Definition of provision
The definition of provision is key to IAS 37. A provision is a liability of uncertain timing or amount, meaning that there is some question over either how much will be paid or when this will be paid. In the past, these uncertainties may have been exploited by companies trying to ‘smooth profits’ in order to achieve the results they believe that their various stakeholder may want.
As part of the attempt of IASB to further restrict this type of earnings management within IFRSs, IASB adopted an update of IAS 37 in April 2001 originating from September 1998. IAS 37 was further updated for Onerous contracts – Costs of fulfilling a contract in May 2020.
IAS 37: ‘Onerous Contracts – Cost of Fulfilling a Contract’
lAS 37 defines an onerous contract as one in which the unavoidable costs of meeting the entity’s obligations exceed the economic benefits to be received under that contract. Unavoidable costs are the lower of the net cost of exiting the contract and the costs to fulfil the contract. The amendment clarifies the meaning of ‘costs to fulfil a contract’.
- the incremental costs of fulfilling that contract (for example, direct labour and materials); and
- an allocation of other costs that relate directly to fulfilling contracts (for example, an allocation ofthe depreciation charge for an item of PP&E used to fulfil the contract).
The amendment also clarifies that, before a separate provision for an onerous contract is established, an entity recognises any impairment loss that has occurred on assets used in fulfilling the contract, rather than on assets dedicated to that contract.