IAS 37 : Provisions, Contingent Liabilities and Contingent Assets Flashcards

Question

Recognition - Provision : An entity has a present obligation (legal or constructive) as a result of a past event’ The more subjective area is the possibility that an act by the entity will give rise to a constructive obligation. The example given is of an entity publicly accepting responsibility for rectification of previous environmental damage in a way that creates a constructive obligation. [IAS 37.21]. This seems to introduce a certain amount of flexibility to management when reporting results. By bringing forward or delaying a public announcement of a commitment that management had always intended to honour, it can affect the reporting period in which a provision is recognised. Nevertheless, the existence of a public announcement provides a more transparent basis for recognising a provision than, for example, a decision made behind the closed doors of a boardroom.

Answer 1

The more subjective area is the possibility that an act by the entity will give rise to a constructive obligation. The example given is of an entity publicly accepting responsibility for rectification of previous environmental damage in a way that creates a constructive obligation. [IAS 37.21]. This seems to introduce a certain amount of flexibility to management when reporting results. By bringing forward or delaying a public announcement of a commitment that management had always intended to honour, it can affect the reporting period in which a provision is recognised. Nevertheless, the existence of a public announcement provides a more transparent basis for recognising a provision than, for example, a decision made behind the closed doors of a boardroom.

Answer 2

The meaning of probable in these circumstances is that the outflow of resources is more likely than not to occur; that is, it has a probability of occurring that is greater than 50%. [IAS 37.23]. The standard also makes it clear that where there are a number of similar obligations, the probability that an outflow will occur is based on the class of obligations as a whole. This is because in the case of certain obligations such as warranties, the possibility of an outflow for an individual item may be small (likely to be much less than 50%) whereas the possibility of at least some outflow of resources for the population as a whole will be much greater (almost certainly greater than 50%). [IAS 37.24]

Answer 3

With regard to the measurement of a provision arising from a number of similar obligations, the standard refers to the calculation of an ‘expected value’, whereby the obligation is estimated by weighting all the possible outcomes by their associated probabilities. [IAS 37.39]. Where the obligation being measured relates to a single item, the standard suggests that the best estimate of the liability may be the individual most likely outcome. [IAS 37.40]. For the purposes of recognition, a determination that it is more likely than not that any outflow of resources will be required is sufficient.

Answer 4

The standard takes the view that a sufficiently reliable estimate can almost always be made for a provision where an entity can determine a range of possible outcomes. Hence, the standard contends that it will only be in extremely rare cases that a range of possible outcomes cannot be determined and therefore no sufficiently reliable estimate of the obligation can be made. [IAS 37.25]. In these extremely rare circumstances, no liability is recognised. Instead, the liability should be disclosed as a contingent liability. [IAS 37.26]

Answer 5

IAS 37 says that contingent liabilities and contingent assets should not be recognised, but only disclosed. [IAS 37.27-28, 31, 34]. Contingent liabilities that are recognised separately as part of allocating the cost of a business combination are covered by the requirements of IFRS 3. [IFRS 3.23]. Such liabilities continue to be measured after the business combination at the higher of: (a) the amount that would be recognised in accordance with IAS 37, and (b) the amount initially recognised less, if appropriate, the cumulative amount of income recognised in accordance with the principles of IFRS 15. [IFRS 3.56].

Answer 6

A contingent liability is defined in the standard as: (a) 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 (b) a present obligation that arises from past events but is not recognised because: (i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or (ii) the amount of the obligation cannot be measured with sufficient reliability. [IAS 37.10].

Answer 7

At first glance, this definition is not easy to understand because a natural meaning of ‘contingent’ would include any event whose outcome depends on future circumstances. The meaning is perhaps clearer when considering the definition of a liability and the criteria for recognising a provision in the standard. A possible obligation whose existence is yet to be confirmed does not meet the definition of a liability; and a present obligation in respect of which an outflow of resources is not probable, or which cannot be measured reliably does not qualify for recognition. [IAS 37.14]

Answer 8

On that basis a contingent liability under IAS 37 means one of the following: (a) an obligation that is estimated to be less than 50+% likely to exist (i.e. it does not meet the definition of a liability). Where it is more likely than not that a present obligation exists at the end of the reporting period, a provision is recognised. [IAS 37.16(a)]. Where it is more likely than not that no present obligation exists, a contingent liability is disclosed (unless the possibility is remote); [IAS 37.16(b)]

Answer 9

(b) a present obligation that has a less than 50+% chance of requiring an outflow of economic benefits (i.e. it meets the definition of a liability but does not meet the recognition criteria). Where it is not probable that there will be an outflow of resources, an entity discloses a contingent liability (unless the possibility is remote); [IAS 37.23] or (c) a present obligation for which a sufficiently reliable estimate cannot be made (i.e. it meets the definition of a liability but does not meet the recognition criteria). In these rare circumstances, a liability cannot be recognised and it is disclosed as a contingent liability. [IAS 37.26].

Answer 10

The term ‘possible’ is not defined, but literally it could mean any probability greater than 0% and less than 100%. However, the standard effectively divides this range into four components, namely ‘remote’, ‘possible but not probable’, ‘probable’ and ‘virtually certain’. The standard requires a provision to be recognised if ‘it is more likely than not that a present obligation exists at the end of the reporting period’. [IAS 37.16(a)]. Therefore, IAS 37 distinguishes between a ‘probable’ obligation (which is more likely than not to exist and, therefore requires recognition as a provision) and a ‘possible’ obligation (for which either the existence of a present obligation is yet to be confirmed or where the probability of an outflow of resources is 50% or less). [IAS 37.13]

Answer 11

The standard requires that contingent liabilities are assessed continually to determine whether circumstances have changed, in particular whether an outflow of resources embodying economic benefits has become probable. Where this becomes the case, then provision should be made in the period in which the change in probability occurs (except in the rare circumstances where no reliable estimate can be made). [IAS 37.30]. Other changes in circumstances might require disclosure of a previously remote obligation on the grounds that an outflow of resources has become possible (but not probable).

Answer 12

Example 27.4: When the likelihood of an outflow of benefits becomes probable After a wedding in 2019, ten people died, possibly as a result of food poisoning from products sold by the entity. Legal proceedings are started seeking damages from the entity. The entity disputes any liability and, up to the date on which its financial statements for the year ended 31 December 2019 are authorised for issue, its lawyers have advised that is probable that the entity will not be found liable. However, when the entity prepares its financial statements for the year ended 31 December 2020, its lawyers advise that, owing to developments in the case, it is probable that the entity will be found liable. At 31 December 2019, no provision is recognised and the matter is disclosed as a contingent liability unless the probability of any outflow is regarded as remote. On the basis of the evidence available when the financial statements were approved, there is no obligation as a result of a past event. At 31 December 2020, a provision is recognised for the best estimate of the amount required to settle the obligation. The fact that an outflow of economic benefits is now believed to be probable means that there is a present obligation. [IAS 37 IE Example 10].

Answer 13

A contingent asset is defined in a more intuitive way. It is ‘a possible asset 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 wholly within the control of the entity’. [IAS 37.10]. In this case, the word ‘possible’ is not confined to a level of probability of 50% or less, which may further increase the confusion over the different meaning of the term in the definition of contingent liabilities.

Answer 14

Contingent assets usually arise from unplanned or other unexpected events that give rise to the possibility of an inflow of economic benefits to the entity. An example is a claim that an entity is pursuing through legal process, where the outcome is uncertain. [IAS 37.32]. The standard states that a contingent asset should not be recognised, as this could give rise to recognition of income that may never be realised. However, when the realisation of income is virtually certain, then the related asset is no longer regarded as contingent and recognition is appropriate. [IAS 37.33].

Answer 15

Virtual certainty is not defined in the standard, but it is certainly a much higher hurdle than ‘probable’ and indeed more challenging than the term ‘highly probable’, defined in IFRS 5 as ‘significantly more likely than probable’. [IFRS 5 Appendix A]. We think it reasonable that virtual certainty is interpreted as being as close to 100% as to make any remaining uncertainty insignificant. What this means in practice requires each case to be decided on its merits and any judgement should be made in the knowledge that, in any event, it is rarely possible to accurately assess the probability of the outcome of a particular event.

Answer 16

The standard requires disclosure of the contingent asset when the inflow of economic benefits is probable. [IAS 37.34]. For the purposes of the standard ‘probable’ means that the event is more likely than not to occur; that is, it has a probability greater than 50%. [IAS 37.23]

Answer 17

As with contingent liabilities, any contingent assets should be assessed continually to ensure that developments are appropriately reflected in the financial statements. If it has become virtually certain that an inflow of economic benefits will arise, the asset and the related income should be recognised in the period in which the change occurs. If a previously unlikely inflow becomes probable, then the contingent asset should be disclosed. [IAS 37.35]

Answer 18

The requirement to recognise the effect of changing circumstances in the period in which the change occurs extends to the analysis of information available after the end of the reporting period and before the date of approval of the financial statements. In our view, such information would not give rise to an adjusting event after the reporting period. In contrast to contingent liabilities (in respect of which IAS 10 includes as a specific example of an adjusting event ‘the settlement after the reporting period of a court case that confirms that the entity had a present obligation at the end of the reporting period’ [IAS 10.9]), no adjustment should be made to reflect the subsequent settlement of a legal claim in favour of the entity. In this instance, the period in which the change occurs is subsequent to the reporting period. There is also no suggestion that the example in IAS 10 is referring to anything but liabilities. An asset could only be recognised if, at the end of the reporting period, the entity could show that it was virtually certain that its claim would succeed.

Answer 19

Entities may sometimes be required to pay contingent fees to a third party dependent upon the successful recovery of a contingent asset. For example, the payment of fees to a legal advisor in a contract agreed on a ‘no win, no fee’ basis will depend upon the successful outcome of a legal claim. In such cases, we believe that the obligation for the success fee arises from an executory contract that should be evaluated separately from the legal claim. The liability for the success fee would therefore only be recognised by the entity upon winning the claim.

Answer 20

IAS 37 uses the term executory contracts to mean ‘contracts under which neither party has performed any of its obligations, or both parties have partially performed their obligations to an equal extent’. [IAS 37.3]. When a contract for services is wholly contingent on recovering a contingent asset, no service requiring payment is deemed to be provided until or unless the matter is resolved successfully. Unless the contract also required payment to be made in the event of failure, the amount of work put in by the lawyer to prepare a case and argue for recovery of the contingent asset is irrelevant to the existence of a liability to pay fees.

Answer 21

If the entity has deemed it appropriate to recognise an asset in respect of the claim, it would be appropriate to take account of any such fees in the measurement of that asset (in determining the net amount recoverable); but no accrual should be made for the legal fees themselves unless a successful outcome is confirmed. This analysis is specific to a no win-no fee arrangement related to a contingent asset and may not be appropriate in other circumstances.

Answer 22

The following matrix summarises the treatment of contingencies under IAS 37: Refer OneNote

Answer 23

The standard does not put a numerical measure of probability on either ‘virtually certain’ or ‘remote’. In our view, the use of such measures would downgrade a process requiring the exercise of judgement into a mechanical exercise. It is difficult to imagine circumstances when an entity could reliably determine an obligation to be, for example, 92%, 95% or 99% likely, let alone be able to compare those probabilities objectively. Accordingly, we think it reasonable to regard ‘virtually certain’ as describing a likelihood that is as close to 100% as to make any remaining uncertainty insignificant; to see ‘remote’ as meaning a likelihood of an outflow of resources that is not significant; and for significance to be a matter for judgement and determined according to the merits of each case.

Answer 24

In most cases, the recognition of a provision results in an immediate expense in profit or loss. Nevertheless, in some cases it may be appropriate to recognise an asset. These issues are not discussed in IAS 37, which neither prohibits nor requires capitalisation of the costs recognised when a provision is made. It states that other standards specify whether expenditures are treated as assets or expenses. [IAS 37.8].

Answer 25

Example 27.5: When the recognition of a provision gives rise to an asset. An entity operates an offshore oilfield where its licensing agreement requires it to remove the oil rig at the end of production and restore the seabed. 90% of the eventual costs relate to the removal of the oil rig and restoration of damage caused by building it, with 10% expected to arise through the extraction of oil. At the end of the reporting period, the rig has been constructed but no oil has been extracted. A provision is recognised in respect of the probable costs relating to the removal of the rig and restoring damage caused by building it. This is because the construction of the rig, combined with the requirement under the licence to remove the rig and restore the seabed, creates an obligating event as at the end of the reporting period. These costs are included as part of the cost of the oil rig. However, there is no obligation to rectify any damage that will be caused by the future extraction of oil. [IAS 37 IE Example 3].

Answer 26

IAS 37 requires the amount to be recognised as a provision to be the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. [IAS 37.36]. This measure is determined before tax, as the tax consequences of the provision, and changes to it, are dealt with under IAS 12. [IAS 37.41].

Answer 27

The standard equates this ‘best estimate’ with ‘the amount that an entity would rationally pay to settle the obligation at the end of the reporting period or to transfer it to a third party at that time’. [IAS 37.37]. It is interesting that a hypothetical transaction of this kind should be proposed as the conceptual basis of the measurement required, rather than putting the main emphasis upon the actual expenditure that is expected to be incurred in the future.

Answer 28

The standard does acknowledge that it would often be impossible or prohibitively expensive to settle or transfer the obligation at the end of the reporting period. However, it goes on to state that ‘the estimate of the amount that an entity would rationally pay to settle or transfer the obligation gives the best estimate of the expenditure required to settle the present obligation at the end of the reporting period’. [IAS 37.37].

Answer 29

The estimates of outcome and financial effect are determined by the judgement of the entity’s management, supplemented by experience of similar transactions and, in some cases, reports from independent experts. The evidence considered will include any additional evidence provided by events after the reporting period. [IAS 37.38].

Answer 30

The standard suggests that there are various ways of dealing with the uncertainties surrounding the amount to be recognised as a provision. It mentions three, an expected value (or probability-weighted) method; the mid-point of the range of possible outcomes; and an estimate of the individual most likely outcome. An expected value approach would be appropriate when a large population of items is being measured, such as warranty costs. This is a statistical computation which weights the cost of all the various possible outcomes according to their probabilities, as illustrated in the following example taken from IAS 37. [IAS 37.39].

Answer 31

An entity sells goods with a warranty under which customers are covered for the cost of repairs of any manufacturing defects that become apparent within the first six months after purchase. If minor defects were detected in all products sold, repair costs of £1 million would result. If major defects were detected in all products sold, repair costs of £4 million would result. The entity’s past experience and future expectations indicate that, for the coming year, 75 per cent of the goods sold will have no defects, 20 per cent of the goods sold will have minor defects and 5 per cent of the goods sold will have major defects. In accordance with paragraph 24 of IAS 37 (see 3.1.2 above) an entity assesses the probability of a transfer for the warranty obligations as a whole. The expected value of the cost of repairs is: (75% of nil) + (20% of £1m) + (5% of £4m) = £400,000

Answer 32

Where the obligation being measured relates to a single item, the standard suggests that the best estimate of the liability may be the individual most likely outcome. However, even in such a case, it notes that consideration should be given to other possible outcomes and where these are predominantly higher or mainly lower than the most likely outcome, the resultant ‘best estimate’ will be a higher or lower amount than the individual most likely outcome. To illustrate this, the standard gives an example of an entity that has to rectify a fault in a major plant that it has constructed for a customer. The most likely outcome is that the repair will succeed at the first attempt. However, a provision should be made for a larger amount if there is a significant chance that further attempts will be necessary. [IAS 37.40].

Answer 33

It is clear from the definition of a provision as a liability of uncertain timing or amount that entities will have to deal with risk and uncertainty in estimating an appropriate measure of the obligation at the end of the reporting period. It is therefore interesting to consider how the measurement rules detailed in IAS 37 help entities achieve a faithful representation of the obligation in these circumstances. A faithful representation requires estimates that are neutral, that is, without bias. [CF(2010) QC12, QC14]

Answer 34

The standard does not refer to neutrality as such; however, it does discuss the concept of risk and the need for exercising caution and care in making judgements under conditions of uncertainty. It states that ‘the risks and uncertainties that inevitably surround many events and circumstances shall be taken into account in reaching the best estimate of a provision’. [IAS 37.42]. It refers to risk as being variability of outcome and suggests that a risk adjustment may increase the amount at which a liability is measured. [IAS 37.43]

Answer 35

Whilst the standard provides an example of a case in which the best estimate of an obligation might have to be larger than the individual most likely outcome, [IAS 37.40], it gives no indication of how this increment should be determined. It warns that caution is needed in making judgements under conditions of uncertainty, so that expenses or liabilities are not understated. However, it says that uncertainty does not justify the creation of excessive provisions or a deliberate overstatement of liabilities. Accordingly, care is needed to avoid duplicating adjustments for risk and uncertainty, for example by estimating the costs of a particularly adverse outcome and then overestimating its probability. [IAS 37.43]. Any uncertainties surrounding the amount of the expenditure are to be disclosed. [IAS 37.44].

Answer 36

The standard requires that where the effect of the time value of money is material, the amount of a provision should be the present value of the expenditures expected to be required to settle the obligation. [IAS 37.45]. The discount rate (or rates) to be used in arriving at the present value should be ‘a pre-tax rate (or rates) that reflect(s) current market assessments of the time value of money and the risks specific to the liability.

Answer 37

The discount rate(s) shall not reflect risks for which the future cash flow estimates have been adjusted.’ [IAS 37.47]. However, it is worth noting that no discounting is required for provisions where the cash flows will not be sufficiently far into the future for discounting to have a material impact. [IAS 37.46].

Answer 38

The main types of provision where the impact of discounting will be significant are those relating to decommissioning and other environmental restoration liabilities. IFRIC 1 addresses some of the issues relating to the use of discounting (in the context of provisions for obligations to dismantle, remove or restore items of property, plant and equipment, referred to as ‘decommissioning, restoration and similar liabilities’)

Answer 39

IAS 37 does not indicate whether the discount rate should be a real discount rate or a nominal discount rate. The discount rate to be used depends on whether: (a) the future cash flows are expressed in current prices, in which case a real discount rate (which excludes the effects of general inflation) should be used; or (b) the future cash flows are expressed in expected future prices, in which case a nominal discount rate (which includes a return to cover expected inflation) should be used.

Answer 40

IAS 37 does not indicate whether the discount rate should be a real discount rate or a nominal discount rate. The discount rate to be used depends on whether: (a) the future cash flows are expressed in current prices, in which case a real discount rate (which excludes the effects of general inflation) should be used; or (b) the future cash flows are expressed in expected future prices, in which case a nominal discount rate (which includes a return to cover expected inflation) should be used.

Answer 41

IAS 37 indicates that where discounting is used, the carrying amount of a provision increases in each period to reflect the passage of time, and that this increase is recognised as a finance cost. [IAS 37.60]. This is the only guidance that the standard gives on the unwinding of the discount. IFRIC 1 in relation to provisions for decommissioning, restoration and similar liabilities requires that the periodic unwinding of the discount is recognised in profit or loss as a finance cost as it occurs.

Answer 42

IAS 37 indicates that where discounting is used, the carrying amount of a provision increases in each period to reflect the passage of time, and that this increase is recognised as a finance cost. [IAS 37.60]. This is the only guidance that the standard gives on the unwinding of the discount. IFRIC 1 in relation to provisions for decommissioning, restoration and similar liabilities requires that the periodic unwinding of the discount is recognised in profit or loss as a finance cost as it occurs.

Answer 43

The standard states that ‘future events that may affect the amount required to settle an obligation shall be reflected in the amount of a provision where there is sufficient objective evidence that they will occur’. [IAS 37.48]. The types of future events that the standard has in mind are advances in technology and changes in legislation.

Answer 44

The standard states that ‘future events that may affect the amount required to settle an obligation shall be reflected in the amount of a provision where there is sufficient objective evidence that they will occur’. [IAS 37.48]. The types of future events that the standard has in mind are advances in technology and changes in legislation.

Answer 45

For example, an entity may believe that the cost of cleaning up a site at the end of its life will be reduced by future changes in technology. The amount recognised has to reflect a reasonable expectation of technically qualified, objective observers, taking account of all available evidence as to the technology that will be available at the time of the clean-up. Thus it is appropriate to include, for example, expected cost reductions associated with increased experience in applying existing technology or the expected cost of applying existing technology to a larger or more complex clean-up operation than has previously been carried out. [IAS 37.49].

Answer 46

Similarly, if new legislation is to be anticipated, there will need to be evidence both of what the legislation will demand and whether it is virtually certain to be enacted and implemented. In many cases sufficient objective evidence will not exist until the new legislation is enacted. [IAS 37.50].

Answer 47

Entities may sometimes expect to settle an obligation in a currency other than their functional currency. In such cases, the provision would be measured in the currency in which settlement is expected and then discounted using a discount rate appropriate for that currency. This approach is consistent with that required by IAS 36 – Impairment of Assets – for foreign currency cash flows in value in use calculations. [IAS 36.54].

Answer 48

The present value would be translated into functional currency at the spot exchange rate at the date at which the provision is recognised. [IAS 21.21]. If the provision is considered to be a monetary liability, i.e. it is expected to be paid in a fixed or determinable number of units of currency, [IAS 21.8], it would thereafter be retranslated at the spot exchange rate at each reporting date. [IAS 21.23]. In most cases, exchange differences arising on provisions will be taken to profit or loss in the period in which they arise, in accordance with the general rule for monetary items in IAS 21 – The Effects of Changes in Foreign Exchange Rates. [IAS 21.28]

Answer 49

In some circumstances an entity is able to look to a third party to reimburse part of the costs required to settle a provision or to pay the amounts directly to a third party. Examples are insurance contracts, indemnity clauses and suppliers’ warranties. [IAS 37.55]. A reimbursement asset is recognised only when it is virtually certain to be received if the entity settles the obligation. The asset cannot be greater than the amount of the provision. No ‘netting off’ is allowed in the statement of financial position, with any asset classified separately from any provision. [IAS 37.53]. However, the expense relating to a provision can be shown in the income statement net of reimbursement. [IAS 37.54]

Answer 50

The main area of concern with these requirements is whether the ‘virtually certain’ criterion that needs to be applied to the corresponding asset might mean that some reimbursements will not be capable of recognition at all. For items such as insurance contracts, this may not be an issue, as entities will probably be able to confirm the existence of cover for the obligation in question and accordingly be able to demonstrate that a recovery on an insurance contract is virtually certain if the entity is required to settle the obligation.

Answer 51

Except when an obligation is determined to be joint and several, any form of net presentation in the statement of financial position is prohibited. This is because the entity would remain liable for the whole cost if the third party failed to pay for any reason, for example as a result of the third party’s insolvency. In such situations, the provision should be made gross and any reimbursement should be treated as a separate asset (but only when it is virtually certain that the reimbursement will be received if the entity settles the obligation). [IAS 37.56].

Answer 52

If the entity has no liability in the event that the third party cannot pay, then these costs are excluded from the estimate of the provision altogether because, by its very nature, there is no liability. [IAS 37.57]. In contrast, where an entity is assessing an onerous contract, it is common for entities to apply what looks like a net approach. However, because an onerous contract provision relates to the excess of the unavoidable costs over the expected economic benefits, [IAS 37.68], there is no corresponding asset to be recognised

Answer 53

It is interesting to contrast the approach of IAS 37 to reimbursements with the case where an entity is jointly and severally liable for an obligation. Joint and several liability arises when a number of entities are liable for a single obligation (for example, to damages), both individually and collectively. The holder of the obligation in these circumstances can collect the entire amount from any single member of the group or from any and all of the members in various amounts until the liability is settled in full.

Answer 54

Even when the members have an agreement between themselves as to how the total obligation should be divided, each member remains liable to make good any deficiency on the part of the others. This situation is different from proportionate liability, where individual members of a group might be required to bear a percentage of the total liability, but without any obligation to make good any shortfall by another member. Joint and several liability can be established in a contract, by a court judgement or under legislation

Answer 55

An entity that is jointly and severally liable recognises only its own share of the obligation, based on the amount it is probable that the entity will pay. The remainder that is expected to be met by other parties is treated only as a contingent liability. [IAS 37.29, 58].

Answer 56

IAS 37 states that gains from the expected disposal of assets should not be taken into account in measuring a provision, even if the expected disposal is closely linked to the event giving rise to the provision. Such gains should be recognised at the time specified by the Standard dealing with the assets concerned. [IAS 37.51-52]. This is likely to be of particular relevance in relation to restructuring provisions. However, it may also apply in other situations.

Answer 57

After recognition, a provision will be re-estimated, used and released over the period up to the eventual determination of a settlement amount for the obligation. IAS 37 requires that provisions should be reviewed at the end of each reporting period and adjusted to reflect the current best estimate. If it is no longer probable that an outflow of resources embodying economic benefits will be required to settle the obligation, the provision should be reversed. [IAS 37.59]. Where discounting is applied, the carrying amount of a provision increases in each period to reflect the passage of time. This increase is recognised as a finance cost in the income statement. [IAS 37.60]

Answer 58

The standard does not allow provisions to be redesignated or otherwise used for expenditures for which the provision was not originally recognised. [IAS 37.61]. In such circumstances, a new provision is created and the amount no longer needed is reversed, as to do otherwise would conceal the impact of two different events. [IAS 37.62]. This means that the questionable practice of charging costs against a provision that was set up for a different purpose is specifically prohibited

Answer 59

In a business combination, the usual requirements of IAS 37 do not apply and the acquirer recognises a liability at the acquisition date for those contingent liabilities of the acquiree that represent a present obligation arising as a result of a past event and in respect of which the fair value can be measured reliably. [IFRS 3.23]. After initial recognition, and until the liability is settled, cancelled or expires, the acquirer measures the contingent liability recognised in a business combination at the higher of: [IFRS 3.56] (a) the amount that would be recognised in accordance with IAS 37; and (b) the amount initially recognised less, if appropriate, the cumulative amount of income recognised in accordance with the principles of IFRS 15. [IFRS 3.56].

Answer 60

IAS 37 explicitly states that ‘provisions shall not be recognised for future operating losses’. [IAS 37.63]. This is because such losses do not meet the definition of a liability and the general recognition criteria of the standard. [IAS 37.64]. In particular there is no present obligation as a result of a past event. Such costs should be left to be recognised as they occur in the future in the same way as future profits.

Answer 61

Repairs and maintenance provisions in respect of owned assets are generally prohibited under IAS 37. Under the standard, the following principles apply: (a) provisions are recognised only for obligations existing independently of the entity’s future actions (i.e. the future conduct of its business) and in cases where an entity can avoid future expenditure by its future actions, for example by changing its method of operation, it has no present obligation; [IAS 37.19]

Answer 62

(b) financial statements deal with an entity’s position at the end of the reporting period and not its possible position in the future. Therefore, no provision is recognised for costs that need to be incurred to operate in the future; [IAS 37.18] and (c) for an event to be an obligating event, the entity can have no realistic alternative to settling the obligation created by the event. [IAS 37.17].

Answer 63

These principles are applied strictly in the case of an obligation to incur repairs and maintenance costs in the future, even when this expenditure is substantial, distinct from what may be regarded as routine maintenance and essential to the continuing operations of the entity, such as a major refit or refurbishment of the asset.

Answer 64

Example 27.12: Prohibition on maintenance provisions relating to owned assets Scenario 1: Re-lining costs of a furnace An entity operates a furnace, the lining of which needs to be replaced every five years for technical reasons. At the end of the reporting period, the lining has been in use for three years. In these circumstances, a provision for the cost of replacing the lining is not recognised because, at the end of the reporting period, no obligation to replace the lining exists independently of the entity’s future actions. Even the intention to incur the expenditure depends upon the entity deciding to continue operating the furnace or to replace the lining. Instead of a provision being recognised, the initial cost of the lining is treated as a significant part of the furnace asset and depreciated over a period of five years. [IAS 16.43]. The re-lining costs are then capitalised when incurred and depreciated over the next five years. [IAS 37 IE Example 11A]

Answer 65

Example 27.12: Prohibition on maintenance provisions relating to owned assets Scenario 2: Overhaul costs of an aircraft An airline is required by law to overhaul its aircraft once every three years. Even with the legal requirement to perform the overhaul, there is no obligating event until the three year period has elapsed. As with Scenario 1, no obligation exists independently of the entity’s future actions. The entity could avoid the cost of the overhaul by selling the aircraft before the three year period has elapsed. Instead of a provision being recognised, the overhaul cost is identified as a separate part of the aircraft asset under IAS 16 and is depreciated over three years. [IAS 37 IE Example 11B].

Answer 66

Entities might try to argue that a repairs and maintenance provision should be recognised on the basis that there is a clear intention to incur the expenditure at the appointed time and that this means it is more likely than not, as at the end of the reporting period, that an outflow of resources will occur. However, the application of the three principles noted above, particularly that an entity should not provide for future operating costs, make an entity’s intentions irrelevant. In the example above, recognition was not allowed because the entity could do all manner of things to avoid the obligation, including selling the asset, however unlikely that might be in the context of the entity’s business or in terms of the relative cost of replacement as compared to repair. The existence of a legal requirement, probably resulting in the aircraft being grounded, was still not enough.

Answer 67

The effect of the prohibition on setting up provisions for repairs obviously has an impact on presentation in the statement of financial position. It may not always, however, have as much impact on the statement of comprehensive income. This is because it is stated in the examples that depreciation would be adjusted to take account of the repairs. For example, in the case of the furnace lining, the lining should be depreciated over five years in advance of its expected repair. Similarly, in the case of the aircraft overhaul, the example in the standard states that an amount equivalent to the expected maintenance costs is depreciated over three years. The result of this is that the depreciation charge recognised in profit or loss over the life of the component of the asset requiring regular repair may be equivalent to that which would previously have arisen from the combination of depreciation and a provision for repair. This is the way IAS 16 requires entities to account for significant parts of an item of property, plant and equipment which have different useful lives.

Answer 68

In the normal course of business it is unlikely that provisions for staff training costs would be permissible, because it would normally contravene (breach) the general prohibition in the standard on the recognition of provisions for future operating costs. [IAS 37.18]. In the context of a restructuring, IAS 37 identifies staff retraining as an ineligible cost because it relates to the future conduct of the business. [IAS 37.81]. Example 27.2 at 3.1.1 above reproduces an example in the standard where the government introduces changes to the income tax system, such that an entity in the financial services sector needs to retrain a large proportion of its administrative and sales workforce in order to ensure continued compliance with financial services regulation.

Answer 69

The standard argues that there is no present obligation until the actual training has taken place and so no provision should be recognised. We also note that in many cases the need to incur training costs is not only future operating expenditure but also fails the ‘existing independently of an entity’s future actions’ criterion, [IAS 37.19], in that the cost could be avoided by the entity, for example, if it withdrew from that market or hired new staff who were already appropriately qualified.

Answer 70

This example again illustrates how important it is to properly understand the nature of any potential ‘constructive obligation’ or ‘obligating event’ and to determine separately its financial effect in relation to past transactions and events on the one hand and in relation to the future operation of the business on the other. Otherwise, it can be easy to mistakenly argue that a provision is required, such as for training costs to ensure that staff comply with new legal requirements, on the basis that the entity has a constructive obligation to ensure staff are appropriately skilled to adequately meet the needs of its customers. However, the obligation, constructive or not, declared or not, relates to the entity’s future conduct, is a future cost of operation and is therefore ineligible for recognition under the standard until the training takes place.

Answer 71

IAS 37 allows entities to recognise restructuring provisions, but it has specific rules on the nature of obligations and the types of cost that are eligible for inclusion in such provisions, as discussed below. These rules ensure that entities recognise only obligations that exist independently of their future actions, [IAS 37.19], and that provisions are not made for future operating costs and losses. [IAS 37.63].

Answer 72

IAS 37 defines a restructuring as ‘a programme that is planned and controlled by management, and materially changes either: (a) the scope of a business undertaken by an entity; or (b) the manner in which that business is conducted’. [IAS 37.10].

Answer 73

This is said to include: (a) the sale or termination of a line of business; (b) the closure of business locations in a country or region or the relocation of business activities from one country or region to another; (c) changes in management structure, for example, eliminating a layer of management; and (d) fundamental reorganisations that have a material effect on the nature and focus of the entity’s operations. [IAS 37.70].

Answer 74

This definition is very wide and whilst it may be relatively straightforward to establish whether an operation has been sold, closed or relocated, the determination of whether an organisational change is fundamental, material or just part of a process of continuous improvement is a subjective judgement. Whilst organisational change is a perennial feature in most business sectors, entities could be tempted to classify all kinds of operating costs as restructuring costs and thereby invite the user of the financial statements to perceive them in a different light from the ‘normal’ costs of operating in a dynamic business environment.

Answer 75

IAS 37 requires that restructuring costs are recognised only when the general recognition criteria in the standard are met, i.e. there is a present obligation (legal or constructive) as a result of a past event, in respect of which a reliable estimate can be made of the probable cost. [IAS 37.71]

Answer 76

The standard’s specific requirements for the recognition of a provision for restructuring costs seek to define the circumstances that give rise to a constructive obligation and thereby restrict the recognition of a provision to cases when an entity: (a) has a detailed formal plan for the restructuring identifying at least: (i) the business or part of a business concerned; (ii) the principal locations affected; (iii) the location, function, and approximate number of employees who will be compensated for terminating their services; (iv) the expenditures that will be undertaken; and (v) when the plan will be implemented; and

Answer 77

(b) has 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. [IAS 37.72].

Answer 78

The standard gives examples of the entity’s actions that may provide evidence that the entity has started to implement a plan, quoting the dismantling of plant or selling of assets, or the public announcement of the main features of the plan. However, it also emphasises that the public announcement of a detailed plan to restructure will not automatically create an obligation; the important principle is that the announcement is made in such a way and in sufficient detail to give rise to valid expectations in other parties such as customers, suppliers and employees that the restructuring will be carried out. [IAS 37.73]

Answer 79

The standard also suggests that for an announced plan to give rise to a constructive obligation, its implementation needs to be planned to begin as soon as possible and to be completed in a timeframe that makes significant changes to the plan unlikely. Any extended period before commencement of implementation, or if the restructuring will take an unreasonably long time, will mean that recognition of a provision is premature, because the entity is still likely to have a chance of changing the plan. [IAS 37.74]

Answer 80

The criteria set out above for the recognition of provisions mean that a board decision, if it is the only relevant event arising before the end of the reporting period, is not sufficient. This message is reinforced specifically in the standard, the argument being made that a constructive obligation is not created by a management decision. There will only be a constructive obligation where the entity has, before the end of the reporting period: (a) started to implement the restructuring plan; or (b) announced the main features of the restructuring plan to those affected by it in a sufficiently specific manner to raise a valid expectation in them that the entity will carry out the restructuring. [IAS 37.75].

Answer 81

If the restructuring is not started or announced in detail until after the end of the reporting period, no provision is recognised. Instead, the entity discloses a non-adjusting event after the reporting period. [IAS 37.75, IAS 10.22(e)].

Answer 82

Example 27.13: The effect of timing of the creation of a constructive obligation on the recognition of a restructuring provision Scenario 1: Closure of a division – no implementation before end of the reporting period. On 12 December 2019, the board of Entity A decided to close down a division. No announcement was made before the end of the reporting period (31 December 2019) and no other steps were taken to implement the decision before that date. In these circumstances, no provision is recognised because management’s actions are insufficient to create a constructive obligation before the end of the reporting period. [IAS 37 IE Example 5A].

Answer 83

Example 27.13: The effect of timing of the creation of a constructive obligation on the recognition of a restructuring provision Scenario 2: Closure of a division –communication/implementation before end of the reporting period. In another case, the board of Entity B decides on 12 December 2019 to close down one of its manufacturing divisions. On 20 December 2019 a detailed plan for closure was agreed by the board; letters were sent to customers warning them to seek an alternative source of supply and redundancy notices were sent to the staff of the division. The communication of management’s decision to customers and employees on 20 December 2019 creates a valid expectation that the division will be closed, thereby giving rise to a constructive obligation from that date. Accordingly, a provision is recognised at 31 December 2019 for the best estimate of the costs of closing the division. [IAS 37 IE Example 5B].

Answer 84

The standard acknowledges that there will be circumstances where a board decision could trigger recognition, but not on its own. Only if earlier events, such as negotiations with employee representatives for termination payments or with purchasers for the sale of an operation, have been concluded subject only to board approval would the decision of the board create an obligation. In such circumstances, it is reasoned that when board approval has been obtained and communicated to the other parties, the entity is committed to restructure, assuming all other conditions are met. [IAS 37.76].

Answer 85

In practice it can be very difficult to determine whether it is appropriate to recognise a provision for the future costs of a restructuring programme. The determination of whether an organisational change is fundamental, material or just part of a process of continuous improvement is a subjective judgement. Once it has been established that the activities in question constitute a restructuring rather than an ongoing operating cost, it can be difficult to determine whether management’s actions before the reporting date have been sufficient to have ‘raised a valid expectation in those affected’. [IAS 37.72]

Answer 86

Even if a trigger point is easily identifiable, such as the date of an appropriately detailed public announcement, it might not necessarily commit management to the whole restructuring, but only to specific items of expenditure such as redundancy costs. When the announcement is less clear, referring for example to consultations, negotiations or voluntary arrangements, particularly with employees, judgement is required. Furthermore, taken on its own, the ‘valid expectation’ test is at least as open to manipulation as one based on the timing of a board decision. Entities anxious to accelerate or postpone recognition of a liability could do so by advancing or deferring an event that signals such a commitment, such as a public announcement, without any change to the substance of their position. In these situations it is important to consider all the related facts and circumstances and not to ‘home in’ on a single recognition criterion.

Answer 87

IAS 37 has some further specific rules governing when to recognise an obligation arising on the sale of an operation, stating that no obligation arises for the sale of an operation until the entity is committed to the sale, i.e. there is a binding sale agreement. [IAS 37.78]. Thus a provision cannot be made for a loss on sale unless there is a binding sale agreement by the end of the reporting period. The standard says that this applies even when an entity has taken a decision to sell an operation and announced that decision publicly, it cannot be committed to the sale until a purchaser has been identified and there is a binding sale agreement. Until there is such an agreement, the entity will be able to change its mind and indeed will have to take another course of action if a purchaser cannot be found on acceptable terms. [IAS 37.79].

Answer 88

Even in cases where it is part of a larger restructuring that qualifies for recognition under IAS 37, an obligation arising from the sale is not recognised until there is a binding sale agreement. Instead, the assets of the operation must be reviewed for impairment under IAS 36. This may therefore mean that an expense is recorded in the income statement; it is just that the expense gives rise to a reduction of the carrying amount of assets rather than the recognition of a liability. The standard also recognises that where a sale is only part of a restructuring, the entity could be committed to the other parts of restructuring before a binding sale agreement is in place. [IAS 37.79]. Hence, the costs of the restructuring will be recognised over different reporting periods

Answer 89

Having met the specific tests in the standard for the recognition of a restructuring provision at the end of the reporting period, IAS 37 imposes further criteria to restrict the types of cost that can be provided for. Presumably these additional restrictions are intended to ensure that the entity does not contravene (breach) the general prohibition in IAS 37 against provision for future operating losses. [IAS 37.63].

Answer 90

A restructuring provision should include only the direct expenditures arising from the restructuring, which are those that are both: (a) necessarily entailed by the restructuring; and (b) not associated with the ongoing activities of the entity. [IAS 37.80].

Answer 91

The standard gives specific examples of costs that may not be included within the provision, because they relate to the future conduct of the business. Such costs include: (a) retraining or relocating continuing staff; (b) marketing; or (c) investment in new systems and distribution networks. [IAS 37.81].

Answer 92

Because these costs relate to the future conduct of the business, they are recognised on the same basis as if they arose independently of a restructuring. [IAS 37.81]. In most cases, this means that the costs are recognised as the related services are provided.

Answer 93

Example 27.14: Distinguishing restructuring costs from ongoing expenses. See OneNote example and exlanation

Answer 94

Decommissioning costs arise when an entity is required to dismantle or remove an asset at the end of its useful life and to restore the site on which it has been located, for example, when an oil rig or nuclear power station reaches the end of its economic life. Rather than allowing an entity to build up a provision for the required costs over the life of the facility, IAS 37 requires that the liability is recognised as soon as the obligation arises. This is because the construction of the asset (and the environmental damage caused by it) creates the past obligating event requiring restoration in the future. [IAS 37 IE Example 3].

Answer 95

The accounting for decommissioning costs is dealt with in IAS 37 by way of an example relating to an oil rig in an offshore oilfield. A provision is recognised at the time of constructing the oil rig in relation to the eventual costs that relate to its removal and the restoration of damage caused by building it. Additional provisions are recognised over the life of the oil field to reflect the need to reverse damage caused during the extraction of oil. [IAS 37 IE Example 3]. The total decommissioning cost is estimated, discounted to its present value and it is this amount which forms the initial provision. This ‘initial estimate of the costs of dismantling and removing the item and restoring the site’ is added to the corresponding asset’s cost. [IAS 16.16]. Thereafter, the asset is depreciated over its useful life, while the discounted provision is progressively unwound, with the unwinding charge shown as a finance cost.

Answer 96

The effect of discounting on the statement of comprehensive income is to split the cost of the eventual decommissioning into two components: an expense based on the present value of the expected future cash outflows; and a finance element representing the unwinding of the discount. The overall effect is to produce a rising pattern of cost over the life of the facility, often with much of the total cost of the decommissioning classified as a finance cost

Answer 97

IAS 37 requires provisions to be revised annually to reflect the current best estimate of the provision. [IAS 37.59]. However, the standard gives no guidance on accounting for changes in the decommissioning provision. Similarly, IAS 16 is unclear about the extent to which an item’s carrying amount should be affected by changes in the estimated amount of dismantling and site restoration costs that occur after the estimate made upon initial measurement.

Answer 98

IFRIC 1 applies to any decommissioning, restoration or similar liability that has been both included as part of the cost of an asset measured in accordance with IAS 16 or as part of the cost of a right-of-use asset in accordance with IFRS 16 and recognised as a liability in accordance with IAS 37. [IFRIC 1.2]

Answer 99

It addresses how the effect of the following events that change the measurement of an existing decommissioning, restoration or similar liability should be accounted for: (a) a change in the estimated outflow of resources embodying economic benefits (e.g. cash flows) required to settle the obligation; (b) a change in the current market-based discount rate (this includes changes in the time value of money and the risks specific to the liability); and (c) an increase that reflects the passage of time (also referred to as the unwinding of the discount). [IFRIC 1.3].

Answer 100

IFRIC 1 requires that (c) above, the periodic unwinding of the discount, is recognised in profit or loss as a finance cost as it occurs. [IFRIC 1.8]. For a change caused by (a) or (b) above, however, the adjustment is taken to the income statement only in specific circumstances. Any revision to the provision (other than to reflect the passage of time) is first recognised in the carrying value of the related asset or in other comprehensive income, depending on whether the asset is measured at cost or using the revaluation model. [IFRIC 1.4-7].

Answer 101

If the related asset is measured using the cost model, the change in the liability should be added to or deducted from the cost of the asset to which it relates. Where the change gives rise to an addition to cost, the entity should consider the need to test the new carrying value for impairment. This is particularly relevant for assets approaching the end of their useful life, as their remaining economic benefits are often small compared to the potential changes in the related decommissioning liability. Reductions over and above the remaining carrying value of the asset are recognised immediately in profit or loss. [IFRIC 1.5]. The adjusted depreciable amount of the asset is then depreciated prospectively over its remaining useful life. [IFRIC 1.7].

Answer 102

Example 27.17: Changes in decommissioning costs – related asset measured at cost. See OneNote for exaplanation.

Answer 103

If the related asset is measured using the revaluation model, changes in the liability alter the revaluation surplus or deficit previously recognised for that asset. Decreases in the provision are recognised in other comprehensive income and increase the value of the revaluation surplus in respect of the asset, except that: (a) a decrease in the provision should be recognised in profit or loss to the extent that it reverses a previous revaluation deficit on that asset that was recognised in profit or loss; and (b) if a decrease in the provision exceeds the carrying amount of the asset that would have been recognised under the cost model, the excess should be recognised in profit or loss. [IFRIC 1.6].

Answer 104

Increases in the provision are recognised in profit or loss, except that they should be recognised in other comprehensive income, and reduce the revaluation surplus, to the extent of any credit balance existing in the revaluation surplus in respect of that asset. Changes in the provision might also indicate the need for the asset (and therefore all assets in the same class) to be revalued. [IFRIC 1.6].

Answer 105

Example 27.18: Changes in decommissioning costs – related asset carried at revaluation amount.

Answer 106

IAS 37 is unclear whether a new discount rate should be applied during the year or just at the year-end, and whether the rate should be applied to the new estimate of the provision or the old estimate. Although IFRIC 1 requires that changes in the provision resulting from a change in the discount rate is added to, or deducted from, the cost of the related asset in the current period, it does not deal specifically with these points. However, Example 1 in the illustrative examples to IFRIC 1 indicates that a change in discount rate would be accounted for in the same way as other changes affecting the estimate of a provision for decommissioning, restoration and similar liabilities. That is, it is reflected as a change in the liability at the time the revised estimate is made and the new estimate is discounted at the revised discount rate from that point on. [IFRIC 1.IE5].

Answer 107

When accounting for revalued assets to which decommissioning liabilities attach, the illustrative example in IFRIC 1 states that it is important to understand the basis of the valuation obtained. For example: (a) if an asset is valued on a discounted cash flow basis, some valuers may value the asset without deducting any allowance for decommissioning costs (a ‘gross’ valuation), whereas others may value the asset after deducting an allowance for decommissioning costs (a ‘net’ valuation), because an entity acquiring the asset will generally also assume the decommissioning obligation. For financial reporting purposes, the decommissioning obligation is recognised as a separate liability, and is not deducted from the asset. Accordingly, if the asset is valued on a net basis, it is necessary to adjust the valuation obtained by adding back the allowance for the liability, so that the liability is not counted twice

Answer 108

(b) if an asset is valued on a depreciated replacement cost basis, the valuation obtained may not include an amount for the decommissioning component of the asset. If it does not, an appropriate amount will need to be added to the valuation to reflect the depreciated replacement cost of that component. [IFRIC 1.IE7].

Answer 109

The scope of IFRIC 1 is set out in terms of any existing decommissioning, restoration or similar liability that is both recognised as part of the cost of the asset under IAS 16 or as part of the cost of a right-of-use asset in accordance with IFRS 16; and recognised as a liability in accordance with IAS 37. [IFRIC 1.2]. The Interpretation does not address the treatment of obligations arising after the asset has been constructed, for example as a result of changes in legislation. [IFRIC 1.BC23]. Nevertheless, in our opinion the cost of the related asset should be measured in accordance with the principles set out in IFRIC 1 regardless of whether the obligation exists at the time of constructing the asset or arises later in its life.

Answer 110

IAS 16 makes no distinction in principle between the initial costs of acquiring an asset and any subsequent expenditure upon it. In both cases any and all expenditure has to meet the recognition rules, and be expensed in profit or loss if it does not. IAS 16 states that the cost of an item of property, plant and equipment includes ‘the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period.’ [IAS 16.16(c)].

Answer 111

For example, the introduction of new legislation to require the clean-up of sites that cease to be used as gasoline filling stations would give rise to the recognition of a decommissioning provision and, to the extent that the clean-up obligation arose as a result of the construction of the filling stations, an increase in the carrying value of the properties. Similarly, IFRS 16 states that the cost of a right-of-use asset includes ‘an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories. The lessee incurs the obligation for those costs either at the commencement date or as a consequence of having used the underlying asset during a particular period.’ [IFRS 16.24(d)].

Answer 112

Both IAS 16 and IFRS 16 require an entity to apply IAS 2 to the costs of obligations for dismantling, removing and restoring the site on which an item is located that are incurred during a particular period as a consequence of having used the item to produce inventories during that period. [IAS 16.18, IFRS 16.25]. For example, the cost of restoring the site of a quarry would be reflected as part of the cost of the aggregate extracted from it, and not added to the carrying value of the site. Accordingly, if an entity previously had no obligation to restore the site and new legislation was introduced after 25% of the site had been excavated and 80% of that output had been sold, then 80% of the new estimate of the restoration cost would be expensed; 20% added to the cost of inventory; and none added to the carrying value of the site.

Answer 113

Environmental provisions – general guidance in IAS 37 The standard illustrates its recognition requirements in two examples relating to environmental provisions. The first deals with the situation where it is virtually certain that legislation will be enacted which will require the clean-up of land already contaminated. In these circumstances, the virtual certainty of new legislation being enacted means that the entity has a present legal obligation as a result of the past event (contamination of the land), requiring a provision to be recognised. [IAS 37 IE Example 2A].

Answer 114

However, in its discussion about what constitutes an obligating event, the standard notes that ‘differences in circumstances surrounding enactment make it impossible to specify a single event that would make the enactment of a law virtually certain. In many cases, it will be impossible to be virtually certain of the enactment of a law until it is enacted.’ [IAS 37.22]

Answer 115

The second example deals with a similar situation, except that the entity is not expected to be legally required to clean it up. Nevertheless, the entity has a widely publicised environmental policy undertaking to clean up all contamination that it causes, and has a record of honouring this policy. In these circumstances a provision is still required because the entity has created a valid expectation that it will clean up the land, meaning that the entity has a present constructive obligation as a result of past contamination. [IAS 37 IE Example 2B]

Answer 116

It is therefore clear that where an entity causes environmental damage and has a present legal or constructive obligation to make it good; it is probable that an outflow of resources will be required to settle the obligation; and a reliable estimate can be made of the amount, a provision will be required. [IAS 37.14]

Answer 117

Warranty provisions are specifically addressed in one of the examples appended to IAS 37. However, as noted at 2.2.1.B above, an entity would apply IFRS 15 to separately purchased warranties and to those warranties determined to provide the customer with a service in addition to the assurance that the product complies with agreed-upon specifications. Only if a customer does not have the option to purchase a warranty separately and the warranty is determined only to provide assurance that the product complies with agreed-upon specifications would an entity consider IAS 37. [IFRS 15.B30]

Answer 118

Example 27.22: Recognition of a provision for warranty costs A manufacturer gives warranties at the time of sale to purchasers of its product. Under the terms of the contract for sale, the manufacturer undertakes to make good, by repair or replacement, manufacturing defects that become apparent within three years from the date of sale. On past experience, it is probable (i.e. more likely than not) that there will be some claims under the warranties. In these circumstances the obligating event is the sale of the product with a warranty, which gives rise to a legal obligation. Because it is more likely than not that there will be an outflow of resources for some claims under the warranties as a whole, a provision is recognised for the best estimate of the costs of making good under the warranty for those products sold before the end of the reporting period. [IAS 37 IE Example 1]

Answer 119

The assessment of the probability of an outflow of resources is made across the population as a whole, and not using each potential claim as the unit of account. [IAS 37.24]. On past experience, it is probable that there will be some claims under the warranties, so a provision is recognised

Answer 120

The assessment over the class of obligations as a whole makes it more likely that a provision will be recognised, because the probability criterion is considered in terms of whether at least one item in the population will give rise to a payment. Recognition then becomes a matter of reliable measurement and entities calculate an expected value of the estimated warranty costs. IAS 37 discusses this method of ‘expected value’ and illustrates how it is calculated in an example of a warranty provision. [IAS 37.39]

Answer 121

Although future operating losses in general cannot be provided for, IAS 37 requires that ‘if an entity has a contract that is onerous, the present obligation under the contract shall be recognised and measured as a provision’. [IAS 37.66].

Answer 122

The standard notes that many contracts (for example, some routine purchase orders) can be cancelled without paying compensation to the other party, and therefore there is no obligation. However, other contracts establish both rights and obligations for each of the contracting parties. Where events make such a contract onerous, the contract falls within the scope of the standard and a liability exists which is recognised. Executory contracts that are not onerous fall outside the scope of the standard. [IAS 37.67]

Answer 123

IAS 37 defines an onerous contract as ‘a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it’. [IAS 37.10]. This requires that the contract is onerous to the point of being directly loss-making, not simply uneconomic by reference to current prices

Answer 124

IAS 37 considers that ‘the unavoidable costs under a contract reflect the least net cost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it’. [IAS 37.68]. This evaluation does not require an intention by the entity to fulfil or to exit the contract. It does not even require there to be specific terms in the contract that apply in the event of its termination or breach. Its purpose is to recognise only the unavoidable costs to the entity, which in the absence of specific clauses in the contract relating to termination or breach could include an estimation of the cost of ceasing to honour the contract and having the other party go to court for compensation for the resultant breach.

Answer 125

A provision is recognised at the lower of: ๏ Present value of continuing under the contract, and ๏ Present value of exiting the contract

Answer 126

Study amendment 2020 regarding onerouse contract.

Answer 127

For each class of provision an entity should provide a reconciliation of the carrying amount of the provision at the beginning and end of the period showing: (a) additional provisions made in the period, including increases to existing provisions; (b) amounts used, i.e. incurred and charged against the provision, during the period; (c) unused amounts reversed during the period; and (d) the increase during the period in the discounted amount arising from the passage of time and the effect of any change in the discount rate. Comparative information is not required. [IAS 37.84].

Answer 128

In addition, for each class of provision an entity should disclose the following: (a) a brief description of the nature of the obligation and the expected timing of any resulting outflows of economic benefits; (b) an indication of the uncertainties about the amount or timing of those outflows. Where necessary to provide adequate information, an entity should disclose the major assumptions made concerning future events. This refers to future developments in technology and legislation and is of particular relevance to environmental liabilities; and (c) the amount of any expected reimbursement, stating the amount of any asset that has been recognised for that expected reimbursement. [IAS 37.85].

Answer 129

Unless the possibility of any outflow in settlement is remote, IAS 37 requires the disclosure for each class of contingent liability at the end of the reporting period to include a brief description of the nature of the contingent liability, and where practicable: (a) an estimate of its financial effect, measured in accordance with paragraphs 36-52 of IAS 37; (b) an indication of the uncertainties relating to the amount or timing of any outflow; and (c) the possibility of any reimbursement. [IAS 37.86]. Where any of the information above is not disclosed because it is not practicable to do so, that fact should be stated. [IAS 37.91].

Answer 130

IAS 37 requires disclosure of contingent assets where an inflow of economic benefits is probable. The disclosures required are: (a) a brief description of the nature of the contingent assets at the end of the reporting period; and (b) where practicable, an estimate of their financial effect, measured using the principles set out for provisions in paragraphs 36-52 of IAS 37. [IAS 37.89].

Answer 131

Where any of the information above is not disclosed because it is not practicable to do so, that fact should be stated. [IAS 37.91]. The standard goes on to emphasise that the disclosure must avoid giving misleading indications of the likelihood of income arising. [IAS 37.90].

IAS 37 : Provisions, Contingent Liabilities and Contingent Assets Flashcards

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