A provision is a liability of uncertain timing or amount.

A provision should be recognized if all of the following criteria are met:

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

Provisions are reviewed each year and adjusted to reflect current best estimate.

The amount to be recognized as a provision is the best estimate of the expenditure required to settle the obligation at the end of the reporting period.

Provisions are discounted where the effect of the time value of money is material.

Where the provision involves a large population of items the expected values should be used, taking into account the probability of all expected outcomes.

Example 1

DEF Ltd manufactures small items of equipment. The company sold 20.000 items this year, which also have a one-year guarantee if the equipment fails.

Based on past experience, 15% of items sold are returned for repair or replacement.

In each case, one-third of the items returned are able to be repaired at a cost of $60, while the remaining two-thirds are scrapped and replaced. The manufacturing cost of a replacement item is $170.

Solution 1

A present obligation exists at the end of the reporting period based on historical evidence of items being repaired under the guarantee agreement.

Here, a large population of items is involved. A provision is therefore made for the expected value of the outflow:

20.000*15%*1/3*$60 = $60.000

20.000*15%*2/3*$170 = $340.000

Therefore, the provision to be recognized is $400.000.

Where a single obligation is being measured the individual most likely outcome may be the best evidence of the liability.

Example 2

ABC Ltd is being sued by a customer for refusing to replace or repair an item of equipment within the guarantee period.

The company’s lawyer has advised ABC Ltd that it is more likely than not that they will be found liable. This would result in the company being forced to replace or repair the equipment plus pay court costs and a fine amounting to approximately $18.000.

Based on past experience with similar items of equipment, the company estimates that there is an 80% chance that the central core would need to be replaced which would cost $50.000 and a 20% chance that the repair would only cost about $35.000.

Solution 2

At the end of the reporting period, ABC Ltd is more likely than not to be found guilty, hence a present obligation is assumed to exist. Given that a single obligation is being measured, a provision is made for the outflow of the most likely outcome.

Consequently a provision is recognized for $18.000 + $50.000 = $68.000.

A contingent liability is either:

  • A possible obligation arising from past events whose existence will be confirmed only by the 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 recognized because:
    • It is not probable that an outflow of economic benefits will be required to settle the obligation; or
    • The amount of the obligation cannot be measured with sufficient reliability.

A contingent liability is not recognized. A contingent liability is disclosed unless the possibility of an outflow of economic benefits is remote.

For each class of contingent liability, an entity must disclose at the end of the reporting period, all of the following:

  1. The nature of the contingent liability
  2. An estimate of its financial effect
  3. An indication of the uncertainties relating to the amount or timing of any outflow
  4. The possibility of any reimbursement

A contingent asset is a possible asset arising from past events whose existence will only be confirmed by the occurrence of one or more uncertain future events not wholly within the control of the entity.

A contingent asset is not recognized because it could result in the recognition of profits that may never be realized.

However, where the realization of profit is virtually certain, then the related asset is not a contingent asset and recognition is appropriate.

A contingent asset is disclosed where an inflow of economic benefits is probable.

The following must be disclosed:

  1. A brief description of the nature of the contingent asset at the end of the reporting period
  2. Where practicable, an estimate of the financial effect.

Provisions are not recognised for future operating losses, since the future operating losses do not meet the definition of a liability or the Conceptual Framework recognition criteria.

If an entity has a contract that is onerous a provision must be made for the net loss. IAS 37 defines an onerous contract as one in which unavoidable costs of completing the contract exceed the benefits expected to be received under it.

A provision for restructuring costs is recognized only when the entity has a constructive obligation to restructure. Such an obligation only arises where an entity:

  1. Has a detailed formal plan for the restructuring, and
  2. Has raised a valid expectation in those affected that it will carry out the restructuring by starting to implement the plan or announcing its main features to those affected by it.

A restructuring provision includes only direct expenditures arising from the restructuring and which are:

  1. Necessarily entailed by the restructuring; and
  2. Not associated with the ongoing activities of the entity.

Provisions are normally recognised in P/L, except for provisions in relation to decommissioning and other environmental costs. These provisions should be capitalized under IAS 16, as they form part of the cost of the asset.