of the reporting period) when the provision is first recognised. No provision is made

for costs that may be incurred in the future but where no obligation yet exists. For example, if an entity is planning a reorganisation but does not yet have an obligation (legal or constructive) to undertake the reorganisation, it cannot create a provision for reorganisation costs. For an event to be an ‘obligating event’, it must be shown that the entity had no realistic alternative to settling the obligation. This is the case only where the settlement can be enforced by law or, in the case of a constructive obligation, that a valid expectation has been created. Example: Under new legislation an entity is required to fit smoke filters to its factories by 30 June Year 2. The entity has not fitted the smoke filters. In its accounts to 31 December Year 1, there is no present obligation as the legislation is not yet effective, and so an obligating event has not yet occurred. No provision for the cost of the smoke filters can be recognised in the accounts for Year 1.

Probable outflow of economic benefits: For a provision to exist, the outflow of benefits must be probable. ‘Probable’ is defined by IAS 37 as ‘more likely than not’ (more than 50% probability). For example, an entity may have given a guarantee but may not expect to have to honour it. In such a situation, it cannot create a provision for the cost of expenses that it may have to incur under the terms of the guarantee. This is because a payment under the guarantee is not probable.

Reliable estimate of the obligation: IAS 37 also requires that a provision should not be recognised unless a reliable estimate of the amount of the provision can be made. A reasonable estimate can be based on a range of possible outcomes. In the extremely rare case where no estimate can be made, a provision should not be made and the liability should be disclosed instead as a contingent liability, in a note to the financial statements. Example: In each of the following situations, consider whether a provision should be recognised, assuming that the reporting period ends on 31 December in each case: (1) An entity in the oil industry cleans up contamination caused by its operations when required to do so under the laws of the particular country in which it operates. One country in which it operates has no legislation requiring clean up, and the entity has been contaminating the land for several years. At 31 December 20X4 it is virtually certain that a draft law requiring a clean-up of land already contaminated will be enacted shortly after the year end. (2) The government has introduced a number of changes to the regulation of the financial services industry. As a result of these changes, entities will need to re-train a large proportion of their employees in order to ensure compliance with the financial services regulations. However, re-training is not a statutory requirement. One entity affected by the new regulations had not done any retraining before the end of the reporting period. (3) On 18 December 20X6 the board of an entity decides to close down a division. However, this decision was not communicated to any of those affected and no further steps were taken to implement the decision before the end of the reporting period.

(4) On 18 December 20X6 the board of an entity decides to close down a division. On 23 December a detailed plan for closing down the division was prepared by the board and announcements were made to employees concerning redundancies. In addition, letters were sent to customers advising them of the proposal and recommending alternative suppliers. Answer: (1) By contaminating the land, the entity has created an obligation. There is virtual certainty that the legislation will be introduced, giving a legal obligation to the entity to clean up the land. This will result in a probable outflow of cash and resources to perform the clean-up and so a provision should be made for the best estimate of the clean-up operation. (2) No provision should be created by the entity, because as at the end of the reporting period there has not been a past event giving rise to a present obligation. An obligation only arises where the settlement can be enforced by law or the entity has created a valid expectation in other parties. Neither applies in this situation. (3) As there has not been an obligation created as at the end of the reporting period, no provision should be created. For a constructive obligation to arise, the entity must have communicated the plans to those affected (i.e. employees, customers and suppliers) and implementation must be planned to start shortly. (4) In contrast to situation 3, an obligating event exists as at the end of the reporting period, because the entity has communicated the plans to its employees and customers. This gives rise to a constructive obligation, as the entity has created an expectation which will lead to a probable outflow of cash to settle redundancy payments and contract clauses. Therefore a provision should be made for the best estimate of the costs of closure. Example: An organization gives warranties to the buyers of its product. Under the terms for the contract of sale. The organization undertakes to make goods by repair or replacement, manufacturing defects which apparent within five years of purchase from the date of sale. Based on past experience it is probable that there will be some claims In this scenario sale under warranties give rise to present obligation. It provide for the best estimate of the cost of making goods under the warranty of goods. Sold by the end of reporting period. Example: In wedding of 2015 20 guests got ill due to food poisoning from fppd catering of Duba catering. After few legal proceeding the Lawyer told to Duba catering is likely that you have to pay damages of $50000. So in this scenario there is Present obligation, there is probable outflow and reliable estimate as well so Provision need to be recognized. Example: A super market has policy of refund of goods by dissatisfied customers. Though it is no under legal obligation to do so. Its policy of making refunds is generally known. In this scenario present obligation occurs when sales has been made which gives rise to constructive obligation as valid expectations has been created.

It is also probable that portions of goods will be return and reliable estimate can be made so provision need to be recognized. Example: An organization operates in an oil industry in which contamination occurs and it operates in a country where there is no environmental policy. However organization has published policy in which it clearly states it is the responsibility of the organization that they will clean up the contamination that it causes. In this scenario present obligation occurs when contamination occurs. Therefore it’s a constructive obligation because entity’s past practice creates a valid expectation. Also there is a probable outflow and reliable estimate as well so Provision need to be recognized

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 balance sheet date, that is, the amount that an entity would rationally pay to settle the obligation at the balance sheet date or to transfer it to a third party. It may be derived from management judgment which has been gathered by experience of similar transaction and in some cases expert’s evidence. This means: • Provisions for one-off events (restructuring, environmental clean-up, settlement of a lawsuit) are measured at the most likely amount. • Provisions for large populations of events (warranties, customer refunds) are measured at a probability-weighted expected value. • Both measurements are at discounted present value using a pre-tax discount rate that reflects the current market assessments of the time value of money and the risks specific to the liability. In reaching its best estimate, the entity should take into account the risks and uncertainties that surround the underlying events which may include: • The use of the most likely outcomes in the situations in which single obligation is measured. • An expected value calculation in which there is a large population. In measuring a provision consider future events as follows: • Forecast reasonable changes in applying existing technology. • Ignore possible gains on sale of assets. • Consider changes in legislation only if virtually certain to be enacted. • The present value of future expected cash flows. However, entities should: • Avoid creating excessive provisions (which could be used as a way of manipulating profits between financial years), or • Avoid underestimating provisions.

Example: Entity G has a financial year ending 31 December. On 15 December Year 1 an employee was injured in the workplace and has sued Entity G for compensation under current health and safety legislation. Entity G’s solicitors believe that the employee’s claim has a 60% chance of success. The solicitors estimate that, if successful, the claim will be settled at $60,000. Required: Consider whether or not Entity G should provide for the claim at 31 December Year 1 and, if so, at what amount. Answer: If a provision is to be made: • There must be a present obligation as a result of a past event • It must be probable that an outflow of economic benefits will be required to settle the obligation, and • It must be possible to make a reliable estimate of the amount of the obligation. Applying this to the facts in the example: (1) Entity G has a legal obligation under the health and safety legislation. The obligation has arisen from a past event, which is the accident on 15 December Year 1. (2) It is probable that Entity G will have to pay the employee. A ‘60% chance of success’ means that success is ‘more likely than not’. (A probability above 50% meets the IAS 37 definition of ‘probable’.) (3) A reliable estimate can be made. This is $60,000. Conclusion: A provision of $60,000 should be made at 31 December Year 1. Example: An entity sells high-definition televisions with a 12-month warranty under which customers are covered for the cost of repairs or replacement of manufacturing defects found during the period after purchase. If every product sold required minor repairs, the annual cost would be $0.5 million. If every product was replaced, the annual cost would be $3 million. Based on trading history, it is believed that 80% of all goods sold will have no defects, 15% will have minor defects and 5% will need replacing. The warranty period covers just 12 months, and a provision should therefore be created for the expected value of $225,000 [(80% × $0 nil) + (15% × $0.5 million) + (5% × $3 million)].

Reimbursements: If some or all of the expenditure required to settle a provision is expected to be reimbursed by another party, the reimbursement should be recognised as a separate asset, and not as a reduction of the required provision, when, and only when, it is virtually certain that reimbursement will be received if the entity settles the obligation. The amount recognised should not exceed the amount of the provision. The expense reported in profit or loss may be presented net of the reimbursement.

Remeasurement of provisions • Review and adjust provisions at each balance sheet date and adjusted to reflect the current best estimate. • If an outflow no longer probable, provision is reversed.

Subsequent measurement: If a provision has been discounted to present value, then the discount must be unwound and presented in finance costs in the statement of profit or loss: Dr Finance costs (P/L) Cr Provisions (SFP) Provisions should be remeasured to reflect the best estimate of the expenditure required to settle the liability as at each reporting date.

Derecognition: IAS 37 states that provisions should be used only for expenditure that relates to the matter for which the provision was originally recognised. Contingent asset and contingent liability cannot be setup. It should be recognised separately.

Contingent liabilities: A contingent liability is defined by IAS 37 as: • A possible obligation that arises from past events and whose existence will be confirmed by the outcome of uncertain future events which are outside of the control of the entity, or • A present obligation that arises from past events, but does not meet the criteria for recognition as a provision. This is either because an outflow of economic benefits is not probable or (more rarely) because it is not possible to make a reliable estimate of the obligation. A contingent liability is disclosed, unless the possibility of a future outflow of economic benefits is remote. If an outflow of economic benefits becomes probable then contingent liabilities must be reclassified as provisions. A contingent liability arises when some, but not all, of the criteria for recognising a provision are met. For example, a contingent liability exists, but not a provision or an actual liability if: • A reliable estimate cannot be made, or • No legal obligation or constructive obligation exists: there is merely a possible obligation. Possible can be interpreted to mean less than 50% probability. Example: Entity G is involved in a legal dispute with a customer, who is making a claim against Entity G for losses it has suffered as a consequence of a breach of contract. If Entity G’s solicitors believe that the

likelihood of the claim succeeding is possible rather than probable, and they estimate the possibility at about 30% to 40%. The claim should be treated as a contingent liability and not as a provision. Contingent assets: IAS 37 defines a contingent asset as a possible asset that arises from past events and whose existence will be confirmed by uncertain future events that are outside of the entity's control. A contingent asset should not be recognised: • A contingent asset should be disclosed if the inflow of future economic benefits is at least probable • If the future inflow of benefits is virtually certain, then it ceases to be a contingent asset and should be recognised as a normal asset. An example of a contingent asset might be a probable gain arising from a current legal action that has been taken against a third party, where the likelihood of success is considered to be quite high. The existence of the asset (the money receivable) will only be confirmed by the outcome of the legal dispute. IAS 37 Provisions, contingent liabilities and contingent assets Provisions Contingent liability Contingent asset Only provide if: Potential liability: Potential asset: • Obligation legal or • Assess likelihood of...