Provisions represent liabilities that are uncertain in timing or amount. This differentiates them from accruals or payables, where timing and amount are often contractually determined, and uncertainty is minimal.
In accounting jargon, ‘provision’ is occasionally misused to describe credit loss allowances on financial assets or general impairment losses on non-financial assets. However, these are adjustments to the carrying amount of the assets concerned, not liabilities. Therefore, it’s more accurate to avoid using ‘provision’ when discussing impairment losses.
IAS 37 governs provisions, but it does not deal with items explicitly covered by another standard (these are detailed in IAS 37.5). It’s important to understand that all contractual liabilities, with the exception of onerous contracts, fall within the scope of IFRS 9 or IFRS 15. Therefore, they must be recognised according to the criteria specified in these standards, and IAS 37 does not apply to them.
Recognition criteria
A provision is recognised when it fulfils the following conditions outlined in IAS 37.14:
- The 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.
- The amount of the obligation can be reliably estimated.
Present obligation
A present obligation (IAS 37.15-22) arises from past events that result in an entity having no realistic alternative but to settle that obligation. This typically occurs when the obligation is enforceable by law (legal obligation) or when the event, including the entity’s own actions, creates valid expectations in other parties that the entity will settle the obligation (constructive obligation).
An entity has no present obligation if it can avoid settling the obligation through its future actions. For example, legal requirements or economic realities may compel the entity to take a specific action in the future. However, a present obligation only arises once the entity has actually taken this action (IAS 37.18-19).
It is important to remember that expected future operating losses are not considered a present obligation. Therefore, no provision is recognised for them. Care must be exercised to avoid including future operating losses when measuring a provision recognised for a separate specific obligation. Notably, expectations of future operating losses can indicate asset impairment. This could manifest as a general impairment under IAS 36 or as a decrease in the carrying amount under other relevant standards, such as an inventory write-down to net realisable value.
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Example: Present (legal) obligation
Entity A operates in the transportation industry. In the year 20X0, a law was enacted, mandating that all cargo cars have special exhaust filters installed by June 20X1. The transportation authority can impose a fine of $10,000 for each car lacking the necessary exhaust filters. Entity A has not installed the filters as required by law, despite owning 50 cargo cars.
Analysis at 31 December 20X0
There is no present obligation regarding the exhaust filters or potential fines. Since Entity A has not installed the filters, it doesn’t owe money to any supplier. Similarly, no present obligation exists in relation to potential fines from the transportation authority, as the deadline for filter installation is June 20X1. Even if Entity A does not plan to install the filters, the decision remains fully within its control. It could sell its cargo cars before June 20X1 and use rented cars instead. The business rationale for such a decision is not considered when determining whether a present obligation exists as at the reporting date. As long as Entity A can avoid the obligation through its future actions, no present obligation exists.
Analysis at 31 December 20X1
Entity A still hasn’t installed the filters and therefore doesn’t owe money to any supplier. There is no present obligation in relation to the exhaust filters, but a present obligation exists regarding potential fines from the transportation authority. The deadline has passed and the authority can impose a fine of $10,000 for each cargo car owned by Entity A. Future actions of Entity A, such as installing the required filters next year or using rented cars instead of owned ones, will not change the fact that the authority can impose fines for the period of July-December 20X1. This period denotes when Entity A failed to comply with the requirements.
A constructive obligation arises when an entity establishes a valid expectation among third parties that it will fulfil certain responsibilities. A constructive obligation stems from the entity’s actions and doesn’t typically result from laws or contracts signed with third parties. A valid expectation is formed by an established pattern of past practices, publicly stated policies, or a sufficiently specific statement made to third parties. For more details on the conditions leading to a constructive obligation, refer to the section on restructuring.
Example: Present (constructive) obligation
In December 20X0, Entity A’s board of directors decides to provide a 3-year warranty for all products made by Entity A, encompassing those sold before December 20X0. Lawfully, Entity A is only required to offer a 2-year warranty, which has been their previous practice. This 3-year warranty policy is publicly announced in January 20X1 through extensive advertising. Furthermore, the official terms and conditions are made accessible for download on the entity’s website. Entity A authorises its financial statements for the year ended 31 December 20X0 on 10 March 20X1.
There is no present obligation as of 31 December 20X0 since Entity A had not established a valid expectation among third parties (customers) at that date. Valid expectations were formed in January 20X1, which is when the present obligation was created. This non-adjusting event occurring after the reporting period does not impact the provision valuation as of 31 December 20X0.
Example: Climate-related commitments
Many companies, from large to small, have pledged to contribute to tackling the climate crisis. The IFRS Interpretations Committee explored an interesting question: do these commitments create a present obligation that leads to the recognition of a provision under IAS 37?
The context for this analysis was of a manufacturer who publicly committed to significantly reducing its emissions by a certain year and offsetting the remainder through carbon credits. The Committee’s analysis focused on identifying a constructive obligation per IAS 37, which arises from a company’s actions that create a valid expectation in others that it will discharge certain responsibilities.
If a constructive obligation is established, the Committee considered whether it satisfies the criteria for recognising a provision under IAS 37, which includes a present obligation from a past event, a probable outflow of resources, and a reliable estimate of the amount. The Committee’s conclusion was that an obligation for offsetting emissions becomes a present obligation only when the emissions occur.
The Committee also observed that the entity will not have a present obligation for future modifications to its manufacturing methods, as these costs are incurred for future operations. When the entity eventually purchases resources for these modifications, such as new plant or equipment, it will incur expenses, but it will also receive corresponding resources like property, plant, equipment, energy, product ingredients, or packaging materials. These acquired resources will enable the entity to continue manufacturing and selling its products profitably. This highlights that the costs associated with future modifications are balanced by the acquisition of assets that contribute to the entity’s ongoing profitability.
Learn more:
- Committee’s agenda decision.
- Staff paper prepared for the meeting.
Notably, KPMG has previously explored this topic in their publication on the accounting implications of net-zero commitments.
Probable outflow of resources embodying economic benefits
The second condition necessary for recognising a provision is that it’s probable that an outflow of resources, embodying economic benefits, will be required to settle the obligation (IAS 37.23-24). ‘Probable’ refers to a probability exceeding 50%. For a multitude of similar obligations like warranties, the probability is determined collectively. Even if the likelihood for one particular obligation is considerably less than 50%, the provision is recognised for the entire group, as it’s probable that the settlement, overall, will require the outflow of resources.
Reliable estimate and measurement
A reliable estimate of the amount of the obligation is the third condition needed for recognising a provision (IAS 37.25-26). By nature, provisions are more uncertain than other liabilities, yet IAS 37 clearly states that there will be very few instances where a reliable estimate cannot be made. Claims and litigation present the most difficult areas for reliable provision estimates, but entities must devise a method for calculating the related provision. Thorough disclosure in the notes should explain the assumptions and inherent uncertainties in the measurement.
The measurement of provisions is addressed in IAS 37.36-58. Provisions are measured at the best estimate of the expenditure necessary to settle the obligation at the end of the reporting period. IAS 37 refers to ‘the amount that an entity would rationally pay to settle the obligation’, but in practice, provisions are typically measured at the amount the entity anticipates paying to the other party involved in the case (i.e. transfer to a third party is usually not considered when measuring a provision). Only direct incremental expenditures for settling the obligation are included in the value of the provision. Future costs, such as expected legal fees, aren’t included in the provision until the legal services are provided.
The approach to provision measurement depends on the obligation’s characteristics. For a single obligation, the most likely outcome is used as the measurement basis. However, if possible outcomes significantly differ from the most likely outcome, the value of provision is adjusted to reflect risk (see IAS 37.40; 42-44). Regrettably, IAS 37 does not provide specific guidance on incorporating risk into a valuation of a single obligation, leading to various practical interpretations.
For a large number of similar obligations, such as warranties, the expected value approach is used in measuring the provision (see the example in IAS 37.39). Warranties can fall under IFRS 15 if they are considered a distinct service.
Discounting
Provisions are discounted when the time value of money has a material effect (IAS 37.45-47). This is most likely to be the case for decommissioning provisions, which are set up long before the actual decommissioning occurs. A common approach is to use a discount rate based on a government bond yield that matures around the same time as the cash flows. Note that this is a nominal rate (i.e., after accounting for inflation). Consequently, the cash flows used for measuring the provision should reflect future prices, incorporating expected inflation. Alternatively, IAS 37 permits the use of real discount rates and cash flows expressed in current prices. Refer to Impact of inflation for further guidance on using real and nominal discount rates in measuring present value of future cash flows.
IAS 37 also indicates that a discount rate should reflect risks specific to the liability. However, making a market assessment of risk specific to a liability is complex. Thus, it’s more practical to incorporate the risk into the cash flows, although this can be challenging as well.
IAS 37 does not provide guidelines for reflecting the impact of changes in discount rates. Common practice is to represent the impact of such changes in the same line as the original recognition of provision. Such changes do not reflect the passage of time and should not be treated like the unwinding of a discount. Specific guidance exists for decommissioning provisions, with IFRIC 1.4 stating that any changes in the measurement of existing decommissioning provisions due to a change in discount rates should be added to or deducted from the cost of a related asset.
Continuous reassessment
Provisions should be reviewed at each reporting period and adjusted to reflect the current best estimate. If it is no longer probable that an outflow of resources embodying economic benefits will be required to settle the obligation, the provision should be reversed (IAS 37.59).
Decommissioning provisions
While IAS 37 does not specifically address decommissioning provisions, it does use them as an example of a present obligation (IAS 37.19) and further discusses them in Illustrative Example 3 accompanying IAS 37 (relating to offshore oil fields). Decommissioning provisions are recognised as estimates of costs involved in dismantling a fixed asset, removing it, and restoring the site. Present obligation arises when a fixed asset is acquired, constructed, or in use. The provision is recognised at the present value of these costs, and given that the timeline is typically long, the effect of discounting will often be substantial.
As a general rule, a decommissioning provision is not recognised for fixed asset repairs and maintenance, as entities do not have a current obligation to do so (see illustrative Examples 11A and 11B accompanying IAS 37). However, certain lease agreements sometimes mandate a lessee to undertake specific works during or after the lease term. In such cases, an entity may have a present obligation to repair a broken part etc. due to the lease contract. Nevertheless, the provision is only recognised for damage that has already occurred.
The debit entry of a decommissioning provision increases the cost of a related fixed asset (IAS 16.16) and is then depreciated over the asset’s useful life. IFRIC 1 provides specific guidance for changes in existing decommissioning provisions. According to IFRIC 1.4, changes in the measurement of decommissioning provisions resulting from changes in the estimated timing or amount of the outflow of resources, or changes in the discount rate, are added to or deducted from the cost of the related asset. Depreciation is adjusted prospectively (IFRIC 1.7). The unwinding of discount is presented as finance costs (IFRIC 1.8). Given the often significant time gap between the recognition of the provision and the actual decommissioning of a related asset, cumulative discounting expense may exceed cumulative depreciation expense.
There are no specific guidelines in IFRS regarding decommissioning obligations arising after an asset is in use, e.g., as a result of legislative changes. It is standard practice to treat such new obligations in the same way as changes in existing obligations described above.
IFRIC 1.6 provides specific guidance on the accounting treatment if decommissioning provisions relate to a fixed asset measured using the revaluation model. If entities participate in dedicated decommissioning funds, IFRIC 5 applies.
Onerous contracts
Many contracts, such as certain routine purchase orders, allow cancellation without the necessity of compensating the other party, thereby not constituting an obligation. In contrast, other agreements impose reciprocal rights and obligations on all parties involved. Under circumstances where these contracts become onerous, they fall within the scope of IAS 37, necessitating the recognition of a provision.
A contract is deemed onerous if the unavoidable costs of fulfilling its terms exceed the anticipated economic benefits. These unavoidable costs represent the minimum net expense of withdrawing from the agreement. This amount is determined by comparing the costs of fulfilling the contract with any penalties or compensation incurred from non-fulfilment.
In assessing such costs, all expenses directly associated with the contract, including both incremental and allocated costs, must be taken into account (IAS 37.66-69).
Example: Purchase commitment
Consider Entity A, which has committed to purchasing 10,000 units of component X per annum for the next five years at a fixed price of $20 per unit. This component is used in manufacturing product Y, from which Entity A earns a direct profit of $30 per unit sold. However, by 31 December 20X3, due to the arrival of a new manufacturer in the market, Entity A could purchase component X for $15 per unit. Despite this, the contract does not become onerous as Entity A continues to profit from product Y, which uses component X. In essence, the economic benefits from the contract still exceed the costs of purchasing component X.
Executory contracts
Provisions should not be recognised for executory contracts, unless they become onerous. Executory contracts are defined as agreements where neither party has performed any of its obligations, or both parties have only partially met their obligations to an equal extent (IAS 37.3). For instance, a goods delivery order is an executory contract and isn’t recognised in the statement of financial position until the goods are actually delivered.
Restructuring
IAS 37.70-83 addresses restructuring specifically, offering helpful 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 business is conducted (IAS 37.10).
In practice, ‘restructuring’ is often used to describe organisational changes that don’t necessarily constitute a material change to the entity. This is commonly done as labelling expenses as ‘restructuring expenses’ implies they are non-recurring and not related to ongoing business activities. If the restructuring definition is not met, entities need to apply other IFRS depending on the liability and expense in question. For instance, IAS 19.165-168 apply for the recognition of employee termination expenses.
IAS 37.72-79 further detail when an entity establishes a constructive obligation. Here, it’s clarified that an internal decision and a detailed formal plan alone don’t create a constructive obligation. To do so, the entity must create a valid expectation among affected parties (like employees and customers) that it will implement the programme, typically through a detailed public announcement of the plan.
The restructuring provision should only incorporate direct incremental expenditures required to execute the programme. Expenses related to the company’s future activities and asset disposals are not included (IAS 37.80-83). The fact that an expense will be incurred due to the restructuring programme does not, in itself, justify including it in the restructuring provision.
Expenditures included in the restructuring provision may comprise:
- Termination payments to employees leaving under the restructuring programme,
- Contractual penalties payable to customers and suppliers due to restructuring,
- Costs associated with cleaning up an abandoned site.
Expenditures excluded from the restructuring provision could include:
- Costs for retraining continuing employees or recruiting new ones,
- Additional ‘stay’ salaries or bonuses for employees,
- Costs related to relocating ongoing employees and assets (like equipment, inventory),
- Future operating losses during the transition period,
- Expenditures related to new production or distribution networks,
- Marketing expenses for new or ongoing operations.
Levies
Levies, dealt with by IFRIC 21, are payments imposed by governments on entities according to legislative regulations. Payments that are dealt with under different standards (e.g., income taxes) or stem from penalties for legal violations are beyond the scope of IFRIC 21. This interpretation provides answers to several queries on the timing of recognising a liability to pay a levy. Briefly, IFRIC 21 reinforces the IAS 37 requirements that a liability or provision should only be recognised once an obligating event has occurred. IFRIC 21 explicitly states that business pressures or going concern assumptions are not obligating events.
FAQ: Levies
Consider the scenario where Entity A is a bank operating in country X. The national legislation in X mandates each bank operating in a given year to contribute 0.05% of its previous year’s revenue towards banking supervision. This contribution is non-refundable under any circumstances and is only applicable to banks with an annual revenue exceeding $0.3 billion.
Entity A prepares its financial statements for the year ending 31 December 20X0 on a going concern basis, with its revenue totalling $1 billion. Entity A anticipates its revenue to remain at a similar level in 20X1 and it is virtually certain that it will surpass the $0.3 billion threshold.
Question 1: As of 31 December 20X0, should Entity A recognise a liability of $0.5 million ($1 billion x 0.05%) concerning the anticipated contribution for the year 20X1?
Answer 1: No, the obligating event transpires when Entity A exceeds the $0.3 billion threshold in 20X1. Thus, this liability cannot be recognised in the financial statements for the year ended 31 December 20X0.
Question 2: As of 31 March 20X1, Entity A has generated $0.25 billion in revenue. Should Entity A recognise a quarter of the expected annual contribution to banking supervision in its interim financial statements for the period from 1 January 20X1 to 31 March 20X1?
Answer 2: No, the obligating event occurs when Entity A surpasses the $0.3 billion threshold, so no liability or provision should be anticipated as of 31 March 20X1.
Question 3: When Entity A finally achieves the $0.3 billion threshold, how much should the levy be recognised?
Answer 3: At each reporting period, the levy should be recognised as 0.05% of the actual revenue generated to date. Levies related to revenue expected in future months should not be anticipated.
Question 4: Assuming this contribution is a fixed amount, for example, $1 million for each bank with revenue exceeding $0.3 billion. Entity A reaches this threshold in April 20X1 and recognises a $1 million liability. Can the related expense be evenly spread in P/L as 1/12 each month until the year-end?
Answer 4: No, the full annual expense should be recognised in P/L in April 20X1, i.e., once the threshold is attained. The contribution is non-refundable under any circumstances, and Entity A cannot reasonably expect to obtain any future economic benefits from it.
Question 5: Assuming the conditions are as in Question 4, plus the levy is proportionately refundable if the bank ceases operations during the year. Can the related expense be evenly spread in P/L as 1/12 each month until the year-end?
Answer 5: Yes.
Expected reimbursements
Expected reimbursements are not considered in the measurement of a provision according to IAS 37.53-58. They are instead treated as contingent assets and recognised separately when the inflow of resources is virtually certain.
An exception to this rule is when an entity is jointly and severally liable for an obligation. In this scenario, the entity recognises a provision for the portion of the obligation where an outflow of resources embodying economic benefits is probable. The part of the obligation expected to be met by other parties is treated as a contingent liability. There is no requirement for certainty that the other parties will cover their portion (IAS 37.29;58).
Waste Electrical and Electronic Equipment (WEEE)
The EU Directive on Waste Electrical and Electronic Equipment oversees the collection, treatment, recovery, and environmentally responsible disposal of historical waste equipment, i.e., equipment sold before 13 August 2005. This Directive mandates that the cost of waste management for historical household equipment be covered by the producers of that type of equipment who are in the market during a timeframe specified by local regulations. IFRIC 6 provides guidance on the recognition of liabilities for waste management under the EU Directive on WEEE in the financial statements of producers. As per IFRIC 6, a liability for waste management costs for historical household equipment emerges due to market participation during the measurement period.
Disclosure
Disclosure requirements for provisions are detailed in IAS 37.84-85. These include outlining movements during the period and qualitative disclosure, such as disclosing uncertainties and assumptions.
In extremely rare instances, IAS 37.92 allows entities to forgo certain disclosures if compliance with all requirements is expected to seriously prejudice the entity’s position in a pending case (the ‘not-to-prejudice exemption’). Even if entities utilise this exemption, they are mandated to disclose the general nature of the dispute, along with the reason why the required information has not been disclosed.