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                          IAS 37 Provisions, Contingent Liabilities and Contingent Assets

                                                                                       2011
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Robin Joyce
Professor of the Chair of
International Banking and Finance
Financial University
under the Government of the Russian Federation

Visiting Professor of the Siberian Academy of Finance and Banking                                  Moscow, Russia        2011 Reviewed
                                                                                    IAS 37 Provisions, Contingent Liabilities and Contingent Assets

                                                                                 IAS 37 Provisions, Contingent Liabilities and
                                                                                 Contingent Assets
                                                                                 Illustrative Corporate Financial Statements 2002

CONTENTS
1. Introduction                                                       4
2. Definitions                                                        5
3. Bank accounting                                                    6
4. Provisions and Other Liabilities                                   12
5. Provisions – Specific applications: Future Operating Losses16
6. Restructuring                                                      16
7. Recognition of Provisions                                          21
8. Measurement                                                        25
9. Contingent Liabilities                                             27
10.Relationship between Provisions and Contingent Liabilities 28
11. Contingent Assets                                                 29
12. Disclosure                                                        31
13. Annex – IAS 37 rules for users other than banks.                  34
14. Multiple choice questions                                         40
15. Answers to multiple choice questions                              45
Note: Material from the following PricewaterhouseCoopers publications has been
used in this workbook:

Applying IFRS
Illustrative Corporate Financial Statements 2006 – Banks
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                                                                                IAS 37 Provisions, Contingent Liabilities and Contingent Assets
1.    - Introduction                                                    Background
                                                                        Provisions are used to provide for future liabilities that are uncertain.
Aim
The aim of this workbook is to assist the individual in understanding   Provisions are sometimes mis-used for ‗profit smoothing‘ by inflating
Provisions, Contingent Liabilities and Contingent Assets according to   provisions to reduce profits in good years, then releasing those
IFRS.                                                                   provisions to increase profits in the bad years.

                                                                        Provisions for reorganisation have also been mis-used particularly
Objective
                                                                        those arising through mergers.
The objective of IAS 37 is to provide recognition criteria and
                                                                        IAS 37 is a short standard, but its intention is to limit provisions to the
measurement bases for provisions, contingent liabilities and
                                                                        specific underlying liabilities.
contingent assets, and to specify the information to be disclosed in
                                                                        Contingent liabilities, such as guarantees and warrantees, do not
                                                                        appear on balance sheets, but need to be noted in financial
the notes to the financial statements.
                                                                        statements to enable users to have a complete picture of the
                                                                        undertaking‘s financial position.

                                                                        Contingent assets are uncertain cash inflows that may be received.
                                                                        IAS 37 defines them, and prescribes their reporting treatment.

                                                                        The IASB has issued an exposure draft which proposes to amend
                                                                        IAS 37. A copy and the progress of this exposure draft can be found
                                                                        on the IASB website (English language only) at:
                                                                        http://www.iasb.org/Home.htm

                                                                        Scope
                                                                        IAS 37 should be applied by all undertakings in accounting for
                                                                        provisions, contingent liabilities and contingent assets, except:
                                                                           i those resulting from financial instruments, that are carried at
                                                                               fair value;

                                                                           ii   those arising in insurance undertakings from contracts with
                                                                                policyholders (IFRS 4); and

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                                                                                   IAS 37 Provisions, Contingent Liabilities and Contingent Assets
   iii those covered by another Standard.                                   (i)       financial instruments and guarantees that are not carried at
                                                                                      fair value.
                                                                            (ii)      provisions, contingent liabilities and contingent assets of
Where another Standard deals with a specific type of provision,
                                                                                      insurance undertakings other than those arising from
contingent liability or contingent asset, an undertaking applies that
                                                                                      contracts with policyholders.
Standard instead of IAS 37.
                                                                         2. Definitions
For example, certain types of provisions are also addressed in
Standards on:
   i construction contracts see IAS 11 Construction Contracts;           The following terms are used in IAS 37:

   ii   income taxes see IAS 12 Income Taxes;                               A provision is a liability of uncertain timing, or amount.

   iii leases see IAS 17 Leases (although onerous operating leases          A liability is an obligation arising from past events.
       are covered by IAS 37);
                                                                            An obligating event is an event that creates a legal or
   iv staff benefits: see IAS 19 Staff Benefits;                            constructive obligation.

   v    financial instruments: see IFRS 9; and                              A legal obligation is an obligation that derives from:
                                                                            i a contract through its explicit, or implicit terms; or
   vi   impaired assets: see IAS 36.
                                                                            ii     legislation.
Some amounts treated as provisions may relate to the recognition of
revenue, covered in IAS 18, for example where a bank gives                  A constructive obligation is an obligation where:
guarantees in exchange for a fee.                                           i by practice, policies or a statement, the undertaking has
                                                                               indicated that it will accept certain responsibilities; and
The term ‗provision‘ is also used for items such as depreciation,
impairment of assets and doubtful debts: these are adjustments to           ii     the undertaking has created an expectation that it will
the carrying amounts of assets, and are not addressed in IAS 37.                   discharge those responsibilities.

IAS 37 applies to provisions for restructuring including discontinuing       A contingent liability is:
operations. Discontinuing operations are covered by IFRS 5.                 i a possible obligation that arises from past events, and
                                                                                whose existence will be confirmed by the occurrence, or
IAS 37 applies to:                                                              non-occurrence, of uncertain future events; or


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                                                                               IAS 37 Provisions, Contingent Liabilities and Contingent Assets
   ii   a present obligation that arises from past events, but is not
        recorded because:                                                Provisions
        i it is not probable that payment will be required to settle
           the obligation; or                                            Provisions found in financial statements typically comprise costs
                                                                         of restructuring the bank as it sheds activities that are no longer
        ii   the amount of the obligation cannot be measured.            profitable. Other provisions can be costs relating to contingent
                                                                         liabilities and contractual commitments.
   An undertaking should not record a contingent liability in the
   balance sheet. An undertaking should disclose a contingent            Provisions for pensions are also found, but covered by IAS 19
   liability, unless the possibility of payment is remote.               Staff benefits.
                                                                         Provisions may be necessary when the bank has issued
   It is common practice, particularly in banking, to record all         performance guarantees on behalf of clients who are contractors,
   contingent assets and liabilities in the off balance sheet section.   and a contractor has failed to perform and the bank must finance
                                                                         completion of the contract.
   In enterprises, the practice of commitment accounting is
   becoming more common for management information to record             There is a risk, however small, that a bank will beheld liable for its
   contingent assets and liabilities in the off balance sheet section    client‘s obligations. If the client were to default on a loan and the
   of the books.                                                         bank take control of the client‘s operation, the bank might find
                                                                         itself facing claims for the client‘s environmental damage. Even if
   A contingent asset is a possible asset, that arises from past         the bank is not held to be liable, legal and other expert costs may
   events, and whose existence will be confirmed by the                  be incurred to defend the claim.
   occurrence or non-occurrence of uncertain future events.
                                                                         Contingent liabilities
   An onerous contract is a contract in which the costs of the
   obligations exceed the benefits to be received.                       Banks usually have contingent liabilities to be reported. Banks issue a
                                                                         number of documents on behalf of clients for which they anticipate
   A restructuring is a programme that is planned, and                   being reimbursed by clients. These include:
   controlled, by management, and significantly changes either:
      i the scope of a business; or                                      -Documentary and commercial letters of credit;
      ii the manner in which that business is conducted.
                                                                         -Acceptances (time drafts endorsed by the bank);
3. Bank accounting
All items of provisions, contingent liabilities and contingent assets    -Standby letters of credit (also called demand guarantees).
must be material to the financial statements (see Framework
workbook) to be included.
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                                                                                   IAS 37 Provisions, Contingent Liabilities and Contingent Assets
There is a risk that the bank may not be repaid in full. As a result,        Loan commitments are also listed as contingent liabilities. The bank
such documents outstanding at the balance sheet date are listed as           has contracted to provide a loan to a client, but has yet to disburse
contingent liabilities.                                                      some, or all, of the funds under the contract. Loan commitments
                                                                             include the amount of overdrafts that are not currently being used.
Banks also issue guarantees for various purposes. Guarantees
outstanding at the balance sheet date are also listed as contingent          The bank must have facilities in place to finance the loans when they
liabilities. Banks may not anticipate claims against the guarantees,         are to be disbursed.
but list them to recognise the risk that claims may arise.
                                                                             IFRS 7 requires banks to disclose loan commitments in additional
IFRS 7 requires banks to disclose guarantees in additional ways:             ways:
Guarantees and IFRS 7 – collateral and other credit enhancements
 obtained                                                                    Loan commitments and IFRS 7 – scope of IFRS 7

When an entity obtains financial or non-financial assets during the          IFRS 7 applies to recognised and unrecognised financial instruments.
period by taking possession of collateral it holds as security, or calling   Recognised financial instruments include financial assets and
on other credit enhancements ((examples of the latter being                  financial liabilities that are within the scope of IFRS 9. Unrecognised
guarantees, credit derivatives, and netting agreements that do not           financial instruments include some financial instruments that,
qualify for offset in accordance with IAS 32)), and such assets meet         although outside the scope of IFRS 9, are within the scope of IFRS 7
the recognition criteria in other Standards, an entity shall disclose:       (such as some loan commitments).

(i)    the nature and carrying amount of the assets obtained; and            Loan commitments and IFRS 7 – credit risk

(ii)   when the assets are not readily convertible into cash, its            Activities that give rise to credit risk and the associated maximum
       policies for disposing of such assets, or for using them in its       exposure to credit risk include, but are not limited to, making a loan
       operations.                                                           commitment that is irrevocable over the life of the facility, or is
                                                                             revocable only in response to a material adverse change.
Guarantees and IFRS 7 – credit risk
                                                                             If the issuer cannot settle the loan commitment net in cash, or
Activities that give rise to credit risk and the associated maximum          another financial instrument, the maximum credit exposure is the full
exposure to credit risk include, but are not limited to, granting            amount of the commitment. This is because it is uncertain whether
financial guarantees. In this case, the maximum exposure to credit           the amount of any undrawn portion may be drawn upon in the future.
risk is the maximum amount the entity could have to pay if the
guarantee is called on.                                                      When an entity is committed to make amounts available in
                                                                             instalments, each instalment is allocated to the earliest period in
                                                                             which the entity can be required to pay. For example, an undrawn
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                                                                                     IAS 37 Provisions, Contingent Liabilities and Contingent Assets
loan commitment is included in the time band containing the earliest           In order to present a complete picture, we have included examples
date it can be drawn down.                                                     that relate to IAS 37, but for users other than banks, including
                                                                               subjects such as onerous contracts, in an annex.
Loan commitments and IFRS 7 – interest rate risk
                                                                               Provisions, contingent liabilities and contingent assets –bank
Interest rate risk arises on interest-bearing financial instruments            examples:
recognised in the balance sheet (for example loans and receivables
and debt instruments issued) and on some financial instruments not
recognised in the balance sheet (for example some loan
commitments).
Loan commitments and IFRS 7 – liquidity risk
                                                                               Example - Bank guarantee:
IFRS 7 requires the entity to describe how it manages the liquidity
risk inherent in the maturity analysis of financial liabilities. The factors   Enterprise A applies to the bank for a bank guarantee to Enterprise
that the entity might consider in providing this disclosure include, but       B. Enterprise B is the supplier of expensive technology.
are not limited to, whether the entity:
                                                                               The financial situation of Enterprise A is stable, and the Bank
(i)    expects some of its liabilities to be paid later than the earliest      issues the guarantee for the amount of 100 mln RUR on January
date on which the entity can be required to pay (as may be the case            25, 2XX1. The guarantee term is one year: 01 May 2XX1 - 01 May,
for customer deposits placed with a bank);                                     2XX2. The bank‘s commission for the guarantee is 1 mln RUR.

(ii)  expects some of its undrawn loan commitments not to be                   The two enterprises sign a contract for the term February 01, 2XX1-
drawn.                                                                         February 01, 2XX2. According to the contract, Enterprise B will
                                                                               deliver the equipment in 4 shipments, and Enterprise A pays within
Other contingent liabilities of banks include the outcome of lawsuits          3 months from the delivery date. The value of each delivery is 20
filed against the banks.                                                       mln RUR.

Contingent assets                                                              January 25, 2XX1- Bank issued guarantee:
                                                                               Enterprise A is in good financial health, no outflow of economic
Banks‘ contingent assets normally comprise items such as insurance             benefits from the bank is expected to occur regarding the
claims, when there remains doubt as to whether the amounts will be             guarantee. Consequently, there is no outstanding liability and, on
received.                                                                      the balance sheet, no adjustment is made.
Annex – IAS 37 rules for users other than banks
                                                                               January 25, 2XX1- Bank received commission for the guarantee:
                                                                               Since the sum of 1 mln RUR is for the services for one year period,
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                                                                              IAS 37 Provisions, Contingent Liabilities and Contingent Assets
the bank should recognise income proportionately during that            income will be:
period. The whole amount of the commission is recognised as             1 000 000*2/12=166 667 RUR
deferred income.
                                                                         Income from the guarantee:
In the following examples, I/B refers to Income Statement and                                                   I/B      DR          CR
Balance Sheet (SFP).                                                     Deferred income                         B     166 667
                                                                         Income from guarantee issued             I                166 667


                                                                        In August, a fire in the warehouse destroyed equipment worth 50
 Bank received commission for the guarantee:                            mln RUR. As a result, Enterprise A is not able to pay due for the
                                      I/B               DR         CR   equipment received worth 20 mln RUR.
 Cash                                  B                1m
 Deferred income                       B                           1m   The bank expects that, after October 15, Enterprise B will require
                                                                        the bank to pay for Enterprise A‘s debt of 20 mln RUR.
As at March 31, 2XX1, Enterprise A has not broken its contractual
obligations, and its financial condition has not worsened. In the        August 22, 2XX1- Provision is made:
financial statements (notes to the statements) for the first quarter                                            I/B      DR          CR
the following information is disclosed:                                  Expenses on provisioning                 I      20m
                                                                         Provision                               B                   20m
―January 25, 2XX1 the Bank has issued a guarantee in the amount
of 100 mln RUR. The debt, secured by the guarantee, is serviced         It is also expected that after the payment of 20 mln RUR by the
as agreed.                                                              bank, the contract between the two enterprises will be cancelled.
There is no reason to expect deterioration of the client‘s financial    This expectation must be reflected in the financial statements.
situation, therefore the above-mentioned amount is regarded as
contingent liability‖.                                                   October 16, 2XX1- Payment to Enterprise B for Enterprise A:
                                                                                                              I/B      DR          CR
During the second quarter, Enterprise A continues to service the         Provision                             B       20m
debt properly, and its financial health is stable.                       Cash                                  B                  20m
In the notes to the financial statements for this quarter the same
information is disclosed as was disclosed in the first quarter.         Enterprise A owes the bank 20 mln RUR, so the bank will have an
                                                                        account receivable:
On the income statement, income from the guarantee is recognised
for that quarter. The first two months (May, June) from the
guarantee contract term are in second quarter. The amount of
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                                                                                    IAS 37 Provisions, Contingent Liabilities and Contingent Assets
 October 16, 2XX1- Account receivable – Enterprise A:
                                      I/B      DR                    CR      The bank will seek compensation from Enterprise A for the loss.
 Account receivable – Enterprise A     B      20m
 Expenses on provisioning               I                           20m      Example - Provision-lawsuit:

In the notes to the financial statements for the third quarter the           As a result of an advertising campaign of the bank, 350
following disclosure is made:                                                depositors have sued the bank. They accuse the bank that,
                                                                             because of the unclear messages in the bank‘s advertisement,
―On January 25, 2XX1, the Bank issued a guarantee in the amount              they haven‘t received income of 30 mln RUR. The case
of 100 mln RUR. The guarantee term expires May 1, 2 XX1. A                   against the bank opened on April 1, 2XX2.
provision expense of
20 mln has been set up for the payment of the client‘s unpaid                The investigation and lawsuit are expected to last two years
obligation. There is sufficient reason to expect the cancellation of         and the numbers of unhappy depositors may rise to 500, which
the guarantee contract after the payment of 20 mln. We expect that           will make the total amount of the claim 40 mln RUR.
the cancellation of the contract will not result in an additional
material cost for the bank‖.                                                 As at April 1, 2XX2, lawyers and other experts of the bank
                                                                             expect that, as a result of the court decision, the bank will have
October 20, 2XX1, Enterprise A and Enterprise B agree to cancel              to pay a penalty of 15 mln RUR.
the contract of equipment supply. As a result, the bank guarantee
contract, which was concluded purely for securing the obligations            The bank should immediately set up a provision to reflect this
under the equipment supply contract, is cancelled too.                       liability. Since the payment of 15 mln RUR is expected to be
                                                                             made in 2 years – in March or April 2XX4, the time value of
The unearned part of the commission is recognised as income in               money is significant, and it is necessary to discount the 15 mln
the third quarter                                                            RUR, using a discount rate that expresses the risks regarding
(1 000 000 – 166 667 = 833 333 RUR).                                         this liability.

 October 20, 2XX1- Income recognition:                                       The discount rate in our example is the rate, at which the bank
                                              I/B      DR            CR      can attract money for a term of two years with the same credit
 Deferred income                               B     833 333                 risk. Assume: interest rate reflecting the risks of that liability is
 Income from guarantee issued                   I                  833 333   equal to 24% annually, or 2% per month.

At the end of the financial year, the bank has neither provisions nor        Discounting 15 mln at 2% for a period of 24 months, we find
contingencies. Any information necessary is disclosed in the                 the present value of the liability to be 9 326 000 RUR. This
statements, and there is no need to make additional records in the           amount is the carrying amount of the provision.
notes to the statements.
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                                                                               IAS 37 Provisions, Contingent Liabilities and Contingent Assets

                                                                          May 31, 2XX2- Provisioning:
 April 02, 2XX2- Provision is made:                                                                     I/B       DR             CR
                                          I/B        DR            CR     Borrowing expenses              I     380 000
 Expenses on provisioning                   I         9                   Provision                      B                    380 000
                                                     326
                                                     000                 If the amount of expected penalty changes, or the level of risk
 Provision                                 B                        9    attributable to that liability increases or decreases, then the
                                                                   326   parameters of discounting are corrected.
                                                                   000
                                                                         After 2 years the book value of provision must equal 30 mln
At the end of April new circumstances in the case arise, and             RUR if the amount of the expected penalty has not changed
now the lawyers of the bank think, that the bank will have to            during that time.
pay 30 mln RUR, instead of 15 mln RUR.
                                                                         Suppose, in April 2XX4, the court decides that the bank must
Now it is necessary to calculate the new amount of the                   pay penalty of 30 mln RUR. In that month the bank makes the
provision, discounting 30 mln at 2% for the period 23 months             payment:
(24-1). The new book value is 19 025 000 RUR. Additional
provisioning is made in the amount 9 699 000 RUR (19 025                  April 15, 2XX4- Penalty payment:
000 – 9 326 000).                                                                                             I/B     DR          CR
                                                                          Provision                            B      30m
 May 02, 2XX2- Provision is made:                                         Cash                                 B                 30m
                                         I/B        DR             CR
 Expenses on provisioning                  I         9                   Example – claiming collateral –contingent asset
                                                    699
                                                    000                  On October 15, 2XX2 the bank wrote off the loan to Enterprise X.
 Provision                                B                         9    The sum of the write-off (principal + interest) was 10 mln RUR.
                                                                   699   The loan is secured by a mansion, which is estimated to be worth
                                                                   000   12 mln RUR by independent appraisers.

At the end of each month, the bank calculates the new amount             The bank may dispose of the collateral after the court decision,
of provision. At the end of May that amount is 19 405 000                which is expected to be made in 3 months. The chances for the
RUR, so an additional provision is set up. The difference in the         favourable decision are 50%.
old and new amounts of provision as a result of time value of
money, is charged to borrowing costs:                                    Following the prudence concept, the bank does not recognise the
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                                                                                  IAS 37 Provisions, Contingent Liabilities and Contingent Assets
amount of the claim as an asset, and reflects it as a contingent           EXAMPLE – Provisions versus accruals and other liabilities
asset.
                                                                           Issue
In the financial statements for the year 2XX2, the bank discloses          Provisions are liabilities of uncertain timing or amount. Accruals, in
the following information:                                                 contrast, are liabilities to pay for goods or services that have been
―On October 15, 2XX2 a loan with a total amount due of 10 mln              received or supplied but have not been paid, invoiced or formally
was written off. The loan is secured by a mansion, which is                agreed with the supplier.
estimated to be worth 12 mln RUR by independent appraisers.
                                                                           The following table identifies the types of liabilities that are usually
The bank may dispose of the collateral after the court decision.           presented as provisions and those that are presented as other
The decision is expected to be made in January 2XX3 and the                liabilities.
chances for the favourable decision are 50%. Following the                 Solution
prudence concept, this amount is regarded as a contingent
asset‖.                                                                                                                            Comments
                                                                            Nature of the        Provision         Other
4. Provisions and Other Liabilities                                         obligation                             liabilities
                                                                                                        X
                                                                            Warranties given
Provisions can be distinguished from other liabilities such as trade
                                                                            for goods or
payables and accruals because there is uncertainty about the timing
                                                                            services sold
or amount of the expenditure. By contrast:
                                                                                                        X
                                                                            Refunds given for
   i    trade payables are liabilities to pay for goods or services that    goods sold
        have been received, and have been invoiced by the supplier;
        and                                                                                             X
                                                                            Discounts given
                                                                            for customer
   ii   accruals are liabilities to pay for goods or services that have     loyalty schemes,
        been received but have not been paid, including amounts due         such as frequent
        to employees (for example, amounts relating to accrued              flyer programmes
        vacation pay).
                                                                            Payments for
Although it is sometimes necessary to estimate the amount, or timing,                                   X
                                                                            damages
of accruals, the uncertainty is much less than for provisions.              connected with
Accruals are often reported as part of trade and other payables,            legal cases that
whereas provisions are reported separately.                                 are probable.

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                                                                                     IAS 37 Provisions, Contingent Liabilities and Contingent Assets
                                                                               embodying economic benefits to settle that obligation.
 Dilapidations
 payable at the                X
                                                                               Should management recognise a liability following the placement
 end of an
                                                                               of an order for goods or services?
 operating lease
                                                           Accrual - the       Background
 Interest payments
                                                 X         service has         The management of Bank P has placed two separate orders for
                                                           been received       100 units each of components A and B. Both types of component
                                                           and the timing      are specific to P‘s processes and are not widely used by other
                                                           and amount of       entities.
                                                           payment is
                                                           known.              The terms of both of the contracts are such that once the goods
                                                           Short-term          are manufactured, the manufacturer will notify P, which must
 Holiday pay
 earned by                                       X         compensated         arrange for the goods to be collected from the supplier‘s
                                                           absences are        premises.
 employees
                                                           recognised in
                                                           accordance          P is obliged to accept the goods once it has been notified that the
                                                           with IAS 19.        goods have been manufactured, or pay a substantial penalty if
 Property rentals                                          Accrual - the       P‘s management decide to cancel the contract.
                                                 X         service has
                                                           been received       At the balance sheet date, the supplier has manufactured all 100
                                                           and the timing      of the units of A. The supplier has notified P that the components
                                                           and amount of       are ready for collection but P has not yet arranged for collection.
                                                           payment is          None of the units of B have been manufactured.
                                                           known.
 Ordinary dividend                                         Recognise as a      Bank P‘s management expects to take delivery of all components
                                                           current financial   of A and B that have been ordered.
 declared before
                                                 X         liability
 year-end
                                                                               Solution
EXAMPLE –Recognition of liability for purchase orders                          Yes, a liability for the purchase of component A should be
                                                                               recognised. No liability should be recognised in respect of the
Issue                                                                          purchase of component B.
A liability qualifies for recognition when there is a present
obligation and there is the probability of an outflow of resources
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                                                                                   IAS 37 Provisions, Contingent Liabilities and Contingent Assets
                                                                             The amount recorded as a provision should be the best estimate of
Provisions – when and how they should be recorded                            the expenditure required to settle the obligation at the balance sheet
                                                                             date, or to transfer it to a third party at that time.
A provision should be recorded only when:
                                                                             EXAMPLE – cost of transfer of a liability to a third party
   i    an undertaking has a present obligation, legal or constructive,      You will have a liability for trademark infringements from a court
        as a result of a past event;                                         case that is still in progress at the balance sheet date. Nobody
                                                                             knows how much you will have to pay. An insurance company
   ii   it is probable that a payment will be required to settle the         offers to settle your case for $10 million.
        obligation; and                                                      This amount can be used as your provision, if no better estimate
                                                                             is available.
   iii a reliable estimate can be made of the amount of the                                                            I/B    DR         CR
       obligation.                                                           Trademark infringements                     I     10m
                                                                             Provision                                  B                  10m
A constructive obligation is an obligation where:                            Recording provision

   i    by past practice, policies or statements, the undertaking has        EXAMPLE –Refunds and loyalty schemes
        indicated that it will accept certain responsibilities; and
                                                                             Issue
   (ii) as a result, the undertaking has created an expectation that it      A provision should only be recognised if the conditions set out
        will discharge those responsibilities.                               below are met:

EXAMPLE – constructive obligation                                            i) a bank has a present obligation (legal or constructive) as a
You have a written policy to meet the highest standards of health and        result of a past event;
safety, even if this is more than the law requires. This is a
constructive obligation.                                                     ii) it is probable that an outflow of resources embodying economic
                                                                             benefits will be required to settle the obligation; and
In a lawsuit, it may not be clear if an undertaking has a present
obligation.                                                                  iii) a reliable estimate of the amount of the obligation can be
If money is likely to be owed, there is a present obligation. If it cannot   made.
be quantified, a contingent liability is recorded. If the possibility of a
penalty is remote, nothing is recorded.                                      Does a policy of providing refunds and rewards on services sold
                                                                             give rise to the need to recognise a provision in the financial
                                                                             statements?

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                                                                            IAS 37 Provisions, Contingent Liabilities and Contingent Assets
Background                                                          In measuring a provision:
A bank has several customer loyalty schemes in place. The
schemes are as follows:                                                i    take risks and uncertainties into account. However, uncertainty
                                                                            does not justify the creation of excessive provisions, nor a
i) refunds in respect of services, such as pensions and insurance           deliberate overstatement of liabilities;
are given to dissatisfied customers within 1 month of sale;
                                                                       ii   discount the provisions, where the impact of the time value of
ii) reward points are given to customers. Electronic card systems           money is material, using a pre-tax discount rate. Where
are used to record the points and award the bonuses. The                    discounting is used, the increase in the provision due to the
bonuses take the form of discounts on credit card fees;                     passage of time is recorded as an interest expense.

iii) reward points are accumulated by customers and then               iii take future events, such as changes in the law and technology,
exchanged for vouchers. The vouchers entitle customers to                  into account, where there is evidence that they will occur; and
discounts; and
                                                                       iv do not take gains from the disposal of assets into account,
iv) bonus points that entitle customers to discounted travel are          even if the expected disposal is closely linked to the event
awarded to frequent flyers.                                               giving rise to the provision.

Solution                                                            Provisions should be reviewed at each balance sheet date, and
Yes. In all four cases the sale of goods or the performance of      adjusted to reflect the current best estimate.
services is a past event that gives rise to a present obligation,
and management should recognise a provision provided that it        If it is no longer probable that payment will be required to settle the
can be measured reliably.                                           obligation, the provision should be reversed.

The obligation is either a legal one as defined in the bank‘s       EXAMPLE – provisions no longer required
agreements with its customers or a constructive one, as the bank    You have made a $1 million provision for redundancies. You then
appears to have created a valid expectation in customers that it    purchase another firm which has vacancies that your staff would
will provide refunds or other benefits.                             like to fill. You reverse the $1 million provision.
The valid expectation is created by the bank‘s past behaviour.                                                 I/B      DR     CR
                                                                    Redundancy costs                             I                1m
See also: IFRIC 13 Customer Loyalty Programmes published by         Provision                                   B         1m
the IASB.                                                           Reversing provision

PROVISION – Measurement                                             A provision should be used only for expenditures for which the
                                                                    provision was originally recorded.
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                                                                                 IAS 37 Provisions, Contingent Liabilities and Contingent Assets
                                                                           5. Provisions – Specific applications: Future Operating
Setting expenditures against an unrelated provision would conceal          Losses
the impact of two different events.
                                                                           Provisions should not be recorded for future operating losses. Future
EXAMPLE – provisions to be used only for original purpose                  operating losses do not meet the definition of a liability, and the
You have a provision for $4 million for trademark infringements,           criteria set out for provisions.
which you no longer need. You decide to reorganise the group
and need a provision for                                                   Anticipation of future operating losses is an indication that certain
$3 million. This should be a separate provision, and you should               assets may be impaired under IAS 36 Impairment of Assets.
not use the surplus trademark infringements provision for
reorganisation.                                                            Please see also Onerous Contracts in the Annex.
                                        I/B      DR         CR
Reorganisation costs                      I         3m
Provision                                B                     3m          6. Restructuring
Recording provision
                                                                           A restructuring is a programme that is planned and controlled by
Trademark infringements                       I                       4m   management, and significantly changes either the scope of a
Provision                                     B            4m              business or the manner in which that business is conducted.
Reversing provision
                                                                           EXAMPLE – reduced scope of a business
Specific cases of provisions are provided with interpretations by the      Your business encompasses head office and branches. You
IASB:                                                                      decide to dispose of the branches at a net cost of $10m. This
                                                                           reduces the scope of your business.
IFRIC Interpretation 1: Changes in Existing Decommissioning,                                                    I/B     DR        CR
Restoration and Similar Liabilities                                        Restructuring costs                    I       10m
                                                                           Provision                             B                  10m
IFRIC Interpretation 5: Rights to Interests arising from                   Recording provision
Decommissioning, Restoration and Environmental Rehabilitation
Funds

IFRIC Interpretation 6: Liabilities arising from Participating in a
Specific Market—Waste Electrical and Electronic Equipment



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                                                                                      IAS 37 Provisions, Contingent Liabilities and Contingent Assets
EXAMPLE – change of manner in which business is                            A constructive obligation to restructure arises only when an
conducted                                                                  undertaking:
You own and manage a network of branches. You sell the
ownership of the property of the branches to property investors               1 has a detailed formal plan for the restructuring identifying at
but continue to manage them through management contracts                        least:
with the new owners. Restructuring costs of 1 mln are incurred in
legal costs of selling the branches.                                                  i the business, or part of a business concerned;
This changes the manner in which business is conducted.                               ii the principal locations affected;
                                     I/B      DR        CR
Restructuring costs                    I         1m                                   iii the location, function, and approximate number of
Provision                             B                   1m                          employees who will be compensated for terminating their
Recording provision                                                                   services;

                                                                                      iv the expenditures that will be undertaken;

The following are examples of events that may fall under the                          v when the plan will be implemented;
definition of restructuring:
   i    sale, or termination, of a line of business;                          2 has raised a expectation that it will carry out the restructuring,
                                                                                by starting to implement that plan, or announcing its main
   ii   the closure of business locations in a country or region, or the        features.
        relocation of business activities from one country or region to
        another;                                                           Evidence that an undertaking has started to implement a restructuring
                                                                           plan would be provided:
   iii changes in management structure; and
                                                                              (i)        by dismantling buildings or plant,
   iv fundamental reorganisations that have a material impact on
      the nature and focus of operations.                                     (ii)       selling assets, or by

A provision for restructuring costs is recorded only when the criteria        (iii)      the announcement of the main features of the plan.
for provisions met.




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                                                                                   IAS 37 Provisions, Contingent Liabilities and Contingent Assets
An announcement of a detailed plan constitutes a constructive
obligation to restructure, only if it gives rise to expectations that the   Disclosure may be required under IAS 10 Events After the Balance
undertaking will carry out the restructuring.                               Sheet Date.

                                                                            Although a constructive obligation is not created solely by a
Its implementation needs to be planned to begin as soon as                  management decision, an obligation may result from other earlier
possible, and to be completed in a timeframe that makes significant         events together with such a decision.
changes to the plan unlikely.
                                                                            EXAMPLE – constructive obligation
If it is expected that there will be a long delay before the                Negotiations with staff representatives for termination payments
restructuring begins, or that the restructuring will take an                may have been concluded, subject only to board approval. Only
unreasonably long time, the timeframe allows for opportunities to           when approval has been obtained and communicated to the other
change plans.                                                               parties, is there a constructive obligation to restructure.

A management decision to restructure, taken before the balance              No obligation arises for the sale of an operation until there is a
sheet date, does not give rise to a constructive obligation at the          binding agreement to the sale.
balance sheet date, unless the undertaking has, before the balance
sheet date:
                                                                            Even when an undertaking has taken a decision to sell an operation
   i    started to implement the restructuring plan; or                     and announced that decision publicly, it cannot be committed to the
                                                                            sale until a purchaser has been identified and there is a binding
   ii   announced the main features of the plan that the                    agreement.
        undertaking will carry out.
                                                                            When the sale of an operation is envisaged as part of a restructuring,
In some cases, an undertaking starts to implement a restructuring           the assets of the operation are reviewed for impairment under IAS 36,
plan, or announces its main features to those affected, only after          Impairment of Assets.
the balance sheet date.
                                                                            A restructuring provision should include only the direct expenditures
EXAMPLE – constructive obligation                                           arising from the restructuring, which are those that are both
In December, your board decided to close your book distribution             necessitated by the restructuring and not associated with the ongoing
division.                                                                   activities of the undertaking.
In January, the plans were announced to the staff concerned.
No provision should be made in the December accounts, as no                 A restructuring provision does not include such costs as:
start had been made at the balance sheet date, nor had any
announcement been made.                                                        i   retraining, or relocating continuing staff;

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                                                                               IAS 37 Provisions, Contingent Liabilities and Contingent Assets

   ii   marketing; or                                                    EXAMPLE -Recognition of a liability for expenditure that is
                                                                         contingent on a future event
   iii investment in new systems and distribution networks.
                                                                         Issue
EXAMPLE – restructuring provision                                        An obligating event is one that creates a legal or constructive
Your credit card business is losing money. You reorganise it,            obligation that results in an entity having no realistic alternative to
making redundancies at a cost of $12 million.                            settling that obligation.

You also spend $2 million on retraining, $3 million on new               Should management recognise a liability for expenditure that
equipment, and will suffer another $1 million of trading losses          depends on future events?
before the business breaks even.
                                                                         Background
The restructuring provision will be limited to the $12 million.          A bank intends to alter the terms and conditions of employment
                                                                         at one branch so that overtime will be paid at one-and-a-half
The costs of retraining, new equipment and the future trading            times the normal rate, rather than twice the normal rate, as in the
losses must be expensed when incurred.                                   past.
                                      I/B       DR          CR
Restructuring costs                     I         12m                    The bank intends to compensate staff in advance with a one-off
Provision                              B                      12m        payment and has put this offer to the union. No agreement has
Recording provision                                                      been reached with the union at year-end. The bank is likely to
                                                                         switch overtime work to other branch if the union does not accept
The other expenditures relate to the future of the business, and are     the offer.
not liabilities at the balance sheet date.
                                                                         Solution
Such expenditures are recorded on the same basis as if they arose        No, there is no liability at year-end because there is no
independently of a restructuring.                                        constructive or legal obligation to pay the one-off payment.
                                                                         Management has commenced negotiations with unions but as yet
Identifiable future operating losses up to the date of a restructuring   no agreement has been reached that would raise a valid
are not included in a provision, unless they relate to an onerous        expectation with staff. The entity could avoid the payment by
contract.                                                                using the staff at other plants to carry out overtime.

Gains on the expected disposal of assets are not taken into account
in measuring a restructuring provision, even if the sale of assets is
envisaged as part of the restructuring.
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                                                                                IAS 37 Provisions, Contingent Liabilities and Contingent Assets
IFRS 3 Business Combinations has rules determining the use of
                                                                           Lease cancellation
provisions when one undertaking buys another. These are detailed in                                    X
                                                                           fees for a building
our IFRS 3 workbook.
                                                                           which will no longer
                                                                           be used
EXAMPLE – Costs to be included in a restructuring provision
                                                                                                                     X        Costs
                                                                           Relocation of
Issue                                                                                                                         associated with
                                                                           employees and
A restructuring provision should include only the direct expenditures                                                         ongoing
                                                                           equipment from a
arising from the restructuring, being those that are both:                                                                    activities
                                                                           building (to be
                                                                           closed) to a building
i) necessarily entailed by the restructuring; and                          which will continue to
                                                                           be used
ii) not associated with the bank‘s ongoing activities.
                                                                                                                     X        Costs
                                                                           Retraining of
The following table distinguishes between costs that should be                                                                associated with
                                                                           remaining employees
included and excluded from a restructuring provision.                                                                         ongoing
                                                                                                                              activities
Solution                                                                                                             X        Costs
                                                                           Recruitment costs for
                                                                                                                              associated with
                                                                           a new manager
                                                                                                                              ongoing
                                                                                                                              activities
                                                                                                                     X        Costs
                                                                           Marketing costs to
                                                                                                                              associated with
                                                                           develop new
                                                                                                                              ongoing
                                                                           corporate image
                                                                                                                              activities
    Description of         Included         Excluded          Reason for                                             X        Costs
       costs                                                  exclusion    Investments in a new
                                                                                                                              associated with
                                                                           distribution network
                                X                                                                                             ongoing
 Voluntary
                                                                                                                              activities
 redundancies
                                                                                                                     X        Costs
                                                                           Future identifiable
 Compulsory                                                                                                                   associated with
                                                                           operating losses up
 redundancies, if the             X                                                                                           ongoing
                                                                           to date of a
 target for voluntary                                                                                                         activities
                                                                           restructuring
 redundancies are not
 met
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                                                                                       IAS 37 Provisions, Contingent Liabilities and Contingent Assets
                                                   X         The impairment    and organisational                                      activities
 Impairment write-
 down of certain                                             provision         structures
                                                             should be
 property, plant and
                                                             assessed in
 equipment
                                                             accordance                                                       X        Costs
                                                                               Costs of relocating
                                                             with IAS 36 and                                                           associated with
                                                                               inventory and
                                                             offset against                                                            ongoing
                                                                               equipment that will
                                                             the asset                                                                 activities
                                                                               be used at another
                                                  X          Operations is     location
 Rental costs under
                                                             continued to be
 the lease contract for
                                                             used
 the period after the
 criteria in IAS 37                                                            7. Recognition of Provisions
 were met but before
 operation ceased
                                                                               A provision should be recorded when:
 Incremental increase                                                             i an undertaking has a present obligation: legal, or constructive;
 in those costs related
                                X                                                 ii   it is probable that payment will be required;
 to claims for injuries
 and illnesses for staff
 who will be                                                                      iii an estimate can be made of the obligation.
 terminated, occurring
 prior to satisfying the                                                       If these conditions are not met, no provision should be recorded.
 criteria in IAS 37.
                                                                               Present Obligation
                                                   X         Costs
 Costs to be incurred
                                                             associated with   It will normally be clear whether a past event has given rise to a
 in respect of claims
                                                             ongoing           present obligation.
 for injuries and
                                                             activities
 illnesses occurring
 while the                                                                     In a lawsuit, it may be disputed either whether events have occurred,
 restructuring is being                                                        or whether those events result in a present obligation. An undertaking
 implemented                                                                   determines whether a present obligation exists, at the balance sheet
                                                                               date, by taking account of all evidence, including the opinion of
                                                   X         Costs             experts.
 Consulting fees to
                                                             associated with
 identify future
                                                             ongoing
 corporate strategies
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                                                                                   IAS 37 Provisions, Contingent Liabilities and Contingent Assets
The evidence includes any extra evidence provided by events after            The restoration to the original condition means that T will have to
the balance sheet date. On the basis of such evidence:                       repair all damages and put back any alteration made to the
                                                                             premises.
   i    where it is likely that a present obligation exists at the balance
        sheet date, the undertaking records a provision if the criteria      If management of Bank T does not restore the branches, it will
        are met;                                                             have to pay a penalty calculated as a reasonable amount
                                                                             required by third parties to restore the stores to their original
   ii   where it is likely that no present obligation exists, at the         condition.
        balance sheet date, the undertaking discloses a contingent
        liability, unless the possibility of payment is remote.              Management of T is not sure whether it will extend the lease
                                                                             contract after 10 years.
EXAMPLE -Mandatory renovation in an operating lease
                                                                             Solution
Issue
                                                                             Management of T should recognise a provision when damage
A provision should be recognised when:                                       occurs to the branch, or when an alteration is made to the
i) an entity has a present obligation as a result of a past event;           premises. That is the moment when the obligation arises,
ii) it is probable that an outflow of resources embodying economic           because the repairs are due.
benefits will be required to settle the obligation; and
iii) a reliable estimate can be made of the amount of the
obligation.                                                                  There is no present obligation at inception of the lease to make
                                                                             any expenditure, independent of management‘s future actions.
Should management recognise a provision for expenditure to be
made to restore leased property to its original condition at the
end of the lease term?                                                       There is a probability that management will have to make
                                                                             expenditure regarding the restoration for any normal damages
Background                                                                   that may occur, but the expenditure is not due at the moment of
                                                                             entering the lease agreement.
Bank T, leases several branches for a period of 10 years with
options to extend the lease contracts.                                       Past Event

The lease contracts specify that T has the obligation to restore             An event that leads to an obligation to pay money is called an
the branches to the original condition at the end of the lease               obligating event. For an obligating event, the undertaking must
terms, even if the lease is terminated early.                                have no alternative to settling the obligation. This is the case only:

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                                                                               IAS 37 Provisions, Contingent Liabilities and Contingent Assets
   i    where the settlement can be enforced by law; or                  Examples of such obligations are penalties, or clean-up costs, for
                                                                         environmental damage, both of which would lead to payment,
   ii   in the case of a constructive obligation, where the event        regardless of the future actions of the undertaking (see Annex).
        creates expectations that the undertaking will pay.
                                                                         Future operating expenditure is not an obligation. It should be
Financial statements deal with the financial position at the end of a    accounted for in future periods.
reporting period, and not its possible position in the future. No
provision is recorded for costs that need to be incurred to operate in   EXAMPLE - no present obligation for future expenditure
the future. The only liabilities recorded are those that exist at the    You have been told that new regulations will require you to install a
balance sheet date.                                                      sprinkler system in your office, in the next period.

                                                                         You should record the expenditure when it is incurred, not make a
EXAMPLE - liabilities that exist at the balance sheet date               provision in advance.
You have been sued for $25 million for uncompetitive behaviour,
and you believe that you will have to pay this amount in full. You
will also have to pay $10 million to retrain staff, and buy new          EXAMPLE -Recognition of liability for future maintenance costs
machines, to avoid incurring further legal action. Only the $25
million should be included in your provision, as the $10 million         Issue
relates to future operating costs.                                       A liability is defined as a bank‘s present obligation arising from
                                          I/B        DR        CR        past events, the settlement of which is expected to result in an
Uncompetitive behaviour                     I         25m                outflow from the entity of resources embodying economic
Provision                                  B                    25m      benefits.
Recording provision
                                                                         A past event that leads to a present obligation is called an
Only those obligations arising from past events, existing                obligating event. An obligating event creates a legal or
independently of an undertaking‘s future actions (i.e. the future        constructive obligation.
conduct of its business) are recorded as provisions.
                                                                         Should management recognise a liability for future maintenance
                                                                         costs?
EXAMPLE - obligation arising from past events
You buy a competitor, and plan to open 24 more branches. No              Background
provision is made for these new branches, as there is no obligation      Management is planning a maintenance programme at one of the
arising from past events.                                                entity‘s older offices in a years‘ time. The cost is estimated at
                                                                         100,000.

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                                                                           IAS 37 Provisions, Contingent Liabilities and Contingent Assets
Solution
No, there is no obligating event. The intention to incur             However, this may be considered to be a post-balance sheet event
maintenance expenditure does not create a constructive or legal      and disclosures may be needed to comply with IAS 10.
obligation. No liability should be recognised.
                                                                     An event that may rise to an obligation at a later date due to
                                                                     changes in the law.
It is not necessary, however, to know the identity of the party to   EXAMPLE – obligating event
whom the obligation is owed - the obligation may be to the           In 2XX6, when you issued loans without full explanations to
general public.                                                      clients, there was no obligation to remedy the consequences. In
                                                                     early 2XX7, before your 2XX6 accounts were approved, a new
EXAMPLE - obligation to the general public                           law was passed which required any existing losses to be
You set up a warranty provision for claims, generated from your      rectified.
sale of pensions, for which the promises of returns were
overstated.                                                          The cause of the losses has become an obligating event, when
                                                                     the bank accepts responsibility for rectification. A provision will
You do not know who will make a claim, only that a number of         be made in the 2XX6 accounts.
claims will be made, relating to pensions already sold.                                                      I/B        DR         CR
                                        I/B      DR      CR          Client compensation                       I         32m
Warranty costs                            I         3m               Provision                                B                     32m
Provision – product warranties           B                   3m      Recording provision in the 2XX6
Recording provision                                                  accounts

A management, or board, decision does not give rise to a             Where details of a proposed new law have still to be finalised, an
constructive obligation at the balance sheet date, unless the        obligation arises only when the legislation is virtually certain to be
decision has been communicated before the balance sheet date to      enacted as drafted.
those affected by it.
                                                                     Such an obligation is treated as a legal obligation. Often it will be
EXAMPLE – constructive obligation                                    impossible to be certain of the enactment of a law until it is enacted.
In December, your board decided to close your branches in the
eastern region. In January, the plans were announced to the staff    Probable Settlement and Class of Obligations
concerned.                                                           For a liability to qualify for recognition there must be not only a
                                                                     present obligation, but also the probability of payment.
No provision should be made in the December accounts, as no
start had been made at the balance sheet date, nor had any
announcement been made.
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                                                                            IAS 37 Provisions, Contingent Liabilities and Contingent Assets
Where there are a number of similar obligations e.g. product          Warranty costs                           I          8m
warranties, or similar contracts, the probability of settlement is    Provision – pension claims               B                      8m
determined by considering the class of obligations, as a whole.       Recording provision

Although the likelihood of settlement for any one item may be         Where the provision being measured involves a large population of
small, it is probable that some settlement will be needed to settle   items, the obligation is their ‗expected value‘.
the class of obligations as a whole. In such a case, a provision is
recorded if the other criteria are met.                               The provision will be different, depending on the probability of loss.
                                                                      Where there is a range of possible outcomes, and each point in that
                                                                      range is as likely as any other, the mid-point of the range is used.
8. Measurement
                                                                      Where a single obligation is being measured, the most likely outcome
The amount recorded as a provision should be the best estimate        may be the best estimate of the liability.
of the expenditure required to settle the obligation at the balance
sheet date.                                                           The provision is measured before tax.

This is the amount that would be paid to settle the obligation at     Where no reliable estimate can be made, a liability exists that cannot
the balance sheet date, or to transfer it to a third party, at that   be recorded. That liability is disclosed as a contingent liability.
time.
                                                                      Risks and Uncertainties
The estimates are determined by the judgment of management,           Risks and uncertainties should be taken into account in making the
supplemented by experience of similar transactions and, in some       estimate of a provision.
cases, reports from independent experts. The evidence includes
any additional evidence provided by events after the balance          Risk describes variability of outcome. A risk adjustment may increase
sheet date.                                                           the amount at which a liability is measured. Caution is needed, so
                                                                      that income or assets is not overstated, and expenses or liabilities are
EXAMPLE – estimates of liability                                      not understated.
You set up a warranty provision for claims, generated from your
sale of pensions. History tells you that the claims generated by      Uncertainty does not justify the creation of excessive provisions, nor
last year‘s sales will cost between $5 million and $10 million.       a deliberate overstatement of liabilities.

The most likely figure will be $8 million. This should be recorded    Present Value
as the provision.                                                     Where the effect of the time value of money is material the provision
                                          I/B      DR         CR      should be discounted using a pre-tax rate discount rate should that
                                                                      reflects current market assessments.
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                                                                               IAS 37 Provisions, Contingent Liabilities and Contingent Assets
                                                                         At the end of year 1, the provision will increase to 1,148 as
EXAMPLE - Accretion of discount                                          management discounts the cash outflow of 1,200 for one year
                                                                         instead of two.
Issue
                                                                         The increment of 49 should be recognised as a borrowing cost in
The carrying amount of a provision recognised on a discounted
                                                                         the income statement. Similarly in year 2, the provision will
basis increases in each period to reflect the passage of time. The
                                                                         increase by 52 to equal the amount due.
increase should be recognised as a borrowing cost.

How should management calculate the amount of borrowing
                                                                         EXAMPLE - Change in discount rate
costs recognised on the unwinding of a discount?
                                                                         Issue
Background
                                                                         Provisions should be reviewed at each balance sheet date and
T has litigation pending. Legal advice is that T will lose the case,
                                                                         adjusted to reflect the best estimate. Where discounting is used, a
and costs of 1,200 in two years‘ time are estimated. The liability
                                                                         provision's carrying amount increases in each period to reflect the
is recognised on a discounted basis. The appropriate discount
                                                                         passage of time. This increase is recognised as a borrowing cost.
rate is 4.5 %.
Solution                                                                 How should management calculate the borrowing cost when the
                                                                         discount rate changes from one period to the next?
                                                             Borrowing
                Discount          NPV             Cash
                                                               cost      Background
                factor at                         flows
                  4.5%                                                   A bank has an obligation to a third party for 1,000. The obligation
                                                                         is due at the end of year 5. The nominal risk-free pre-tax rate is
                  0.9157         1,099                                   4.5%. At the end of year 3, the discount rate changed to 4%.
                                                                   49
 Year              0.9569        1,148                                   Solution
 1                                                                       At the beginning of year 0, management should recognise an
                                                                         obligation of 802, which is the present value of 1,000 due at the
 Year              1.0000        1,200            1,200            52    end of year 5, discounted by 4.5%. At the end of year 3 the
 2                                                                       obligation that is recognised at 916 needs to increase to 925 to
                                                                         take account of the change in the discount rate

Management should initially recognise a provision for 1,099,             The difference of 9 should be recognised in the income statement
being the present value of 1,200 discounted at 4.5% for two              as a borrowing cost.
years.
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                                                                                       IAS 37 Provisions, Contingent Liabilities and Contingent Assets

                              Year Year Year Year Year                   Year
                                                                                 Gains on expected disposals of assets are recorded as specified by
                                 0    1    2    3    4                      5
                                                                                 the Standard dealing with the assets concerned.
 Original             4.5%     802     839     876     916    957 1,000
 discount rate
                                                                                 9. Contingent Liabilities
 Revised              4.0%                             925               1,000
 discount rate                                                962
                                                                                 A contingent liability is:
 Original                                37     37      40         41      43       i a possible obligation that arises from past events, and
 borrowing costs                                                                        whose existence will be confirmed by the occurrence, or
                                                                                        non-occurrence, of uncertain future events;
 Adjustment to                                            9        (4)     (5)
 provision                                                                       EXAMPLE - Uncertainty
                                                                                 You have given a performance guarantee, relating to your agent,
 Revised                                 37     37      49         37      38    that services will be successfully supplied to his client, for one year.
 borrowing costs
Future Events                                                                    Whilst you hope that there will be no claim against you, there is a
Future events that may affect the amount of an obligation should be              risk that your agent will not perform satisfactorily, and a claim will
reflected in the amount of a provision, where there is evidence that             be made.
they will occur.
                                                                                 You will not know until either a claim is made or a year has
It is appropriate to include expected cost reductions associated with            elapsed.
increased experience.
                                                                                 This will create a contingent liability based on the risk assessment.
An undertaking does not anticipate the development of a
                                                                                    or
completely new technology unless it is supported by objective
                                                                                    ii a present obligation that arises from past events, but is not
evidence.
                                                                                        recorded because:
                                                                                        i it is not probable that payment will be required to settle
The effect of possible legislation is taken into consideration in
                                                                                             the obligation; or
measuring an existing obligation, when the legislation is virtually
                                                                                        ii the amount of the obligation cannot be measured.
certain to be enacted.
Expected Disposal of Assets
                                                                                 EXAMPLE - Uncertainty
Gains on the expected disposal of assets are not taken into
                                                                                 You are being sued for $30 million for damages that it is claimed
account in measuring a provision.
                                                                                 were caused by your work on a client‘s stock exchange listing. You
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                                                                                     IAS 37 Provisions, Contingent Liabilities and Contingent Assets
dispute the claim. It is unclear whether or not you will be liable. If          ii   contingent liabilities - which are not recorded on the
you are found liable, it is unlikely that you would have to pay the                  balance sheet as liabilities, as they are either:
claim in full.                                                                       i possible obligations, as it has yet to be confirmed
The uncertainties make the claim a contingent liability.                                whether there is an obligation; or

You should not record a contingent liability in the balance sheet. You               ii   obligations that do not meet the criteria in IAS 37 as
should disclose a contingent liability in the notes. If the possibility of                either it is not probable that payment will be required, or
payment is remote no disclosure is necessary.                                             an estimate of the obligation cannot be made.

                                                                             Contingent liabilities are assessed continually to determine
EXAMPLE - possibility of payment is remote                                   whether settlement has become probable. If it becomes probable
Every year for the last 5 years, the government has said that it will        that payment will be required for an item previously dealt with as a
levy a ‗windfall‘ tax on banks. It has yet to do so. Unless the              contingent liability, a provision is recorded in the financial
government takes further steps to enact the tax collection, no               statements of the period in which the change in probability occurs.
contingent liability should be recorded, based on the anticipation that
the government is unlikely to act.                                           EXAMPLE contingent liability which becomes a provision
                                                                             You are being sued for $40 million for uncompetitive behaviour. In
                                                                             2XX8, you recognise a contingent liability, as you believe that the
10.Relationship between Provisions and Contingent Liabilities                there is only a remote chance that you will have to pay.
                                                                             In 2XX9, the court decides the case against you, and the $40
All provisions are contingent, as they are uncertain in timing or            million is changed to a provision.
amount.
Here, the term ‗contingent‘ is used for liabilities, and assets, that        Joint and Several Liability
are not recorded in the balance sheet, as their existence will be
confirmed only by the occurrence or non-occurrence of uncertain              Where an undertaking is jointly, and severally, liable for an
future events.                                                               obligation, the part of the obligation that will be met by other
                                                                             parties is treated as a contingent liability. The undertaking records
In addition, the term ‗contingent liability‘ is used for liabilities that    a provision for the obligation net of contributions by others for
do not meet the recognition criteria.                                        which payment is probable.

IAS 37 distinguishes between:                                                EXAMPLE – joint and several liability
   i provisions - which are recorded as liabilities because they             You and your partners are jointly and severally liable for $50
      are present obligations, and it is probable that payment will          million of damages resulting from work involved in a client‘s stock
      be made to settle them                                                 exchange listing.

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                                                                               IAS 37 Provisions, Contingent Liabilities and Contingent Assets
The case has been brought against you, but your partners will            Contingent assets are recorded off balance sheet as the income
reimburse you for $30 million.                                           that may never be realised.

You make a provision for $20 million, and a contingent liability for     EXAMPLE – contingent asset
$30 million.                                                             You have made a claim for $50 million compensation against your
The contingent liability recognises that your partners may not pay,      insurance company. The claim has gone to court. Similar claims
and you will be liable for the total claim.                              against the same company have also gone to court, and then
                                                                         been paid.
The other party may either reimburse amounts paid by the
                                                                         Treat this as a contingent asset.
undertaking, or pay the amounts directly.
                                                                         When the realisation of income is virtually certain, the related asset
In most cases, the undertaking will remain liable for the whole of       is not a contingent asset, and income should be recorded.
the amount, so that the undertaking would have to pay the full
amount, if the third party failed to pay.                                EXAMPLE – compensation treated as income
                                                                         Your claim for $50 million compensation against your insurance
A provision is recorded for the full amount of the liability, and a      company has been successful. The company has asked for a
separate asset for the reimbursement is recorded when it is              month to pay, but you do not believe there is any serious risk of a
virtually certain that reimbursement will be received.                   bad debt. Treat this as income.
                                                                                                                I/B      DR          CR
The undertaking may not be liable for the costs in question, if the      Accounts receivable                     B         50m
third party fails to pay. In such a case, the undertaking has no         Other income                             I                    50m
liability for those costs, and they are not included in the provision.   Recognition of income
                                                                         Reimbursements
                                                                         Reimbursement of the expenditure required to settle a provision
11. Contingent Assets
                                                                         may arise from insurance contracts, indemnity clauses, or
                                                                         suppliers‘ warranties. An undertaking should:
Contingent assets arise from unplanned events that give rise to the         i record a reimbursement only when it is virtually certain that
possibility of an inflow of benefits. A contingent asset is disclosed           reimbursement will be made. The amount recorded for the
where an inflow of benefits is probable.                                        reimbursement should not exceed the amount of the
                                                                                provision;
An example is a claim being pursued through legal processes,
where the outcome is uncertain but likely to be in your favour.


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                                                                              IAS 37 Provisions, Contingent Liabilities and Contingent Assets
EXAMPLE –reimbursement -1                                               Accounts receivable                     B           4m
In 2XX5, the local government informs you that a new road               Recording       provision        and
will be built in 2XX7. This will cause the destruction of your          compensation in 2XX5
head office. Assets of $5 million will have to be written off. By
the end of 2XX5, no compensation has been agreed.                       EXAMPLE –Potential insurance recovery
In 2XX5, a provision should be made.
In 2XX6, the government agreed to pay $4 million in                     Issue
compensation.                                                           A contingent asset is a possible asset that arises from past
The compensation should be recognised in 2XX6.                          events and whose existence will be confirmed only by the
                                       I/B      DR          CR          occurrence or non-occurrence of one or more uncertain future
Asset sequestration                      I       5m                     events not wholly within the entity‘s control.
Provision                               B                     5m
Recording provision in 2XX5                                             Contingent assets are disclosed where an inflow of economic
                                                                        benefits is probable.
Accounts receivable                        B           4m
Compensation                               I                       4m   When should management recognise income for a potential
Recording compensation           in                                     insurance recovery?
2XX6
                                                                        Background
   and
   (ii)    record the reimbursement as a separate asset. In the         A fire destroyed T‘s branch. T is insured for the replacement
           income statement, the expense relating to a provision        cost of the fixed assets and business interruption. However, the
           may be presented net of the amount recorded for a            potential recovery from the insurance entity depends on the
           reimbursement.                                               outcome of an investigation project that relates to the cause of
EXAMPLE –reimbursement -2                                               the fire.
In 2XX5, the local government informs you that a new road will be
built in 2XX7. This will cause the destruction of your head office.     Recent updates of the investigation report show that it is more
Assets of $5 million will have to be written off. By the end of         likely than not that T‘s insurance claim will be successful.
2XX5, the government agreed to pay $4 million in compensation.
In 2XX5, a provision and the compensation should be recorded.           Solution
The income statement should reflect the provision, net of               The potential insurance recovery meets the definition of a
compensation of $1 million.                                             contingent asset, and should be disclosed as such in T‘s
                                        I/B      DR         CR          financial statements. Contingent assets are not recognised,
Asset sequestration Net                   I         1m                  since this may result in the recognition of income that may never
Provision                                B                      5m      be realised.
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                                                                             IAS 37 Provisions, Contingent Liabilities and Contingent Assets
                                                                        ii  an indication of the uncertainties about the amount or
When the realisation of income becomes virtually certain, then              timing of those outflows and major assumptions made
the related asset is not a contingent asset and its recognition is          concerning future events; and
appropriate                                                             iii the amount of any expected reimbursement, stating the
                                                                            amount of any asset that has been recorded for that
The existence of the insurance recovery will be confirmed by the            reimbursement.
outcome of the investigation project. The investigation project is
an uncertain future event not wholly within T‘s control.             Unless the possibility of settlement is remote, an undertaking
                                                                     should disclose, for each class of contingent liability, at the
Currently it is probable (more likely than not) that the insurance   balance sheet date a brief description of the nature of the
recovery will result in an asset and inflow of economic benefits.    contingent liability and, where practicable:
However, the income can only be recognised once it is virtually
certain that there will be an inflow of economic benefits.              i   an estimate of its financial effect;
                                                                        ii  an indication of the uncertainties relating to the amount,
                                                                            or timing of any outflow; and
12. Disclosure                                                          iii the possibility of any reimbursement.

For each class of provision, an undertaking should disclose:         In determining which provisions or contingent liabilities may be
   i the carrying amount at the beginning, and end, of the           aggregated to form a class, it is necessary to consider whether
       period;                                                       the nature of the items is sufficiently similar for a single
   ii additional provisions made in the period, including            statement about them.
       increases to existing provisions;
   iii amounts used i.e. incurred, and charged against the           Thus, it may be appropriate to treat as a single class of
       provision during the period;                                  provision amounts relating to warranties of different products,
   iv unused amounts reversed during the period; and                 but it would not be appropriate to treat as a single class
   v the increase during the period in the discounted amount         amounts relating to normal warranties, and amounts that are
       arising from the passage of time, and the effect of any       subject to legal proceedings.
       change in the discount rate.
                                                                     Where a provision and a contingent liability arise from the same
Comparative information is not required.                             set of circumstances, an undertaking makes the disclosures in a
                                                                     way that shows the link between the provision and the
An undertaking should disclose the following, for each class (or     contingent liability.
each kind) of provision:
   i a brief description of the nature of the obligation, and the    Where an inflow of benefits is probable, an undertaking should
      expected timing of any resulting outflows of benefits;         disclose a brief description of the nature of the contingent
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                                                                                   IAS 37 Provisions, Contingent Liabilities and Contingent Assets
assets at the balance sheet date, and, where practicable, an                 has infringed trademarks. The competitor is seeking damages of
estimate of their financial effect.                                          100 million. Management recognises a provision for its best
                                                                             estimate of the obligation, but discloses none of the information
                                                                             required by IAS 37 relating to it.
It is important that disclosures for contingent assets avoid giving
misleading indications of the likelihood of income arising.                  Solution
                                                                             Management should disclose the following in a note to the
Where any of the information is not disclosed because it is not              financial statements:
practicable to do so, that fact should be stated.
                                                                             Litigation is in process against the entity relating to a dispute with
                                                                             a competitor, which alleges that the entity has infringed
Disclosure of some or all of the information may prejudice seriously         trademarks and is seeking damages of 100 million.
the position of the undertaking in a dispute with other parties on the
subject matter of the provision, contingent liability or contingent asset.
The example below may apply:                                                 The information usually required by IAS 37 is not disclosed
                                                                             because the directors believe that to do so would seriously
                                                                             prejudice the outcome of the litigation. The directors are of the
EXAMPLE – Disclosure exemption                                               opinion that the bank can successfully resist the claim.

Issue                                                                        Sample Accounting Policy and Notes
In extremely rare cases, disclosure of some or all of the                    (from Illustrative Corporate Financial Statements 2006 – Banks,
information required by IAS 37 can be expected to prejudice                  PWC)
seriously the position of the bank in a dispute with other parties
on the subject matter of the provision.                                      Other provisions (balance sheet)
                                                                                                                       2006         2005
In such cases a bank need not disclose specific information, but
should disclose the general nature of the dispute, together with             At 1 January                               229         100
the fact that the information has not been disclosed, and the
reason why.                                                                  Exchange differences                        3            –
How should management make such a disclosure in the financial
                                                                             Additional provisions charged to           283         149
statements?
                                                                             income statement (below)
                                                                             Utilised during year                       (48)        (20)
Background
Bank M is in dispute with a competitor, which is alleging that M
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                                                                              IAS 37 Provisions, Contingent Liabilities and Contingent Assets
At 31 December                                467          229          losses of non-trading monetary
                                                                        assets
                                                                        Other                                       72        21
Included within provisions are:                                                                                    610       420
• A restructuring provision of $M324 (2005: $M114). The
restructuring of part of the retail banking segment in North
America started in 2004 and will result in reductions in personnel.     Contingent liabilities and commitments (note only)
An agreement was reached with the local union representatives           (i) Legal proceedings
by December 2005 that specified the number of staff involved and
quantified the amounts payable to those made redundant.                 There were a number of legal proceedings outstanding against the
                                                                        Group at 31 December 2006. No provision has been made, as
The full amount of the costs estimated to be incurred has been          professional advice indicates that it is unlikely that any significant loss
recognised as a restructuring provision in the current period and is    will arise.
expected to be fully utilised during 2007; and                          (ii) Capital commitments

• Provisions of $M143 (2005: $M115) have been made in respect of        At 31 December 2006, the Group had capital commitments of $M85
costs arising from continent liabilities and contractual commitments,   (2005: $M82) in respect of buildings and equipment purchases. The
including guarantees of $M58 (2005: $M33) and commitments of            Group‘s management is confident that future net revenues and
$M85 (2005: $M82).                                                      funding will be sufficient to cover this commitment.

Other operating expenses (income statement)                             (iii) Loan commitment, guarantee and other financial facilities

                                              2006      2005            At 31 December 2006, the Group had the contractual amounts of the
                                                                        Group‘s off-balance sheet financial instruments that commit it to
(Profit)/loss on sale of property and          15         (5)           extend credit to customers, guarantee and other facilities as follows:
equipment
Software costs                                 14         11                                             2006             2005

Operating lease rentals                       198        194            Loan commitments                3,577             2,367
                                                                        Acceptances                     1,777              898
Restructuring costs (above )                  283        149
                                                                        Guarantees and                   660               789
Guarantees and other credit related            22         31            standby letters of credit
commitments                                                             Documentary and                  415               391
Foreign currency translation net                6         19            commercial letters of
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                                                                         IAS 37 Provisions, Contingent Liabilities and Contingent Assets
credit                                                             An onerous contract is one in which the unavoidable costs of
mounts in $ millions ($M) unless otherwise stated)                 meeting the obligations under the contract, exceed the benefits
(iv) Operating lease commitments                                   expected to be received under it.
Where a Group company is the lessee, the future minimum
lease payments under non-cancellable operating leases are as       EXAMPLE – onerous contract
follows:                                                           You provide electricity to commercial and domestic clients.
                                                                   The government has instructed you to cut domestic charges
                                                                   by 5% and fix the price for 2 years. This will cost you $20
                                                                   million, as you cannot reduce the cost of your supplies. This is
                                                                   an onerous contract, and a provision should be made for the
                                                                   $20 million loss.
                                         2006           2005                                             I/B        DR         CR
                                                                   Cost of sales-onerous contract          I        20m
No later than 1 year                     205            195        Provision                              B                   210m
                                                                   Recording provision
Later than 1 year and no later           920            880        When contracts can be cancelled without paying compensation
than 5 years                                                       there is no obligation.
Later than 5 years                      1,150          1,320
                                                                   EXAMPLE –Definition of onerous contracts
                                        2,275          2,395
                                                                   Issue
                                                                   An onerous contract is one in which the unavoidable costs of
                                                                   meeting the obligations under the contract exceed the
13. Annex – IAS 37 rules for users other than banks.
                                                                   economic benefits to be received under the contract.
This annex provides examples of the application of IAS37 which
                                                                   What are the circumstances that give rise to an onerous
are rarely found in banks.                                         contract?

Onerous Contracts                                                  Background
                                                                   a) Contract 1
If an undertaking has a contract that is onerous, the present
                                                                    An entity has a contract to purchase 1 million units of gas at
obligation under the contract should be recorded and measured
                                                                   0.15 per unit, giving a contract price of 150,000. The current
as a provision.
                                                                   market price for a similar contract is 0.16 per unit, giving a
                                                                   price of 160,000. The gas will be used in generating electricity
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                                                                         IAS 37 Provisions, Contingent Liabilities and Contingent Assets
and the electricity will be sold at a profit.
                                                                   EXAMPLE – Impairment of assets dedicated to an onerous
b) Contract 2                                                      contract

 An entity has a contract to purchase 1 million units of gas at    Issue
0.23 per unit, giving a contract price of 230,000. The current     An entity must recognise any impairment loss that has
market price for a similar contract is 0.16 per unit, giving a     occurred on assets dedicated to an onerous contract before a
price of 160,000.                                                  separate provision for the contract is established.

The entity does not use the gas in its business but has a          Give an example of a separate provision for an onerous
sales contract to sell it to a third party at 0.18 per unit. The   contract?
entity would have to pay a penalty of 55,000 to exit the
contract.                                                          Background
                                                                   A enters into a contract to provide B with high-quality
Solution                                                           monitors. The sales contract is entered on 30 November
a) Contract 1                                                      20X2 and the delivery date is 1 March 20X3. The contract is
                                                                   for the sale of 100,000 monitors for an amount of 20,000,000.
 These circumstances do not indicate an onerous contract.
The economic benefits from the contract include the benefits       The manufacturing processes take approximately 2 months to
to the entity from using the gas in its business to produce        complete the order. As the delivery of the monitor is critical to
electricity. The electricity is sold at a profit, therefore the    the operation of B, A is required to deliver the monitors on
contract is not onerous.                                           time. Any delay or cancellation will result in high penalty
                                                                   charges of approximately 25,000,000.
b) Contract 2
                                                                   At the end of the financial year, due to a shortage of certain
 These circumstances do indicate an onerous contract. The          components in manufacturing the monitor, the cost of
economic benefit (revenue) from the contract is 180,000 at a       manufacturing the 100,000 units has escalated to 210 per
cost of 230,000. Management should recognise an onerous            unit, which would result in a loss of 1,000,000 for the whole
contract of 50,000, which is the lower of the cost of fulfilling   contract.
the contract and the penalty cost of cancellation (55,000).
                                                                   At year-end, no production has commenced on this order and
                                                                   no materials have been bought specifically to fulfil this order.
Before a separate provision for an onerous contract is
established, impairment losses on assets dedicated to that         The manufacturing equipment that is dedicated to fulfilling this
contract should be provided for per IAS 36.                        order has a carrying amount of 5,000,000. The recoverable
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                                                                          IAS 37 Provisions, Contingent Liabilities and Contingent Assets
amount of the equipment is estimated to be 4,200,000 after          The entity does not occupy the property, but has arranged a
taking the above contract into consideration.                       sublease at a rent of 30,000 a year for 10 years. The total
                                                                    revenue receivable from the sub-lessee is 300,000. The cost
Solution                                                            of continuing with the lease and sublease is 200,000
A should recognise an impairment charge of 800,000 on the           (500,000-300,000).
manufacturing equipment used to fulfil the order, and a further
200,000 should be provided separately for an onerous                The penalty for exiting the lease and the sublease is 150,000.
contract.                                                           However, management believes that exiting from the contract
                                                                    would harm the entity‘s public image and has decided to
The unavoidable costs of meeting the obligations amounts to         continue with the lease and the sublease.
21,000,000 (the cost to manufacture 100,000 monitors at 210
per unit), and that exceeds the benefits of 20,000,000              Solution
expected from the contract (the contracted amount).                 Management should recognise a provision for 150,000, which
                                                                    is the lower of the cost of exiting the leases (150,000) and the
The unavoidable loss should be applied first to reduce the          cost of continuing with the leases (200,000). Management‘s
manufacturing equipment to its recoverable amount and the           decision to continue with the leases does not affect the
balance recognised as a provision for the onerous contract.         amount that should be recognised.

EXAMPLE – Recognition of unavoidable costs under an                 The provision should be discounted at the appropriate pre-tax
onerous contract                                                    rate that reflects current market assessments of the time
                                                                    value of money and the risks specific to the liability for which
Issue                                                               future cash flow estimates have not been adjusted.
The unavoidable costs under a contract reflect the least net
cost of exiting from the contract, which is the lower of the cost
of fulfilling the contract and any compensation or penalties        Past Event
arising from a failure to fulfil it [IAS37R.68].
                                                                    EXAMPLE -Past event that gives rise to a present obligation
How should management measure a provision for an onerous
contract?                                                           Issue
                                                                    A past event is deemed to give rise to a present obligation if,
Background                                                          taking account of all available evidence, it is more likely than
An entity leases a property from a third party. The lease is an     not that a present obligation exists at the balance sheet date.
operating lease and has a 10-year term and a rental of
50,000 a year. The total contract cost is therefore 500,000.        Rarely will the existence of a present obligation be unclear.

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                                                                         IAS 37 Provisions, Contingent Liabilities and Contingent Assets
A past event that leads to a present obligation is called an       balance sheet date, however, there is no obligation to rectify
obligating event. An obligating event creates a legal or           the damage that will be caused by mining the coal in future
constructive obligation.                                           years.

When does a past event lead to a present obligation?               Similarly, a provision for the decommissioning costs of an oil
                                                                   installation, or a nuclear power station, to rectify damage already
Background                                                         caused.
An entity operates a coal mine. Its licensing agreement
requires it to remove the machinery used for mining coal at        EXAMPLE - Recognition of decommissioning and site
the end of production and restore the land. 80% of the             restoration expenses
restoration costs relate to the removal of the machinery and
20% arise through mining the coal.                                 Issue
                                                                   The cost of an item of property, plant and equipment should
The damage caused by mining the coal is assumed to be              include the initial estimate of the costs of dismantling and
incurred in proportion to the volume of coal mined. At the         removing the asset and restoring the site on which it is
balance sheet date the machinery has been built but no coal        located [IAS16.16(c)(R.05) ].
has been mined.
                                                                   How should management recognise the estimated cost of
Solution                                                           dismantling and removing the asset and restoring the site?
A liability should be recognised at the balance sheet date for
the best estimate of the costs that relate to the removal of the   Background
machinery. The corresponding entry should be included as           An oil company has an obligation, at the date of installation,
part of the cost of the machinery. The amount recognised           to decommission an oil rig at the end of its thirty-year life in
should be the discounted amount.                                   accordance with the local legislative requirements.

The 20% of costs that arise through the mining of coal should      The decommissioning costs for the rig are estimated to be
be recognised as a liability over the periods in which the coal    140,000,000 with a net present value of 8,023,197, based on
is mined. The corresponding entry for this element will be to      a discount rate of 10%.
cost of sales because the damage is caused by current
production.                                                        Solution
                                                                   Management should include 8,023,197, the net present value
                                                                   of the decommissioning cost, in the carrying amount of the oil
The construction of the machinery creates a legal obligation,      rig at the time of its installation. A provision for 8,023,197 is
under the terms of the licence, to remove the machinery and        created because the obligating event is the installation of the
restore the land and is therefore an obligating event. At the      oilrig.
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                                                                           IAS 37 Provisions, Contingent Liabilities and Contingent Assets
                                                                     Recording provision
The amount included in PPE will be depreciated with the rest
of the cost of the oil rig in the usual way. The accretion of the    EXAMPLE - Extended warranties that are insured
discount after the initial recognition of the provision should be
recognised as interest expense.                                      Issue
                                                                     A provision should be recognised if the conditions set out below
The double entry required for the recognition of the asset and       are met:
the liability will be:
Dr PPE - plant and machinery     8,023,197                           i) an entity has a present obligation (legal or constructive) as a
Cr Provision - decommissioning         8,023,197                     result of a past event;

Measurement                                                          ii) it is probable that an outflow of resources embodying
EXAMPLE –warranty estimated costs                                    economic benefits will be required to settle the obligation; and
An undertaking sells goods, with a warranty under which clients
are covered for the cost of repairs of any manufacturing defects     iii) a reliable estimate can be made of the amount of the
that become apparent within the first six months after purchase.     obligation.

If minor defects were detected in all products sold, repair costs    Should management recognise a provision for extended
of $1 million would result.                                          warranties that are underwritten by a third party?
If major defects were detected in all products sold, repair costs
of $4 million would result.                                          Background
                                                                     H manufactures DVD players. Management offers customers an
The undertaking‘s past experience and future expectations            extended warranty, which guarantees the performance of the
indicate that, for the coming year, 75 per cent of the goods sold    product for three years. The customer pays a fee for the
will have no defects, 20 per cent of the goods sold will have        extended warranty. Management pays the fee to a third party
minor defects and 5 per cent of the goods sold will have major       insurer, which underwrites the risk.
defects.
                                                                     Solution
The undertaking assesses the probability the warranty obligations    Management should recognise a provision for its best estimate
as a whole. The expected value of the cost of repairs is: 75% of     of the entity‘s obligation under the extended warranty.
nil + 20% of $1m +
5% of $4m = $400,000                                                 The underwriting agreement does not negate the entity‘s
                                      I/B       DR          CR       obligation to the customer. The customer has recourse to the
Warranty costs                          I     400.000                entity for claims under the extended warranty. The entity, in turn,
Provision – product warranties         B                   400.000   can claim against the insurance provider.
http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng                                                                           38
                                                                              IAS 37 Provisions, Contingent Liabilities and Contingent Assets

Management cannot recognise an asset for the insurance                  EXAMPLE -Funded obligations
claims, unless it is virtually certain that it will recover the funds
from the insurer. Management should disclose a contingent               Issue
asset in the notes to the financial statements if it believes that      Where some or all of the expenditure required to settle a
receipt of the insurance proceeds is probable but not virtually         provision is expected to be reimbursed by another party, the
certain.                                                                reimbursement should be recognised when, and only when, it
                                                                        is virtually certain that reimbursement will be received if the
To recognise a contingent asset, management would have to               entity settles the obligation.
demonstrate that: the risk was covered in the insurance policy; it
had a history of successful similar claims made on the insurers,        Does management have to recognise a provision if the
and legal or other professional advice suggesting that the claim        settlement on an obligation is funded when the obligation
would be successful.                                                    incurs?

The expense relating to a provision may be presented net of the         Background
amount recognised for a reimbursement in the income                     The recent implementation of the EU End of Life Vehicles
statement.                                                              Directive mandates that manufacturers/importers are
                                                                        responsible for the collection and disposal of all new cars from
                                                                        1 July 2002 onwards.
Where a single obligation is being measured, the most likely
outcome may be the best estimate of the liability.                      Importers in the Netherlands are obliged to pay a fee to a
                                                                        foundation, Auto Recycling Nederland (ARN), for each new car
EXAMPLE - estimates                                                     sold. ARN organises the collection/recycling dismantling of the
An undertaking has to rectify a serious fault in a major plant,         vehicles. The fee per car is recalculated every three years
built for a client, The most-likely outcome may be for the repair       based on expected new cars to be sold/old cars to be recycled.
to succeed at the first attempt, at a cost of $100,000, but a
provision for a larger amount is made, if there is a significant        ARN operates on a quasi ‗pay as you go‘ basis, and the fees
chance that further attempts will be necessary.                         ARN receives relating to new cars are used to pay for the
                                                                        current recycling of old cars. Therefore there is no direct
If it is probable that another visit, costing $40.000, will be          correlation in the patterns of fees currently being paid to ARN
needed, the total provision should be $140.000.                         and the current recycling programme.
                                         I/B      DR           CR
Repair costs                               I    140.000                 The importer is still legally responsible for the
Provision                                 B                  140.000    dismantlement/recycling of end-of-life vehicles. There would
Recording provision                                                     be no effect on the importer‘s obligation if ARN were to be
http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng                                                                           39
                                                                          IAS 37 Provisions, Contingent Liabilities and Contingent Assets
wound up, nor does the government provide any guarantees to        3. IAS 37 provisions include:
the importers.
                                                                          1. Depreciation.
Solution
Yes. The importer remains liable for the disposal of cars sold
and should, therefore, recognise the gross liability at its               2. Impairment of assets.
present value. The payments to ARN should be recognised as
a separate asset to the extent that it is virtually certain that          3. Doubtful debts.
ARN will reimburse future settlements. The asset should not
exceed the carrying amount of the provision.
                                                                          4. Environmental provisions.

                                                                   4. A provision is :
14. Multiple choice questions
                                                                          1. A liability of uncertain timing, or amount.

1. ‘Profit smoothing’ often involves:
                                                                          2. An obligation arising from past events.

       1. Contingent assets.
                                                                          3. An event that creates a legal, or constructive obligation.
       2. Contingent liabilities.
       3. Provisions.


2. If no claims are probable, product service warrantees are:      5. A liability is:

       1. Contingent assets.                                              1. A liability of uncertain timing, or amount.

       2. Contingent liabilities.                                         2. An obligation arising from past events.

       3. Provisions.                                                     3. An event that creates a legal, or constructive obligation.

                                                                   6. An obligating event is:
http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng                                                                          40
                                                                             IAS 37 Provisions, Contingent Liabilities and Contingent Assets
       1. A liability of uncertain timing, or amount.                         2. For a future obligation.

       2. An obligation arising from past events.                             3. For a future obligation, if the possibility of a penalty is

                                                                       remote.
       3. An event that creates a legal, or constructive obligation.

                                                                       11. If the possibility of a penalty is remote:
7. A contract in which the costs exceed the benefits is:

       1. An onerous contract.                                                1. Do nothing.

       2. A contingent liability.                                             2. Record a contingent liability.

       3. A contingent asset.                                                 3. Record a provision.

8. Provisions are reported:                                            12. The cost of transfer of a liability to a third party is used to:

       1. As part of trade payables.                                          1. Value a contingent liability.
       2. As part of accruals.                                                2. Value a contingent asset.
       3. Separately.                                                         3. Value a provision.
                                                                       13. Discount rates should be:

9. A constructive obligation:                                                 1. Pre-tax.
                                                                              2. Post-tax.
                                                                              3. Changed annually.
       1. Only relates to construction contracts.
       2. Arises when you indicate that you accept certain
          responsibilities.
       3. Arises from a legal duty.                                    14. Gains from disposal of assets should:
10. A provision is recorded:
                                                                              1. Be taken into account in provisions.
       1. For a present obligation.                                           2. Be taken into account in provisions, only if closely linked to
                                                                                 the event giving rise to the provision.
http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng                                                                               41
                                                                                IAS 37 Provisions, Contingent Liabilities and Contingent Assets
       3. Not be taken into account in provisions.                         i   sale, or termination, of a line of business;
                                                                           ii  the closure of business locations in a country or region, or the
                                                                               relocation of business activities from one country or region to
                                                                               another;
15. If it is no longer probable that payment relating to a provision
                                                                           iii changes in management structure;
                                                                           iv fundamental reorganisations, that have a material impact on
will be required:
                                                                               the nature, and focus, of the undertaking‘s operations;
                                                                           v change of company name.
       1. The provision should be used for other liabilities.
       2. The provision should be reversed.
                                                                                1.   i+iii+iv
       3. The provision should be replaced by a contingent liability.
                                                                                2.   i – iii
                                                                                3.   i – iv
                                                                                4.   i-v
16. Future operating losses indicate a need to:

       1. Test for impairment.
                                                                        19. A constructive obligation to restructure only arises when:

       2. Consider making a provision.
                                                                                1. There is a formal plan.
                                                                                2. There is an expectation that there will be restructuring.
       3. Consider making a contingent liability.                               3. Both 1 +2.

17. Onerous contracts indicate a need to:

       1. Test for impairment.
                                                                        20. In November, your board decides to restructure the group. In
       2. Consider making a contingent asset.
                                                                        December, the plan is finalised. In January it is announced. The

       3. Consider making a contingent liability.                       group has a constructive obligation in:

18. Examples of restructuring are:                                              1. November.
                                                                                2. December.

http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng                                                                               42
                                                                                 IAS 37 Provisions, Contingent Liabilities and Contingent Assets
       3. January.                                                               3. Investment in new systems and distribution networks.
                                                                                 4. Redundancy costs.

21. In November, your board decides to restructure the group. In           24. A restructuring provision:

December, the plan is finalised. In January it is announced. A                    1. Does not cover future operating losses.
                                                                                  2. Covers reasonable future operating losses.
provision can be considered in:                                                   3. Does not cover future operating losses, unless they relate
                                                                                     to an onerous contract.
       1. November.                                                        25. A provision should be recorded when:
       2. December.
       3. January.                                                               1. An undertaking has a present obligation legal, or
                                                                                 constructive.
                                                                                 2. It is probable that payment will be required.
22. When a sale is only part of a restructuring, but there is no                 3. An estimate can be made of the obligation.
                                                                                 4. 1-3 are all present.
binding sale agreement:
                                                                           26. If there is a present obligation to pay money, you should
                                                                           record a:
       1. No constructive obligation arises.
                                                                                  1. Contingent asset.

       2. A constructive obligation can arise for the other parts of the
                                                                                   2. Contingent liability.
                                                                                   3. Provision.
       restructuring.
                                                                           27. If there is no present obligation, but one is highly likely, you
                                                                           should record:
       3. A constructive obligation arises from the decision to sell the           1. Nothing.
                                                                                   2. A contingent liability.
       business.                                                                   3. A provision.

23. A restructuring provision covers:
                                                                           28. If there is no present obligation, but one is highly unlikely,
       1. Retraining, or relocating continuing staff.                      you should record:
       2. Marketing.                                                              1. Nothing.
http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng                                                                              43
                                                                         IAS 37 Provisions, Contingent Liabilities and Contingent Assets
       2. A contingent liability.                                        2. They involve cost reductions supported by experts.
       3. A provision.                                                   3. They are normal trading losses.


29. Warranty claims normally generate a:                           33. Reimbursements should be booked when:

       1. Contingent asset.                                              1. Notified.
                                                                         2. When it is virtually certain that the money will be received.
                                                                         3. When you receive the cash.
       2. Contingent liability.

       3. Provision.
                                                                   34. Reimbursements should be recorded as:

30. Provisions should be:
                                                                         1. A reduction of the provision liability.
                                                                         2. An expense.
       1. Exact amounts only.
                                                                         3. A separate asset.

       2. Estimates only.

       3. Either exact amounts or estimates.
                                                                   35. A contingent liability is:
31. Provisions are stated:
                                                                         1. A possible obligation that arises from past events.
       1. Before tax.                                                    2. A specific obligation that arises from past events.
       2. After tax.                                                     3. A possible obligation that arises from future events.
       3. Both before and after tax.

                                                                   36. Joint and several liability.
32. Future events will impact the size of provision if:            You and your partners are liable for $100 million of environmental
                                                                   damages.
       1. They involve anticipated completely new technology.      The case has been brought against you, but your partners will
                                                                   reimburse you for $60 million.
http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng                                                                        44
                                                                         IAS 37 Provisions, Contingent Liabilities and Contingent Assets
You record:                                                        20.              3
      1. A provision of $100 million.                              21.              3
      2. A contingent liability for $100 million.                  22.              2
      3. You make a provision for $40 million, and a contingent    23.              4
         liability for                                             24.              3
       $60 million.                                                25.              4
                                                                   26.              3
37. Contingent asset is recorded when cash inflows are:            27.              2
      1. Received.                                                 28.              1
      2. Virtually certain.                                        29.              3
      3. Probable.                                                 30.              3
                                                                   31.              1
15. Answers to multiple choice questions
                                                                   32.              2
                                                                   33.              2
Question        Answer                                             34.              3
1.                3                                                35.              1
2.                2                                                36.              3
3.                4                                                37.              3
4.                1
5.                2
6.                3
7.                1
8.                3
9.                2
10.               1
11.               1
12.               3
13.               1
14.               3
15.               2
16.               1
17.               1
18.               3
19.               3
http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng                                                                     45

				
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