What is a provision?
Provisions are liabilities of uncertain timing or amount. This uncertainty makes them different from accruals or payables, where the timing and amount are often contractual and the uncertainty is insignificant.
Provisions are dealt with in IAS 37. However, items specifically covered by another standard are scoped out of IAS 37. These are listed in paragraph IAS 37.5. It is especially important to note that most of contractual liabilities (other than onerous contracts) are within the scope of IFRS 15 or IFRS 9 and should be recognised under the criteria specified in these standards.
A provision is recognised when all the following conditions are met (IAS 37.14):
- an entity has a present obligation (legal or constructive) as a result of a past event,
- it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
- a reliable estimate can be made of the amount of the obligation.
Present obligation (see paragraphs IAS 37.15-22) arises from past event(s) that results in an entity having no realistic alternative to settling that obligation. It is the case when the obligation can be enforced by law (legal obligation) or the event, including action by the entity itself, creates valid expectations in other parties that the entity will settle the obligation (constructive obligation).
If entity can avoid settling the obligation by its future actions, there is no present obligation. For example, law requirement or economic reality may require the entity to take specific action in the future. But the present obligation arises only after the entity has actually taken this action (IAS 37.18-19).
Expected future operating losses are not a present obligation and therefore no provision is recognised for them. Care must be taken not to include future operating losses in measurement of a provision that is recognised for other specific obligation. It is worth noting that expectations of future operating losses can be a significant indicator that assets are impaired. It can be either ‘general’ impairment under IAS 36 or decrease in carrying amount under other applicable standards, e.g. inventory write-down to NRV.
Example: Present (legal) obligation
Entity A is a company operating in transportation industry. During the year 20X0, a law was enacted that requires all cargo cars to have special exhaust filters installed by June 20X1. The transportation authority is entitled to impose a fine of $10,000 for each car that doesn’t have exhaust filters installed as required. Entity A prepares annual financial statements as at 31 December 20X1 and it did not install the filters as required by law, despite owning 50 cargo cars.
Analysis at 31 December 20X0
There is no present obligation with respect to exhaust filters or potential fines. Entity A has not installed the filters, so it doesn’t owe money to anyone. There is also no present obligation with respect to potential fines to be imposed by the transportation authority, because the deadline for installation is June 20X1. Even if Entity A does not plan to install filters, the decision is still fully under control of the entity. For example, it can sell its cargo cars before June 20X1 and use rented cars instead. Business rationale of such a decision is not taken into account when deciding whether present obligation exists as at the reporting date. As long as Entity A can avoid the obligation by its future actions, there is no present obligation as at 31 December 20X0.
Analysis at 31 December 20X1
Entity A still didn’t install the filters, so it doesn’t owe money to anyone. There is no present obligation with respect to exhaust filters, but there is a present obligation with respect to potential fines to be imposed by the transportation authority. The deadline has passed and the transportation authority is entitled to impose a fine of $ 10,000 for each cargo car owned by Entity A. Future actions of Entity A, such as installing required filters next year or using rented cars instead of owning them, will not change the fact that the authority can impose fines relating to the July-December 20X1 period, i.e. the period when Entity A did not comply with the requirements.
Constructive obligation arises when entity has created a valid expectation on third parties that it will settle certain responsibilities. Constructive obligation arises from entity’s own actions and usually does not result from law or contracts signed with third parties. A valid expectation is created by an established pattern of past practice, published policies or a sufficiently specific statement made to third parties. See also specific application of the conditions giving rise to a constructive obligation in the section on restructuring.
Example: Present (constructive) obligation
In December 20X0, the board of directors of Entity A decides to give a 3-year warranty for all products manufactured by Entity A, including those sold before December 20X0. The law requires Entity A to give only a 2-year warranty and this is what Entity A has given so far. The policy of 3-year warranty is made public in January 20X1 through extensive advertising. Additionally, official terms and conditions are made available for download on entity’s website. On 10 March 20X1, Entity A authorises its financial statements for the year ended 31 December 20X0.
There is no present obligation as at 31 December 20X0 as Entity A did not create a valid expectation on third parties (customers) at that date. Valid expectations were created in January 20X1 and this is when present obligation arose. This is non-adjusting event after the reporting period and it does not impact valuation of provision as at 31 December 20X0.
Probable outflow of resources embodying economic benefits
The second condition needed for recognition of a provision is that it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation (see paragraphs IAS 37.23-24). ‘Probable’ means that the probability is above 50%. For a large number of similar obligations, such as warranties, probability is determined for the class of obligations as a whole. So even if the probability for one specific obligation is well below 50%, the provision is still recognised for the whole class, as it is probable that the settlement, taken as a whole, will require outflow of resources.
Reliable estimate and measurement
A reliable estimate of the amount of the obligation is the third condition needed for recognition of a provision (see paragraphs IAS 37.25-26). Provisions are, by their nature, more uncertain than other liabilities, but IAS 37 explicitly states that it will be only rare cases where no reliable estimate can be made. Claims and litigation are the most challenging area for reliable estimate of provisions, but entities need to develop a way of calculation of a related provision. Proper disclosure in the notes should explain assumptions and uncertainties inherent in the measurement.
Measurement of provisions is covered in paragraphs IAS 37.36-58. Provisions are measured at the best estimate of the expenditure required to settle the obligation at the end of the reporting period. IAS 37 points to ‘the amount that an entity would rationally pay to settle the obligation’ but in practice, provisions are most often measured at the amount that entity expects to ultimately pay to the other party concerned with the case (i.e. transfer to a third party is usually not considered when measuring a provision). Only direct incremental expenditures necessary to settle the obligation are included in the value of the provision. Future costs, such as expected lawyers’ fees, are not included in the provision until the legal services are rendered.
The approach to measurement of provisions depends on the characteristics of the obligation. When there is a single obligation, the most likely outcome is used as a basis for measurement. But if there are possible outcomes that differ significantly from the most likely outcome, the value of provision is adjusted to reflect risk (see IAS 37.40;42-44). Unfortunately, IAS 37 is not very specific on how to incorporate risk into valuation of a single obligation and therefore different approaches have been applied in practice.
For a large number of similar obligations, such as warranties, the expected value approach is applied in measuring the provision (see the example in IAS 37.39). Warranties can fall into the scope of IFRS 15 if they are considered to be a distinct service.
Provisions are discounted if the effect of the time value of money is material (IAS 37.45-47). This effect is most likely to be material for decommissioning provisions where the decommissioning takes place long after the provision is set up.
Usually a government bond yield with maturity close to timing of cash flows is used as a discount rate. Note that this is a nominal rate (i.e. after inflation) so in this case cash flows taken for measurement of provision should be expressed in future prices after inflation. IAS 37 allows also using real discount rate and cash flows expressed in current prices, but this approach is more troublesome in practice, as the changes in provision will have to reflect changes in current prices resulting from inflation.
IAS 37 states also that a discount rate should reflect risks specific to the liability, but it is hardly possible to make market assessment of a risk specific to a liability. Therefore, it is better to build the risk into cash flows, though it is not easy as well.
IAS 37 does not deal with accounting for changes in discount rates. It is accepted practice to present the impact of changes in discount rates in the same line as original recognition of provision. Such a change does not reflect passage of time and therefore should not be treated the same way as unwinding of discount. Specific guidance is available for decommissioning provisions. IFRIC 1.4 states that changes in measurement of existing decommissioning provisions resulting from a change in the discount rate should be added to/deducted from the cost of a related asset.
IAS 37 does not have specific section on decommissioning provisions, but these provisions are given as an example for present obligation (IAS 37.19) and covered in the Illustrative example 3 accompanying IAS 37 (offshore oil field). Decommissioning provision is recognised as an estimate of the costs of dismantling and removing a fixed asset and restoring the site on which it is located. Present obligation arises when a fixed asset is acquired or constructed or during the use of the asset. The provision is recognised at the present value of the above-mentioned costs, and given that the time horizon is often distant, the effect of discounting will often be material.
As a rule, decommissioning provision is not recognised for repairs and maintenance of fixed assets as entities do not have a present obligation to do it (see illustrative examples 11A and 11B accompanying IAS 37). However, certain lease agreements sometimes do oblige a lessee to carry out certain works after the end of (or during) the lease term. In such a case, it is possible that an entity has a present obligation to repair a broken part etc. because such an obligation is included in the lease contract. Still, the provision is recognised only for damage that already occurred in the past.
The debit entry of a decommissioning provision increases the cost of a related fixed asset (IAS 16.16) and is then depreciated over the useful life of the asset. There is a dedicated interpretation covering changes in existing decommissioning provisions – IFRIC 1. According to IFRIC 1, changes in measurement of decommissioning provisions resulting from changes in estimated timing or amount of the outflow of resources, or from changes in discount rate, are added to, or deducted from, the cost of the related asset [IFRIC 1.4]. Depreciation is adjusted prospectively [IFRIC 1.7].
Unwinding of discount is presented as finance costs [IFRIC 1.8]. Given the often significant time gap between recognition of the provision and actual decommissioning of a related asset, cumulative discounting expense may be higher than cumulative depreciation expense.
There is no specific guidance in IFRS on decommissioning obligations that arise after an asset was put into use, e.g. as a result of changes in legislation. It is common practice to treat such new obligations the same way as changes in existing obligations described above.
IFRIC 1 gives also specific guidance on accounting treatment if decommissioning provisions relate to a fixed asset measured using the revaluation model [IFRIC 1.6].
Some entities participate in dedicated decommissioning funds. In such a case, IFRIC 5 applies.
An onerous contract is 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 37.66-69). The difference between costs and benefits is recognised as a provision.
In June 2017, IFRIC deliberated on how the unavoidable costs should be understood, i.e. whether they should include only incremental costs or should include also an allocation of overhead costs if those costs are incurred for activities required to complete the contract. The conclusion was that both approaches were acceptable (see IFRIC June 2017 update). However, the IASB proposes to amend IAS 37 and clarify that all the costs that relate directly to the contract (rather than only the incremental costs of the contract) should be taken into account.
Example: Purchase commitment
Entity A entered into a contract to purchase 10,000 units of component X per year for the next 5 years. The price of component X is fixed in the contract at $20 per unit. Entity A uses component X to manufacture product Y. Entity A earns a direct margin of $30 on each unit of product Y sold. The contract starts on 1 January 20X1.
On 31 December 20X3 Entity A assesses that it could buy component X for $15 per unit because a new manufacturer entered the market. The question then arises whether the contract became onerous at 31 December 20X3 because the entity is committed to buy component X at a price higher than current price available on the market?
The answer to that question is no. The contract has not become onerous because Entity A still earns a profit on product Y for which component X is used. In other words, economic benefits from the contract (ability to produce and sell product Y at a profit) are still higher than costs of purchasing X.
Provisions should not be recognised for executory contracts (unless they become onerous). Executory contracts are defined as 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). For example, an order for delivery of goods is an executory contract and it is not recognised in the statement of financial position until the actual delivery of goods.
IAS 37 specifically covers restructuring (IAS 37.70-83), which gives also a useful application guidance on circumstances that create a constructive obligation. Restructuring is defined as a programme that is planned and controlled by management, and materially changes either the scope of business activities or the manner in which that business is conducted (IAS 37.10). In practice, the term ‘restructuring’ is often used also with reference to organisational changes that are not necessarily a material change to the entity. This is often done so because reporting expenses as ‘restructuring expenses’ implies that they are non-recurring and not related to the ongoing business activities. When a definition of restructuring is not met, entities need to apply other IFRS depending on the liability/expense in question. For example, for recognition of employee termination expenses, paragraphs IAS 19.165-168 apply.
Paragraphs IAS 37.72-79 elaborate on when an entity creates a constructive obligation. As we can see there, an internal decision and detailed formal plan is not enough to create a constructive obligation. In order to create a constructive obligation, an entity must create a valid expectation on affected parties, such as employees and customers, that it will carry out the programme, e.g. through a public announcement of the plan made in sufficient detail.
Restructuring provision should include only direct incremental expenditures necessary to carry out the programme. Expenditures relating to future activities of the company and the impact of disposal of assets are not taken into account (IAS 37.80-83). The fact that an expense will be incurred because of the restructuring programme is not in itself a sufficient criterion to include it in restructuring provision.
The following are examples of expenditures that are included in restructuring provision:
- termination indemnities to employees leaving the company under the restructuring programme,
- contractual penalties that need to be paid to customers and suppliers as a result of restructuring,
- cleaning-up abandoned site.
The following are examples of expenditures that are excluded from restructuring provision:
- retraining continuing employees/ recruiting new employees,
- additional ‘stay’ salaries/bonuses for employees,
- relocating continuing employees and assets (e.g. equipment, inventory),
- future operating losses in transition period,
- expenditures relating to new production or distribution networks,
- marketing expenses for new/ continuing operations.
There is a specific interpretation covering levies (IFRIC 21). Levies are payments imposed by governments on entities under a legislation. Payments covered by other standards (e.g. income taxes) or resulting from fines and penalties for breaches of the law are out of scope of IFRIC 21. This interpretation answers several questions on the timing of recognition of a liability to pay a levy. In short, IFRIC 21 reinforces requirements of IAS 37 that a liability/provision can, and should, be recognised only after an obligating event took place. IFRIC 21 explicitly states that business pressure or going concern assumption are not obligating events.
Entity A is a bank operating in country X. National legislation in X requires each bank operating in a given year to contribute 0.05% of its previous year’s revenue to banking supervision. This contribution is not refundable under any circumstances and relates only to banks with revenue exceeding $0.3 billion for a year in question.
Entity A prepares its financial statements as a going concern for a year ending 31 Dec 20X0 with revenue amounting to $1 billion. Entity A forecasts its revenue to be at a comparable level in 20X1 and it is virtually certain that it will exceed the $0.3 billion threshold.
Question 1: Should Entity A recognise a liability of $0.5 million ($1 billion x 0.05%) as at 31 December 20X0 relating to contribution for the year 20X1?
Answer 1: No, the obligating event happens when Entity A exceeds the $0.3 billion threshold in 20X1, therefore this liability cannot be recognised in financial statements for the year ended 31 December 20X0.
Question 2: As at 31 March 20X1, Entity A generated $0.25 billion of revenue. Should Entity A recognise ¼ of expected annual contribution to the banking supervision in its interim financial statements for the period from 1 January 20X1 to 31 March 20X1?
Answer 2: No, the obligating event happens when Entity A exceeds the $0.3 billion threshold, therefore no liability/provision should be recognised (anticipated) as at 31 March 20X1.
Question 3: When Entity A finally reaches the $0.3 billion threshold, in what amount should the levy be recognised?
Answer 3: At each reporting period, the levy should be recognised as a 0.05% of actual revenue to date. Levy relating to revenue expected to be generated in subsequent months should not be anticipated.
Question 4: Let’s assume that this contribution is in fixed amount, e.g. $1 million for each bank with revenue exceeding $0.3 billion. Entity A reaches this threshold in April 20X1 and recognises $1 million of liability. Can the related expense be spread evenly in P/L as a 1/12 each month until the year-end?
Answer 4: No, full annual expense should be recognised in profit or loss in April 20X1, i.e. once the threshold is reached. The contribution is not refundable under any circumstances and Entity A cannot reasonably expect to obtain any economic benefits from it in the future.
Question 5: Assumptions as in Question 4 plus the assumption that the levy is proportionately refundable if the bank ceases operations during a year. Can the related expense be spread evenly in P/L as a 1/12 each month until the year-end?
Answer 5: Yes.
Expected reimbursements are not taken into account in measurement of the provision (IAS 37.53-58). Instead, they are treated as contingent assets and recognised separately only when the inflow of resources is virtually certain. An exception to this approach is a situation where an entity is jointly and severally liable for an obligation. In such case, the entity recognises a provision for the part of the obligation for which an outflow of resources embodying economic benefits is probable, and the part of the obligation that is expected to be met by other parties is treated as a contingent liability. There is no requirement to be virtually certain that other parties will actually cover their part (IAS 37.29;58).
Waste Electrical and Electronic Equipment (WEEE)
The EU Directive on Waste Electrical and Electronic Equipment regulates the collection, treatment, recovery and environmentally sound disposal of historical waste equipment (i.e. sold before 13 August 2005). Under this Directive, the cost of waste management for historical household equipment is borne by producers of that type of equipment that are in the market during a period to be specified by local regulation. There is a separate interpretation (IFRIC 6) that provides guidance on the recognition, in the financial statements of producers, of liabilities for waste management under the EU Directive on WEEE. Under IFRIC 6, a liability for waste management costs for historical household equipment arises as a result of participation in the market during the measurement period.
Disclosure requirements for provisions are specified in paragraphs IAS 37.84-85. These include breaking down movements during the period and qualitative disclosure, such as disclosing uncertainties and assumptions.
In extremely rare cases, paragraph IAS 37.92 allows entities to skip some of the disclosure if fulfilling all the requirements would be expected to prejudice seriously the position of the entity in a pending case (‘not-to-prejudice exception’). Even if entities take advantage of this expedient, they are required to disclose the general nature of the dispute, together with the fact that, and reason why, the information has not been disclosed.