Under IAS 37, Provisions, Contingent Liabilities, and Contingent Assets, those liabilities for which amount or timing of expenditure is uncertain are deemed to be “provisions”. IAS 37 provides a comprehensive definition of the term “provision”
It mandates, in a clear-cut manner, that a provision should be recognized only if: (1) The entity has a present obligation [legal or constructive] as a result of a past event; (2) It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and (3) A reliable estimate can be made of the amount of the obligation.
Explanations and Clarifications of IAS 37
Many reserves found in financial statements in days past are clearly not permitted under IFRS. IAS 37 offers in-depth guidance on the topic of provisions. The Standard explains each of the key words in the definition of the term “provision” in detail. Explanations and clarifications offered by the Standard are summarized below:
- Present obligation -The Standard opines that in almost all cases, it will be clear when a present obligation exists. The notion of an obligation in the Standard includes not only a legal obligation (e.g., deriving from a contract or legislation) but also a constructive obligation. It explains that a constructive obligation exists when the entity from an established pattern of past practice or stated policy has created a valid expectation that it will accept certain responsibilities.
- Past event – There must be some past event that has triggered the present obligation—an accidental oil spill, for example. An accounting provision cannot be created in anticipation of a future event. The entity must also have no realistic alternative to settling the obligation caused by the event.
- Probable outflow of resources embodying economic benefits – For a provision to qualify for recognition, it is essential that it is not only a present obligation of the reporting entity, but also it should be probable that an outflow of resources embodying benefits used to settle the obligation will in fact result. For the purposes of this Standard, “probable” is defined as “more likely than not.” A footnote to the Standard states that this interpretation of the term “probable” does not necessarily apply to other IAS.
- Reliable estimate of the obligation – The Standard recognizes that using estimates is common in the preparation of financial statements and suggest that by using a range of possible outcomes, an entity usually will be able to make an estimate of the obligation that is sufficiently reliable to use in recognizing a provision. Where no reliable estimate can be made, though, no liability is recognized.
Other Features of Provisions Under IAS 37
There are twelve other salient features of provisions explained by IAS 37, as discussed next. Read on…
For all estimated liabilities that are included within the definition of provisions, the amount to be recorded and presented on the statement of financial position should be the best estimate, at the statement of financial position date, of the amount of expenditure that will be required to settle the obligation. Often this is referred to as the “expected value” of the obligation, which may be defined operationally as the amount the entity would pay, currently, either to settle the actual obligation or to provide consideration to a third party to assume it (e.g., as a single-occurrence insurance premium).
For estimated liabilities comprised of large numbers of relatively small, similar items, weighting by probability of occurrence can be used to compute the aggregate expected value; this is often used to compute accrued warranty reserves, for example. For those estimated liabilities consisting of only a few (or a single) discrete obligations, the most likely outcome may be used to measure the liability when there is a range of outcomes having roughly similar probabilities; but if possible outcomes include amounts much greater (and lesser) than the most likely, it may be necessary to accrue a larger amount if there is a significant chance that the larger obligation will have to be settled—even if that is not the most likely outcome as such.
The concept of “expected value” can be best explained through a numeric illustration below.
Example Of Provision For Warranty Claims
Lie Dharma Company manufactures and sells pinball machines under warranty. Customers are entitled to refunds if they return defective machines with valid proof of purchase. Lie Dharma estimates that if all machines sold and still in warranty had major defects, total replacement costs would equal $1,000,000; if all those machines suffered from minor defects, the total repair costs would be $500,000. Lie Dharma’s past experience, however, suggests that only 10% of the machines sold will have major defects and that another 30% will have minor defects. Based on this information, the expected value of the product warranty costs to be accrued at year-end would be computed as expected value of the cost of refunds:
Resulting from major defects:
$1,000,000 × 0.10 = $100,000
Resulting from minor defects:
$ 500,000 × 0.30 = 150,000
No defects: $ 0 × 0.60 = —
Total = $250,000
. Risk and Uncertainties
The “risks and uncertainties” surrounding events and circumstances should be taken into account in arriving at the best estimate of a provision. However, as pointedly noted by the Standard, uncertainty should not be used to justify the creation of excessive provisions or a deliberate overstatement of liabilities.
. The Use of Discounting Or Present Value
The Standard also addresses the use of present values or discounting (i.e., recording the estimated liability at present value, after taking into account the time value of money). Discounting is required when the effect would be material, but it can be ignored if immaterial in effect. Thus, provisions estimated to be due farther into the future will have more need to be discounted than those due currently. As a practical matter, all but trivial provisions should be discounted unless the timing is unknown (which makes discounting a computational impossibility).
IAS 37 clarifies that the discount rate applied should be consistent with the estimation of cash flows (i.e., if cash flows are projected in nominal terms). That is, if the estimated amount expected to be paid out reflects whatever price inflation is anticipated to occur between the statement of financial position date and the date of ultimate settlement of the estimated obligation, then a nominal discount rate should be used.
. Future Events That May Affect The Amount Required
Future events that may affect the amount required to settle an obligation should be reflected in the provision amount where there is sufficient objective evidence that such future events will in fact occur. For example, if an entity believes that the cost of cleaning up a plant site at the end of its useful life will be reduced by future changes in technology, the amount recognized as a provision for cleanup costs should reflect a reasonable estimate of cost reduction resulting from any anticipated technological changes. In many instances, however, making such estimates will not be possible.
. Changes In Decommissioning Provisions
IFRIC 1 mandates that changes in decommissioning provisions should be recognized prospectively (i.e., by amending future depreciation charges).
. Gains From Expected Disposals Of Assets
Gains from expected disposals of assets should not be taken into account in arriving at the amount of the provision (even if the expected disposal is closely linked to the event giving rise to the provision).
. Reimbursements By Other Parties
Reimbursements by other parties should be taken into account when computing the provision only if it is virtually certain that the reimbursement will be received.
. Changes In Provisions
Changes in provisions should be considered at each statement of financial position date, and provisions should be adjusted to reflect the current best estimate. If upon review it appears that it is no longer probable that an outflow of resources embodying economics will be required to settle the obligation, then the provision should be reversed through current period results of operations.
. Expense That Was Originally Recognized For Other Purpose
Use of provision is to be restricted to the purpose for which it was recognized originally. A reserve for plant dismantlement, for example, cannot be used to absorb environmental pollution claims or warranty payments. If an expense is set against a provision that was originally recognized for another purpose, it would camouflage the impact of the two different events, distorting income performance and possibly constituting financial reporting fraud.
. Provisions For Future Operating Losses
Provisions for future operating losses should not be recognized. This is explicitly proscribed by the Standard, since future operating losses do not meet the definition of a liability at the statement of financial position date (as defined in the Standard) and the general recognition criteria set forth in the Standard.
. Present Obligations Under Onerous Contracts
Present obligations under onerous contracts should be recognized and measured as a provision. The Standard introduces the concept of onerous contracts, which it defines as contracts under which the unavoidable costs of satisfying the obligations exceed the economic benefits expected. Executory contracts that are not onerous do not fall within the purview of this Standard. In other words, the expected negative implications of such contracts (executory contracts that are not onerous) cannot be recognized as a provision.
The Standard mandates that unavoidable costs under a contract represent the “least net costs of exiting from the contract”. Such unavoidable costs should be measured at the lower of:
- The cost of fulfilling the contract; or
- Any compensation or penalties arising from failure to fulfill the contract.
. Provisions For Restructuring Costs
Provisions for restructuring costs are recognized only when the general recognition criteria for provisions are met. A constructive obligation to restructure arises only when an entity has a detailed formal plan for the restructuring which identifies at least: the business or the part of the business concerned, principal locations affected, approximate number of employees that would need to be compensated for termination resulting from the restructuring (along with their function and location), expenditure that would be required to carry out the restructuring, and information as to when the plan is to be implemented.
Furthermore, the recognition criteria also require that the entity should have raised a valid expectation among those affected by the restructuring that it will, in fact, carry out the restructuring by starting to implement that plan or announcing its main features to those affected by it. Thus, until both the conditions just mentioned are satisfied, a restructuring provision cannot be made based upon the concept of constructive obligation. In practice, given the strict criteria of IAS 37, restructuring costs are more likely to become recognizable when actually incurred in a subsequent period.
Only direct expenditures arising from restructuring should be provided for. Such direct expenditures should be both necessarily incurred for the restructuring and not associated with the ongoing activities of the entities. Thus, a provision for restructuring would not include such costs as cost of retraining or relocating the entity’s current staff members or costs of marketing or investments in new systems and distribution networks (such expenditures are categorically disallowed by the Standard, as they are considered to be expenses relating to the future conduct of the business of the entity and thus are not liabilities relating to the restructuring program).
Also, identifiable future operating losses up to the date of an actual restructuring are not to be included in the provision for a restructuring (unless they relate to an onerous contract). Furthermore, in keeping with the general measurement principles relating to provisions outlined in the Standard, the specific guidance in IAS 37 relating to restructuring prohibits taking into account any gains on expected disposal of assets in measuring a restructuring provision, even if the sale of the assets is envisaged as part of the restructuring.
A management decision or a board resolution to restructure taken before the statement of financial position date does not automatically give rise to a constructive obligation at the statement of financial position date unless the entity has, before the statement of financial position date, either started to implement the restructuring plan or announced the main features of the restructuring plan to those affected by it in a sufficiently specific manner such that a valid expectation is raised in them (i.e., that the entity will in fact carry out the restructuring and that benefits will be paid to them).
Examples of events that may fall within the definition of restructuring are:
- A fundamental reorganization of an entity that has a material effect on the nature and focus of the entity’s operations;
- Drastic changes in the management structure—for example, making all functional units autonomous;
- Removing the business to a more strategic location or place by relocating the headquarters from one country or region to another; and
- The sale or termination of a line of business (if certain other conditions are satisfied, such that a restructuring could be considered a discontinued operation under IFRS 5).
Restructuring Provision Example
Lie Dharma Company acquired all of LDP Corporation’s assets and liabilities by issuing 20,000 shares of its $4 par value common stock on January 1, 2008. At that date, Lie Dharma shares were selling at $11 per share. Fair values assigned to LDP Corporation’s identifiable assets and liabilities were $450,000 and $320,000, respectively. Accordingly, the amount of goodwill arising on acquisition is $90,000 (=$220,000 – $130,000). On that date Lie Dharma Company decided to create a restructuring provision of $50,000 for future restructuring activities related to LDP. The company recorded this provision with a debit of $50,000 to increase the amount assigned to goodwill and a credit of $50,000 to the restructuring provision account.
As a result, since the restructuring provision is recorded against goodwill, an expense for the restructuring will never be recorded and will never affect company’s profit. Consequently, the creation of this provision protected Lie Dharma’s future profits.