IAS 37 Provisions, Contingent Liabilities and Contingent Assets

This Standard is effective for financial statementscovering periods beginning on or after 1 July 1999.

Introduction


1   IAS 37 prescribes theaccounting and disclosure for all provisions, contingent liabilities andcontingent assets, except:
(a) those resulting from financialinstruments that are carried at fair value;
(b) those resulting from executorycontracts, except where the contract is onerous. Executory contracts arecontracts under which neither party has performed any of its obligations orboth parties have partially performed their obligations to an equal extent;
(c) those arising in insurance enterprisesfrom contracts with policyholders; or
(d) those covered by another InternationalAccounting Standard.

Provisions


2   The Standard definesprovisions as liabilities of uncertain timing or amount. A provision should berecognised when, and only when:
(a) an enterprise has a present obligation(legal or constructive) as a result of a past event;
(b) it is probable (i.e. more likely thannot) that an outflow of resources embodying economic benefits will be requiredto settle the obligation; and
(c) a reliable estimate can be made of theamount of the obligation. The Standard notes that it is only in extremely rarecases that a reliable estimate will not be possible.
3   The Standard defines aconstructive obligation as an obligation that derives from an enterprise'sactions where:
(a) by an established pattern of pastpractice, published policies or a sufficiently specific current statement, theenterprise has indicated to other parties that it will accept certainresponsibilities; and
(b) as a result, the enterprise has createda valid expectation on the part of those other parties that it will dischargethose responsibilities.
4   In rare cases, forexample in a law suit, it may not be clear whether an enterprise has a presentobligation. In these cases, a past event is deemed to give rise to a presentobligation if, taking account of all available evidence, it is more likely thannot that a present obligation exists at the balance sheet date. An enterpriserecognises a provision for that present obligation if the other recognitioncriteria described above are met. If it is more likely than not that no presentobligation exists, the enterprise discloses a contingent liability, unless thepossibility of an outflow of resources embodying economic benefits is remote.
5   The amount recognised asa provision should be the best estimate of the expenditure required to settlethe present obligation at the balance sheet date, in other words, the amountthat an enterprise would rationally pay to settle the obligation at the balancesheet date or to transfer it to a third party at that time.
6   The Standard requiresthat an enterprise should, in measuring a provision:
(a) take risks and uncertainties intoaccount. However, uncertainty does not justify the creation of excessiveprovisions or a deliberate overstatement of liabilities;
(b) discount the provisions, where theeffect of the time value of money is material, using a pre-tax discount rate(or rates) that reflect(s) current market assessments of the time value ofmoney and those risks specific to the liability that have not been reflected inthe best estimate of the expenditure. Where discounting is used, the increasein the provision due to the passage of time is recognised as an interestexpense;
(c) take future events, such as changes inthe law and technological changes, into account where there is sufficientobjective evidence that they will occur; and
(d) not take gains from the expecteddisposal of assets into account, even if the expected disposal is closelylinked to the event giving rise to the provision.
7   An enterprise may expectreimbursement of some or all of the expenditure required to settle a provision(for example, through insurance contracts, indemnity clauses or suppliers'warranties). An enterprise should:
(a) recognise a reimbursement when, and onlywhen, it is virtually certain that reimbursement will be received if theenterprise settles the obligation. The amount recognised for the reimbursementshould not exceed the amount of the provision; and
(b) recognise the reimbursement as aseparate asset. In the income statement, the expense relating to a provisionmay be presented net of the amount recognised for a reimbursement.
8   Provisions should bereviewed at each balance sheet date and adjusted to reflect the current bestestimate. If it is no longer probable that an outflow of resources embodyingeconomic benefits will be required to settle the obligation, the provisionshould be reversed.

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An example is given below of the disclosures required by paragraph 92 where some of the information required is not given because it can be expected to prejudice seriously the position of the enterprise.
Example 3 Disclosure Exemption
An enterprise is involved in a dispute with a competitor, who is alleging that the enterprise has infringed patents and is seeking damages of 100 million. The enterprise recognises a provision for its best estimate of the obligation, but discloses none of the information required by paragraphs 84 and 85 of the Standard. The following information is disclosed:
Litigation is in process against the company relating to a dispute with a competitor who alleges that the company has infringed patents and is seeking damages of 100 million. The information usually required by IAS 37, Provisions, Contingent Liabilities and Contingent Assets, is not disclosed on the grounds that it can be expected to prejudice seriously the outcome of the litigation. The directors are of the opinion that the claim can be successfully resisted by the company.

Appendix D - Example: Disclosures
The appendix is illustrative only and does not form part of the Standard. The purpose of the appendix is to illustrate the application of the Standard to assist in clarifying its meaning.
Two examples of the disclosures required by paragraph 85 are provided below and on the following page.
Example 1 Warranties
A manufacturer gives warranties at the time of sale to purchasers of its three product lines. Under the terms of the warranty, the manufacturer undertakes to repair or replace items that fail to perform satisfactorily for two years from the date of sale. At the balance sheet date, a provision of 60,000 has been recognised. The provision has not been discounted as the effect of discounting is not material. The following information is disclosed:
A provision of 60,000 has been recognised for expected warranty claims on products sold during the last three financial years. It is expected that the majority of this expenditure will be incurred in the next financial year, and all will be incurred within two years of the balance sheet date.
Example 2 Decommissioning Costs
In 2000, an enterprise involved in nuclear activities recognises a provision for decommissioning costs of 300 million. The provision is estimated using the assumption that decommissioning will take place in 60-70 years' time. However, there is a possibility that it will not take place until 100-110 years' time, in which case the present value of the costs will be significantly reduced. The following information is disclosed:
A provision of 300 million has been recognised for decommissioning costs. These costs are expected to be incurred between 2060 and 2070; however, there is a possibility that decommissioning will not take place until 2100-2110. If the costs were measured based upon the expectation that they would not be incurred until 2100-2110 the provision would be reduced to 136 million. The provision has been estimated using existing technology, at current prices, and discounted using a real discount rate of 2 per cent.

Example 11B: Refurbishment Costs - Legislative Requirement
An airline is required by law to overhaul its aircraft once every three years.
Present obligation as a result of a past obligating event - There is no present obligation.
Conclusion - No provision is recognised (see paragraphs 14 and 17-19).
The costs of overhauling aircraft are not recognised as a provision for the same reasons as the cost of replacing the lining is not recognised as a provision in example 11A. Even a legal requirement to overhaul does not make the costs of overhaul a liability, because no obligation exists to overhaul the aircraft independently of the enterprise's future actions - the enterprise could avoid the future expenditure by its future actions, for example by selling the aircraft. Instead of a provision being recognised, the depreciation of the aircraft takes account of the future incidence of maintenance costs, i.e. an amount equivalent to the expected maintenance costs is depreciated over three years.

(b) At 31 December 2001
Present obligation as a result of a past obligating event - On the basis of the evidence available, there is a present obligation.
An outflow of resources embodying economic benefits in settlement - Probable.
Conclusion - A provision is recognised for the best estimate of the amount to settle the obligation (paragraphs 14-16).
Example 11: Repairs and Maintenance
Some assets require, in addition to routine maintenance, substantial expenditure every few years for major refits or refurbishment and the replacement of major components. IAS 16, Property, Plant and Equipment, gives guidance on allocating expenditure on an asset to its component parts where these components have different useful lives or provide benefits in a different pattern.
Example 11A: Refurbishment Costs - No Legislative Requirement
A furnace has a lining that needs to be replaced every five years for technical reasons. At the balance sheet date, the lining has been in use for three years.
Present obligation as a result of a past obligating event - There is no present obligation.
Conclusion - No provision is recognised (see paragraphs 14 and 17-19).
The cost of replacing the lining is not recognised because, at the balance sheet date, no obligation to replace the lining exists independently of the company's future actions - even the intention to incur the expenditure depends on the company deciding to continue operating the furnace or to replace the lining. Instead of a provision being recognised, the depreciation of the lining takes account of its consumption, i.e. it is depreciated over five years. The re-lining costs then incurred are capitalised with the consumption of each new lining shown by depreciation over the subsequent five years.

Example 10: A Court Case
After a wedding in 2000, ten people died, possibly as a result of food poisoning from products sold by the enterprise. Legal proceedings are started seeking damages from the enterprise but it disputes liability. Up to the date of authorisation of the financial statements for the year to 31 December 2000 for issue, the enterprise's lawyers advise that it is probable that the enterprise will not be found liable. However, when the enterprise prepares the financial statements for the year to 31 December 2001, its lawyers advise that, owing to developments in the case, it is probable that the enterprise will be found liable.
(a) At 31 December 2000
Present obligation as a result of a past obligating event - On the basis of the evidence available when the financial statements were approved, there is no obligation as a result of past events.
Conclusion - No provision is recognised (see paragraphs 15-16). The matter is disclosed as a contingent liability unless the probability of any outflow is regarded as remote (paragraph 86).

Editorial note: Example 9 substituted by improvements project standard IAS 39 (as amended by IAS Corrections List, May 2004) with effect for annual periods beginning on or after 1 January 2005. If an entity applies this Standard for an earlier period, these amendments shall be applied for that earlier period. Previously "During 1999, Enterprise A gives a guarantee of certain borrowings of Enterprise B, whose financial condition at that time is sound. During 2000, the financial condition of Enterprise B deteriorates and at 30 June 2000 Enterprise B files for protection from its creditors.

(a) At 31 December 1999

Present obligation as a result of a past obligating event - The obligating event is the giving of the guarantee, which gives rise to a legal obligation.
An outflow of resources embodying economic benefits in settlement - No outflow of benefits is probable at 31 December 1999.
Conclusion - No provision is recognised (see paragraphs 14 and 23). The guarantee is disclosed as a contingent liability unless the probability of any outflow is regarded as remote (see paragraph 86).

(b) At 31 December 2000
Present obligation as a result of a past obligating event - The obligating event is the giving of the guarantee, which gives rise to a legal obligation.
An outflow of resources embodying economic benefits in settlement - At 31 December 2000, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation.
Conclusion - A provision is recognised for the best estimate of the obligation (see paragraphs 14 and 23).

Note: This example deals with a single guarantee. If an enterprise has a portfolio of similar guarantees, it will assess that portfolio as a whole in determining whether an outflow of resources embodying economic benefit is probable (see paragraph 24). Where an enterprise gives guarantees in exchange for a fee, revenue is recognised under IAS 18, Revenue."

Second paragraph inserted by IFRS 4 with effect for annual periods beginning on or after 1 January 2005. Earlier application is encouraged. If an entity applies this IFRS for an earlier period, it shall disclose that fact.

Example 9: A Single Guarantee
On 31 December 1999, Entity A gives a guarantee of certain borrowings of Entity B, whose financial condition at that time is sound. During 2000, the financial condition of Entity B deteriorates and at 30 June 2000 Entity B files for protection from its creditors.
This contract meets the definition of an insurance contract in IFRS 4. IFRS 4 permits the issuer to continue its existing accounting policies for insurance contracts if specified minimum requirements are satisfied. IFRS 4 also permits changes in accounting policies that meet specified criteria. The following is an example of an accounting policy that IFRS 4 permits.
(a) At 31 December 1999
Present obligation as a result of a past obligating event - The obligating event is the giving of the guarantee, which gives rise to a legal obligation.
An outflow of resources embodying economic benefits in settlement - No outflow of benefits is probable at 31 December 1999.
Conclusion - The guarantee is recognised at fair value
(b) At 31 December 2000
Present obligation as a result of a past obligating event - The obligating event is the giving of the guarantee, which gives rise to a legal obligation.
An outflow of resources embodying economic benefits in settlement - At 31 December 2000, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation.
Conclusion - The guarantee is subsequently measured at the higher of (a) the best estimate of the obligation (see paragraphs 14 and 23), and (b) the amount initially recognised less, when appropriate, cumulative amortisation in accordance with IAS 18 Revenue.
Note: Where an entity gives guarantees in exchange for a fee, revenue is recognised under IAS 18 Revenue.

(b) At the balance sheet date of 31 December 2000
Present obligation as a result of a past obligating event - There is still no obligation for the costs of fitting smoke filters because no obligating event has occurred (the fitting of the filters). However, an obligation might arise to pay fines or penalties under the legislation because the obligating event has occurred (the non-compliant operation of the factory).
An outflow of resources embodying economic benefits in settlement - Assessment of probability of incurring fines and penalties by non-compliant operation depends on the details of the legislation and the stringency of the enforcement regime.
Conclusion - No provision is recognised for the costs of fitting smoke filters. However, a provision is recognised for the best estimate of any fines and penalties that are more likely than not to be imposed (see paragraphs 14 and 17-19).
Example 7: Staff Retraining as a Result of Changes in the Income Tax System
The government introduces a number of changes to the income tax system. As a result of these changes, an enterprise in the financial services sector will need to retrain a large proportion of its administrative and sales workforce in order to ensure continued compliance with financial services regulation. At the balance sheet date, no retraining of staff has taken place.
Present obligation as a result of a past obligating event - There is no obligation because no obligating event (retraining) has taken place.
Conclusion - No provision is recognised (see paragraphs 14 and 17-19).
Example 8: An Onerous Contract
An enterprise operates profitably from a factory that it has leased under an operating lease. During December 2000 the enterprise relocates its operations to a new factory. The lease on the old factory continues for the next four years, it cannot be cancelled and the factory cannot be re-let to another user.
Present obligation as a result of a past obligating event - The obligating event is the signing of the lease contract, which gives rise to a legal obligation.
An outflow of resources embodying economic benefits in settlement - When the lease becomes onerous, an outflow of resources embodying economic benefits is probable. (Until the lease becomes onerous, the enterprise accounts for the lease under IAS 17, Leases).
Conclusion - A provision is recognised for the best estimate of the unavoidable lease payments (see paragraphs 5(c), 14 and 66).