IAS 37 Provisions – best estimate and timely recognition

IAS 37 Provisions are liabilities of uncertain timing or amount

A provision is recognised for a legal or constructive obligation arising from a past event, if there is a probable outflow of resources and the amount can be estimated reliably. ‘Probable’ in this context means more likely than not. A ‘constructive obligation’ arises when an entity’s actions create valid expectations of third parties that it will accept and discharge certain responsibilities.

To better understand the nature of the financial reporting line ‘Provisions’ a comparison is made with other liabilities and contingent liabilities. From their nature provisions are more or less in between other liabilities (quite certain) and contingent liabilities (more uncertain). But first an introduction to IAS 37 in the context of IFRS Reporting in Financial Statements.

Definition and recognition

A ‘provision’ is a liability of uncertain timing or amount. A provision is recognised when:

• there is a legal or constructive obligation arising from past events, or when it is more likely than not that a legal or constructive obligation has arisen from a past event;
• it is more likely than not that there will be an outflow of benefits; and
• the amount can be estimated reliably. [par 10, par 14–16, par 23]

Possible new legislation gives rise to a legal obligation when it is virtually certain to be enacted. However, in many cases it is not possible to be virtually certain that the legislation will be enacted before actual enactment. [par 22]

A constructive obligation arises when an entity, by past practice or sufficiently specific communication to affected parties, has created a valid expectation in other parties that it will carry out an action. A management or board decision alone (e.g. to restructure) does not give rise to a constructive obligation; see below for decommissioning and  termination benefits. [par 10, par 75]

An entity may be subject to penalties only if obligating events are detected.

• In general, if an entity is obliged to self-report obligating events, then the detection risk (i.e. the possibility that the event will not be detected) should not be considered when measuring the obligation. Examples of events that generally require self-reporting include, but are not limited to, taxes (see Income taxes) and, in some countries, environmental contamination.
• When self-reporting is not required and there is uncertainty about the amount of an obligation in respect of a past event, then in general it may be appropriate to consider detection risk in measuring the provision (i.e. the possibility that the event will not be detected). [IFRIC 23.8]

An entity may be involved in a dispute, in which the existence of a liability is uncertain, and be required to make a payment pending resolution of the case or may choose to do so to avoid interest charges – e.g. in a dispute with a tax authority about an uncertain levy in the scope of the provisions standard. Such a payment meets the definition of an asset.

If the existence of an obligation depends on the future actions of the entity, then a provision is not recognised until the obligation is unavoidable. [par 19]

Generally, a provision cannot be recognised for expenses to be incurred in a future period or future operating losses, with the exception of qualifying restructuring costs and onerous contracts (see below). [par 18, par 63, par 66]

A provision for restructuring costs is not recognised until there is a formal plan and details of the restructuring have been communicated to those affected by the plan. [par 71–72]

Measurement of provisions

The amount recognised as a provision is the best estimate of the expenditure to be incurred. [par 36]

If the provision is being made for a large population of items, such as for product warranties, then the provision is measured at its expected value, which considers all possible outcomes weighted based on their probabilities. [par 39]

If there is a continuous range of possible outcomes in which each value is as likely as any other, then the provision is measured at the mid-point of the range. [IAS 37.39]

If a single obligation is being measured and the possible outcomes are mostly higher (or mostly lower) than the single most likely outcome, then the amount provided for will be higher (lower) than the single most likely outcome. [par 40]

In general, when a provision is measured at its best estimate, which is less than the amount that could be payable, the difference between the two amounts is not a contingent liability, and there is no requirement to disclose the possible additional obligation. [IAS 1.125, IAS 37.85(b)]

IFRS does not provide much guidance on the types of costs to be included in the measurement of a provision. In general, anticipated incremental costs that are related directly to the settlement of a provision should be included in the measurement of the provision to the extent that a third party who assumes the liability would require compensation. This is likely to be the case if the incremental costs are probable and can be estimated reliably. Therefore, we believe that costs that are not incremental should not be included in the measurement of a provision, even if there is a reasonable basis for allocating a portion of these costs to the settlement of the provision. [IAS 37.18, IAS 37.36–37]

If the effect is material, then the estimate of a provision is discounted at a pre-tax rate that reflects the time value of money and the risks specific to the liability, even if the timing of the outflows is not fixed or determinable. Risk is reflected by adjusting either the cash flows or the discount rate. The rate of return on assets set aside to fund an obligation is not used to discount the provision. [IAS 37.45, IAS 37.47]

Provisions are remeasured at each reporting date based on the best estimate of the expenditure to be incurred, and for changes in interest rates. [IAS 37.36, IAS 37.59, IFRIC 1.4]

Future events are reflected in measuring a provision if there is sufficient objective evidence that they will occur. For example, a technological development that would make decommissioning less expensive is considered if there is evidence that the new technology will be available. [IAS 37.48–49]

Gains from the expected disposal of assets are not considered in measuring a provision. [IAS 37.51]

Reimbursements of provisions

Reimbursements (e.g. insurance recoveries, indemnities or warranty claims) are recognised as a separate asset when recovery is virtually certain. The amount recognised is limited to the amount of the related provision. Changes in the amount of a reimbursement right are recognised in profit or loss. [IAS 37.53]

Restructuring

A ‘restructuring’ (or variations of such word such as reorganisation), is a programme planned and controlled by management that significantly changes the scope of the business or the manner in which it is conducted. [IAS 37.10]

Recording a provision for restructuring (parts) of a business is a rather precise and therefor sensitive accounting process, although the provision ultimately recorded remains a best estimate. This is primarily a result of the misuse of such previsions in the past (new management started with setting up a provision for a restructuring, but later conclude it could be (largely or partly) reversed.

A constructive obligation (a strictly defined IFRS term – so there is no way back!) for a restructuring arises only when:

• there is a formal plan for the restructuring specifying:
  • the business or part of a business concerned;
  • the principal locations affected;
  • the location, function and approximate number of employees whose services will be terminated;
  • the expenditure to be incurred; and
  • when the plan will be implemented; and
• the entity has raised a valid expectation in those affected that it will carry out the plan by either:
  • starting to implement the plan; or
  • announcing its main features to those affected by it. [IAS 37.72]

Implementation of the plan should begin as soon as possible and be completed in a time frame that makes significant changes unlikely. [IAS 37.74]

IFRS do not specifically address provisions for contract termination costs. However, an obligating event that results in an entity having no realistic alternative to settling the obligation is provided for as an onerous contract – e.g. a service contract under which the entity will continue to incur costs for its remaining term without economic benefit.

Restructuring provisions include only incremental costs associated directly with the restructuring. [IAS 37.80]

IFRS Standards prohibit the recognition of a provision for costs associated with ongoing activities. [IAS 37.80(b), IAS 37.81]

Decommissioning or restoration

The cost of property, plant and equipment includes the estimated cost of dismantling and removing the asset and restoring the site (decommissioning or restoration) to the extent that such cost is recognised as a provision (see above). [IAS 16.16(c)]

Decommissioning costs comprise liabilities incurred during the period of use for purposes other than producing inventory. Decommissioning or restoration costs related to the production of inventory are included in the cost of inventory. [IAS 16.16(c), IAS 16.18, IFRIC 1.5(a)]

If an entity uses the cost model for the subsequent measurement of property, plant and equipment, then any changes to an existing decommissioning or restoration obligation (other than changes related to the unwinding of the discount) are added to or deducted from the cost of the related asset, and are depreciated prospectively over the asset’s useful life. However, the amount deducted from the cost of the asset cannot exceed its carrying amount; any excess is recognised immediately in profit or loss. [IFRIC 1.5]

The remeasurement of a decommissioning or restoration provision includes the effect of changes in interest rates (see above). [IFRIC 1.3]

Under the revaluation model, changes in a liability for decommissioning or restoration (other than changes related to the unwinding of the discount) are recognised in the same way as a revaluation (see below), unless the change would reduce the depreciated cost of the asset to below zero. [IFRIC 1.6]

Termination benefits

Although part of IAS 19 Employee benefits, termination benefits are many times an integral part of a reorganisation provision. So keep in mind IAS 19 is written from the perspective on one termination of an employment contract of one person.

‘Termination benefits’ are those benefits provided in exchange for termination of an employee’s employment as a result of either an entity’s decision to terminate that employment before the normal retirement date or an employee’s decision to accept an offer of benefits in exchange for termination (see above). [IAS 19.8, IAS 19.159]

An obligation for termination benefits is regarded as arising from the termination and not from the employee’s service. An entity recognises a  liability and an expense for termination benefits at the earlier of:

• when it recognises costs for a restructuring in the scope of the provisions standard that includes the payment of termination benefits; and
• when it can no longer withdraw the offer of those benefits. [IAS 19.165]

The entity can no longer withdraw the offer (this is the same as the above mentioned constructive obligation) when it has communicated to the affected employees a plan of termination meeting all of the following criteria:

• actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made;
• the plan identifies:
  • the number of employees whose employment is to be terminated;
  • their job classifications or functions and their locations (although the plan need not identify these for individual employees); and
  • the expected completion date; and
• the plan establishes the termination benefits that employees will receive in sufficient detail so that employees can determine the type and amount of benefits they will receive when their employment is terminated. [IAS 19.167]

If the termination benefits are payable as the result of an employee’s decision to accept an offer of benefits (or in a reorganisation the acceptance of an offer by a work council, labor union or other employee representation group) in exchange for the termination of employment – i.e. to take voluntary redundancy – then the entity can no longer withdraw the offer of termination benefits at the earlier of:

• when the employee accepts the offer; and
• when a restriction (such as a legal, regulatory or contractual requirement) on the entity’s ability to withdraw the offer takes effect. [IAS 19.166]

Under IFRS Standards, if the benefit is conditional on future services being provided, then it is not a termination benefit. [IAS 19.162]

Termination benefits are measured in accordance with the nature of the employee benefit provided:

• if they are provided as an enhancement to a post-employment benefit, then an entity applies the requirements for post-employment benefits, except that the requirements for the attribution of benefits are not relevant;
• if they are expected to be settled wholly before 12 months after the end of the annual reporting period in which the termination benefit is recognised, then an entity applies the requirements for short-term employee benefits; and
• if they are not expected to be settled wholly before 12 months after the annual reporting date, then an entity applies the requirements for other long-term employee benefits. [IAS 19.169–170]

Provisions and other liabilities

Provisions can be distinguished from other liabilities such as trade payables and accruals because there is uncertainty about the timing or amount of the future expenditure required in settlement. By contrast:

1. trade payables are liabilities to pay for goods or services that have been received or supplied and have been invoiced or formally agreed with the supplier; and
2. accruals are liabilities to pay for goods or services that have been received or supplied but have not been paid, invoiced or formally agreed with the supplier, including amounts due to employees (for example, amounts relating to accrued vacation pay). Although it is sometimes necessary to estimate the amount or timing of accruals, the uncertainty is generally much less than for provisions.

Accruals are often reported as part of trade and other payables, whereas provisions are reported separately.

Provisions and contingent liabilities

In a general sense, all provisions are contingent because they are uncertain in timing or amount. However, in this case the term ‘contingent’ is used for liabilities that are not recognised because their 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. In addition, the term ‘contingent liability’ is used for liabilities that do not meet the recognition criteria.

Therefore the standard distinguishes between:

1. provisions – which are recognised as liabilities (assuming that a reliable estimate can be made) because they are present obligations and it is probable that an outflow of resources embodying economic benefits will be required to settle the obligations; and
2. contingent liabilities – which are not recognised as liabilities because they are either:
   1. possible obligations, as it has yet to be confirmed whether the entity has a present obligation that could lead to an outflow of resources embodying economic benefits;
   2. present obligations that do not meet the recognition criteria in this Standard (because either it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation, or a sufficiently reliable estimate of the amount of the obligation cannot be made).

The valuation of provisions includes discounting and fair value based measurements. Provisions are discounted if the effect of discounting is material. IFRS does not specifically address provisions for contract termination costs. Provisions are not recognised for repairs or maintenance of own assets or for self-insurance before an obligation is incurred.

Provisions are remeasured at each reporting date based on the best estimate of the expenditure to be incurred, and for changes in interest rates. [IAS 37 36, IAS 37 59]

Some specific types of provisions

• Termination benefits
  A termination benefit liability is recognised when the entity can no longer withdraw the offer of those benefits (IAS 19 165) – additional guidance is provided on when this date occurs in relation to an employee’s decision to accept an offer of benefits on termination, and as a result of an entity’s decision to terminate an employee’s employment or when the entity recognises costs for a restructuring under IAS 37 which involves the payment of termination benefits. Termination benefits are measured in accordance with the nature of employee benefit, i.e. as an enhancement of other post employment benefits, or otherwise as a short-term employee benefit or other long-term employee benefit.
• Restructuring provisions
  Restructuring provisions are recognised only when the general recognition criteria for provision are met. A constructive restructuring obligation arises only when there is a detailed formal plan identifying the main features of restructuring and a valid expectation in those affected that the entity will carry out the restructuring by starting to implement the plan or announcing its main features to those affected. Restructuring provisions include only incremental costs associated directly with the restructuring. [IAS 37 80]
• Contingent liabilities
  IAS 37 also deals with contingencies, since there is a common ground as regards liabilities that are uncertain. It requires that entities disclose contingent liabilities, unless the possibility of an outflow of economic resources is remote. Where it is not probable that a present obligation exists, an entity discloses a contingent liability, unless the possibility of an outflow of resources embodying economic benefits is remote.
• Accounting for refunds
  Assuming that the revenue recognition criteria are met, a past practice or published policy of giving refunds to dissatisfied customers creates a constructive obligation; the obligating event is the sale of the product. If it is probable that a certain portion of the goods sold will be returned, then a provision is recognised (at the same time as revenue is recognised) for the best Estimate of the cost of refunds, applying the same principles as for warranty provisions.  (see provisions Example 4 Refunds policy)
• Provisions for construction contracts
  An expected loss on a construction contract should be recognised as an expense as soon as such loss is probable.
• Provision related to employee benefits
  A liability that arises from the wind-up of a multi-employer defined benefit plan, or the entity’s withdrawal from a multi-employer defined benefit plan, is recognised and measured in accordance with the provisions standard. [IAS 19 39]
  A provision is recognised for the expected cost of bonus or profit-sharing plans if an entity has a present legal or constructive obligation and a reliable estimate of the obligation van be made [IAS 19 19]. The amount provided is the best estimate of the undiscounted amount that the entity expects to pay. If payment is conditional (e.g. on the employee remaining in service), then the conditions and the possibility of forfeiture are taken into account in measuring the obligations [IAS 19 20, IAS 19 BC55]
• Contract termination costs
  IFRS does not specifically address provisions for contract termination costs. However, an obligating event that results in an entity having no realistic alternative to settling the obligation would be provided for as an onerous contract – e.g. a lease contract under which the entity will continue to incur costs for its remaining term without economic benefit.
• Environmental provisions
  Although there is no formal distinction between environmental and decommissioning provisions under IFRS, in general environmental provisions exclude provisions related to damage incurred in installing an asset (see decommissioning provisions). Environmental provisions are discounted if the effect of discounting is material.
• Onerous customer service contracts
  If a contract is for the sale of goods, or if an entity recognises and measures onerous customer service contracts under the provisions standard, then only the unavoidable costs that are directly associated with meeting the entity’s obligations to deliver the goods or services under the contract should be considered in determining whether the contract is onerous and in measuring any resulting provision. The ‘unavoidable costs’ of meeting the obligations under the contract are only costs that:
  • are directly variable with the contract and therefore incremental to the performance of the contract;
  • do not include allocated or shared costs that will be incurred regardless of whether the entity fulfills the contract; and
  • cannot be avoided by the entity’s future actions.
• Warranty provision
  When a warranty is not sold separately, the warranty (or part thereof) may still be a performance obligation, if the warranty (or part thereof) provides the customer with a service in addition to the assurance that the product complies with agreed-upon specifications. A warranty that only covers the compliance of a product with agreed-upon specifications (an ‘assurance warranty’) is accounted for under the provisions standard. [IFRS 15 B29–B30]