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 (less uncertain) and contingent liabilities (more uncertain).
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:
- 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
- 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 IAS 37 Provisions, Contigent liabilities and Contingent Assets distinguishes between:
- 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
- contingent liabilities – which are not recognised as liabilities because they are either:
- 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;
- 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.
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. (IAS 37 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]
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