IAS 37 PROVISIONS, CONTINGENT

LIABILITIES & CONTINGENT ASSETS

A provision is a liability of uncertain timing or amount. A liability is a present obligation of an
entity arising from past events, the settlement which is expected to result from an outflow of
resources embodying economic benefits. A provision may be necessary as a result of

a legal obligation
a constructive obligation
A legal obligation is one that derives from a contract, legislation or other operation of law.
A constructive obligation is one which derives from an entity’s actions where;
- By an established pattern of past practices, published policies or a sufficiently specific
statement, the entity has indicated to other parties that it will accept other responsibilities.
- As a result the entity has created a valid expectation on the part of those other parties that it
will discharge those responsibilities.

Recognition of a provision
A provision should be recognised when;
1. An entity has a present obligation (legal or constructive) as a result of a past event.
2. It is probable that an outflow of resources embodying economic benefits will be required to
settle an obligation
3. A reliable estimate can be made of the amount of the obligation.
N.B If any of these conditions is not met, no provision will be recognised.

Example 1 (Refunds)
A retail store has a policy of refunding dissatisfied customers even though it is under no legal
obligation to do so. Its policy of making refunds is generally known.
Should a provision be made at the year end?

 The policy is well known and creates a valid expectation

 There is a constructive obligation
 It is probable that some refunds will be made
 These can be measured using expected values
 Therefore a provision is required

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Question 1
Entity G has a financial ending 31 December. On 15 December 2020, an employee was injured
in the workplace and has sued Entity G for compensation under current health and safety
legislation. Entity G’s solicitors believe that the employee’s claim has a 60% chance of success.
The solicitors estimate that, if successful, the claim will be settled at $20 000.
Required
Consider whether or not Entity G should provide for the claim at 31 December 2020 and, if at
what amount.

Question 2
Laws have been passed that require an entity to fit certain health and safety features in its
factories by 30 June 2021. At 31 December 2020 (the reporting date) the entity has not yet
fitted the health and safety features.
Required
How should this be accounted for in the financial statements?

Measurement of provisions
The amount recognised as a provision should be

a) Realistic estimate
b) Prudent estimate of expenditure needed to settle the obligation existing at the reporting
date
c) Discounted whenever the settlement of this is material

Methods of measuring uncertainties

These include:
 Weighting the cost of all probable outcomes according to their probabilities (expected
values)
 Considering a range of possible outcomes

Example 2
An entity sells goods with a warranty covering custom for the cost of repairs of any defects that
are discovered within the first two months. Past experience suggest that 88% of the goods sold
will have no defects, 7% will have minor defects and 5% will have major defects. If minor
defects were detected in all products sold, the cost of repairs will be $24 000. If major defect
were detected in all products sold, the cost of repairs will be $200 000. What amount of
provision could be made?

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Degree of defect Probability Cost of repairs Expected values
Minor defects 0,07 $24 000 $1 680
Major 0,05 $200 000 $10 000
Figure to put for the provision $11 680

Types of provisions

1. Warranty provisions
A warranty provision is often given in a retailing business. It is either an express (legal) or
implied (constructive) obligation to make good or replace faulty products. This requires the
seller to analyse past experience so that they can estimate

 How many claims will be made, if manufacturing technology improves, there will be fewer
claims in the future than they have been in the past.
 How much each repair will cost, as technology becomes complex, each repair may cost
more. Therefore the provision set up at the time in the future is the probability multiplied
by the expected cost for each repair.

The double entry of such a provision is as follows:

Dr Expenses (P/L) Cr Provision (SFP)

Question 3
An entity sells goods with a warranty under which customers are covered for the cost of repairs
of any manufacturing defects that become apparent within the first six months after purchase.
If minor defects were detected in all products sold, repair costs of $1 million would result. If
major defects were detected in all products sold repair costs of $4 million would result. The
entity’s past experience and future expectations indicate that for the coming year, 75% of the
goods sold will have no defects, 20% of the goods sold will have minor defects and 5% of the
goods sold will have major defects. In accordance with paragraph 24 of IAS 37, an entity
assesses the probability of an outflow for the warranty obligations as a whole.
Requirement
What is the expected value of the cost of repairs and under what three circumstances should a
provision be recognised?

Question 4
Eagle Ltd. offers a 12-month warranty on all goods sold. During the year ended 31 March 2021
it sold 14,000 units of product for total revenue of $700,000. At 31 March 2021, the directors
estimated that 400 of these units would prove defective within the warranty period. The

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average cost of repairing each defective unit is expected to be $45 and the cost of replacing
defective units is likely to be $40. There is an existing provision for warranty costs amounting to
$20,000 carried in the books at 31 March 2021. This dates from 1 April 2020.
Required
What is the correct accounting entry to record the above information?

2. Guarantees
In some instances (particularly in groups) one company will make guarantee to another to pay
off a loan if the other company is unable to do so. This guarantee should be provided for that
the payment will have to be made. It may otherwise require disclosure as a contingent liability.

The double entry of such a provision is as follows:

Dr Expenses (P/L) Cr Provision (SFP)

3. Onerous contracts
It is a contract in which unavoidable costs of meeting the obligations under the contracts
exceed the economic benefits expected to be received under it. An onerous lease is an onerous
contract, which is when unavoidable costs under the lease exceed the benefits expected to be
gained from it. If leased premises become surplus to requirements but the lessee cannot find
someone to sublet the premises to, the lessee will still have to make regular lease payments
without having to use the leased premises.

The double entry of such a provision is as follows:

Dr Expenses (P/L) Cr Provision (SFP)

Question 5
A company has ten years left to run the lease of a property that is currently unoccupied. The
present value of the future rentals at the reporting date is $50,000. Subletting possibilities are
limited but the directors feel that likely future subletting rentals could have a present value of
$10,000.
Requirement
What is the accounting treatment?

4. Environmental provisions
A provision will be made for future environmental costs if there is either a legal or constructive
obligation to carry out the work. This will be discounted to present value. As well as recognising
a liability for future expenditure, an entity normally recognises an asset. For example, under IAS
16 a provision for the initial estimates of dismantling and removing an item of PPE and restoring
the site on which it is located is included in the cost of the item. This expenditure meets the
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definition of an asset because it gives the entity access to future economic benefits in the form
of sales revenue. The asset is depreciated over its useful life. The double entry of such a
provision is as follows:

Dr Non-Current assets (SFP) Cr Provision (SFP)

Question 6
On 1 April 2020, Peach Plc purchased a goldmine, and commenced mining operations. A
condition of the mining licence is that the site be restored on completion of mining operations.
This is estimated to cost $30 million in 8 years. The present value of $30 million on 1 April 2020
is $16.21 million, using a discount rate of 8%.
Required
What should be the carrying value of the provision at 31 March 2021 under IAS 37 Provisions,
Contingent Liabilities and Contingent Assets?

Question 7
IAS 37 - Provisions, Contingent Liabilities and Contingent Assets sets out the principles for
recognising and measuring provisions. IAS 37 requires that, in cases where the time value of
money is material, the provision be measured at present value at the reporting date.

Paul Ltd has an obligation to restore a site following the completion of mining works currently
under way. The estimated cost of these works is $30.225 million, and the works are expected to
be completed on 1 April 2030.

Using the company’s cost of capital of 8%, the present value of the restoration cost was
recorded at $14.0 million on 1 April 2020.
Required
What adjustment should be recorded at 31 March 2021, Paul’s reporting date, to ensure the
provision is correctly accounted for?

5. Decommissioning or abandonment costs

When an oil company initially purchases an oil field it is put under a legal obligation to
decommission the site at the end of its life. The decommissioning costs should be provided for.
These will be discounted to present value. As well as recognising a liability for future
decommissioning costs, an entity normally recognises an asset. For example, under IAS 16 a
provision for the initial estimates of decommissioning an item of PPE is included in the cost of
the item. This expenditure meets the definition of an asset because it gives the entity access to
future economic benefits in the form of sales revenue. The asset is depreciated over its useful
life. The double entry of such a provision is as follows:
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 Dr Non-Current assets (SFP) Cr Provision (SFP)

Question 8
The following items have arisen during the preparation of Borough’s draft financial statements
for the year ended 30 September 2021.

i. On October 2020, Borough commenced the extraction of crude oil from a new well seabed.
The cost of a 10 year license to extract the oil was $50 million. At the end of the extraction,
although not legally bound to do so, Borough intends to make good the damage the
extraction has caused to the seabed environment. This intention has been communicated to
parties external to Borough. The cost of this will be in two parts; a fixed amount of $20
million and a variable amount of 2 cents per barrel extracted. Both of these amounts are
based on their present values at 1 October 2020 (discounted at 8%) of the estimated costs
in 10 years’ time. In the year to 30 September 2021 Borough extracted 150 million barrels
of oil.
ii. Borough owns the whole of the equity share capital of its subsidiary Hamlet. Hamlet’s
statement of financial position includes a loan of $25 million that is repayable in five years’
time. $15 million of this loan is secured on Hamlet’s property and the remaining $10 million
is guaranteed by Borough in the event of default by Hamlet. The economy in which Hamlet
operates is currently experiencing a deep recession, the effects of which are that the
current value of its property is estimated at $12 million and there are concerns over
whether Hamlet can survive the recession and therefore repay the loan.

Required
Describe, and quantify where possible, how items (i) and (ii) above should be treated in
Borough’s statements of financial position for the year ended 30 September 2021.
In the case of item (ii) only, distinguish between Borough’s entity and consolidated financial
statements and refer to any disclosure notes. Your answer should only refer to the treatment of
the loan and should not consider any impairment of Hamlet’s property or Borough’s investment
in Hamlet.
Note: The treatment in the income statement is NOT required for any of the items:

Question 9
The following matters relate to Chigayo Limited mining activities in Mberengwa district:
(i) Chigayo started operating a new mine in January 2020 under a five-year government
licence which required Chigayo Limited to landscape the area after mining ceased at an
estimated cost of $100 000.

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(ii) During 2020, Chigayo Limited’s mining activities caused environmental pollution on
adjoining piece of government land. There is no legislation which requires Chigayo
Limited to rectify this damage, however Chigayo Limited does have a published
environment policy which includes that it would rectify any damage caused. The
estimated cost of the rectification is $100 000.

In terms of IAS 37, Provision, Contingent Liabilities and Contingent Assets, what is the correct
treatment in the financial statement of Chigayo Limited for the year ended 31 December 2020?
(10 marks)

6. Restructuring provisions
A restructuring is a programme planned and controlled by management and materially changes
either

a) The scope of a business undertaken by an entity or

b) The manner in which that business is conducted.

A provision may only be made if

i. A detailed formal and approved plan exists
ii. The plan has been announced to those affected

The provision should

i. Include direct expenditure arising from the exercise
ii. Exclude costs associated with ongoing activities.

NB: The following costs should specifically not be included within the restructuring provision

 Retraining or relocating continuing staff

 Marketing
 Investment in systems and distribution networks

Question 10
At 31 March 2020, Fred Ltd carried a provision in its books for $3.2 million. This represented the
expected cost of a restructuring announced earlier in March. This was communicated to all
affected parties. During the year ended 31 March 2021, restructuring costs of $1.5 million were
incurred and charged to administrative expenses.
The estimate of costs remaining to complete the restructuring at 31 March 2021 was $1 million.
Required
What adjustment (journal entry) should be made at 31 March 2021 to reflect the current
estimate?

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Question 11
IAS 37 Provisions, Contingent Liabilities and Contingent Assets sets out the accounting
treatment and disclosures for these transactions and events. The standard discusses general
principles of recognition, measurement and presentation as well as specific application
guidance for certain issues. This guidance aims to assist preparers of financial statements in
applying IAS 37.

The following situations have arisen during the preparation of the draft financial statements of
Haywood Ltd for year ended 31 July 2021:

(i) On 1 August 2020, Haywood Ltd acquired a nuclear power plant at a cost of $200
million. Part of the arrangement was that the plant be dismantled and the site restored
after its useful economic life of 20 years had passed. The cost of restoration was
estimated on 1 August 2020, after discounting to present value, to be $40 million. This
amount reflected an appropriate discount rate of 6%, (75% of this estimate related to
the dismantling of the plant, and 25% to the removal of waste fuel). At 31 July 2021, due
to regulatory and other obstacles, no power had yet been produced, hence no waste
fuel had been generated.
(ii) During the year ended 31 July 2021, Haywood Ltd decided to close both its coal burning
power generating plants in October 2021. This decision has been announced publicly,
and a detailed formal plan prepared. The plan proposes to make 75 employees
redundant, retrain 25 other staff to work in the nuclear plant, and sell the coal-fired
plants in their current condition. It is anticipated that the redundancy costs will amount
to $7.5 million, and the retraining will cost $1 million. The coal plants will be disposed of
for zero consideration as the new owner will be expected to dismantle the plants and
clean up the sites. The carrying value of these plants is $12 million at 31 July 2021.
REQUIREMENT:
(a) Discuss the accounting treatment in relation to provisions, contingent liabilities and
contingent assets required by IAS 37. (8 marks)
(b) In the case of (i) and (ii) above, set out the appropriate accounting treatment as at 31 July
2021, applying IAS 37 and other relevant standards. (12 marks)
[Total: 20 Marks]

Question 12
On 14 June 2019 a decision was made by the board of an entity to close down a division. The
decision was not communicated at the time to any of those affected and no other steps were
taken to implement the decision by the end of 30 June 2019. The division was closed in
September 2019.

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Requirement
Should a provision be made at 30 June 2019 for the cost of closing down the division?

Disclosure requirements for a provision

a) Disclosure of the details of change in carrying value of a provision from the beginning to the
end of the year.
b) Disclosure of the background to the making of the provision.

Future Operating Losses

An entity may forecast that it will make a substantial operating loss in the next year or several
years to come. If so its directors might want to take all the bad news immediately and create a
provision for the future losses. Provisions cannot be made for future operating losses. This is
because they arise from future events, not past events.
NB They do not meet the definition of a liability and the general recognition criteria set out in
IAS 37.

Future repairs and refurbishment to assets

Some assets need to be repaired or to have parts replaced at intervals during their lives. e.g.
suppose that a furnace has a lining that has to be replaced, the furnace will breakdown. Prior to
the issues of IAS 37, entities would often recognise provisions for the cost of future repairs or
replacement parts. IAS 37 effectively prohibits this treatment. The logic behind this is that an
entity almost always has an alternative to incurring the expenditure (even if it is required by law
for safety reasons).
For example the entity which has to replace the lining of its furnace could sell the furnace or
stop using it.

Contingent liability
It is:
 A possible obligation that arises from past events and whose existence will be confirmed
only by the occurrence or non-occurrence of one or more uncertain future events not
wholly within the entity’s control or present obligation that arises from past events but is
not recognised because
 It is not probable that an outflow of resources embodying benefits will be required to
settle the obligation
 The amount of the obligation cannot be measured with sufficient reliability

Treatment of contingent liability

 Should not be recognised in the SFP

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  Should be disclosed in a note unless the possibility of transfer of resources is remote

The required disclosures are:

 A brief description of the nature of contingent liabilities
 An estimate of its effect
 An indication of the uncertainties that exist

Contingent assets
It is a possible asset that arises from past events whose existence will be confirmed only by the
occurrence or non-occurrence of one or more uncertain future events not wholly within control
of the entity.

Treatment of contingent assets

Should not generally be recognised but if the inflow of economic benefits is probable, this
should be disclosed. If a gain is virtually certain it falls within the definition of an asset and be
recognised as such, not as a contingent asset.

Liability (outflow) Asset (inflow)

Virtually certain (>95%) Recognise a provision Recognise an asset
Probable (>50%) Recognise a provision Disclose as note - contingent
asset
Possible (<50%) Disclose as note - contingent Ignore
liability
Remote (<5%) Ignore Ignore

Re-imbursements
Where some or all of the expenditure required to settle a provision is expected to be
reimbursed by another party, the reimbursement is recognised when, and only when, it is
virtually certain that reimbursement will be received if the entity settles the obligation. The
reimbursement is treated as a separate asset. The amount recognised for the reimbursement
may not exceed the amount of the provision.

Question 13
Georgina Company is preparing its financial statements for the year ended 30 September 2015.
The following matters are all outstanding at the year-end.
1. Georgina is facing litigation for damages from a customer for the supply of faulty goods on 1
September 2015. The claim, which is for $500 000, was received on 15 October 2015.
Georgina’s legal advisors consider that Georgina is liable and that it is likely that this claim

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 will succeed. On 25 October 2015 Georgina sent a counter claim to its suppliers for $40 000.
Georgina’s legal advisors are unsure whether or not this claim will succeed.
2. Georgina’s sales director, who was dismissed on 15 September, has lodged a claim for $100
000 for unfair dismissal. Georgina’s legal advisors believe that there is no case to answer
and therefore think it is unlikely that this claim will succeed
3. Although Georgina has no legal obligation to do so, it has habitually operated a policy of
allowing customers to return goods within 28 days, even where those goods are not faulty.
Georgina estimates that such returns usually amount to 1% of sales. Sales in September
2015 were $400 000. By end of October 2015, prior to the drafting of the financial
statements, goods sold in September for $3 500 had been returned.
4. On 15 September 2015 Georgina announced in the press that it is to close one of its
divisions in January 2016. A detailed closure plan is in place and the cost of closure are
reliably estimated at $300 000, including $50 000 for staff relocation.
Required
State, with reasons, how the above should be treated in Georgina’s financial statements for the
year ended 30 September 2015.

Question 14
The following provisions have been included in the financial statements of Professional Limited
as at 31 December 2013:
$
i. Provision for repair costs for sales under warranty 250,000
ii. Provision for repairs and maintenance of plant and machinery 75,000
iii. Provision for expected operating losses to be incurred
in a trade show schedule for March 2014 35,000
iv. Provision for the dismantling and selling of non-
current assets classified as held for sale 15,000
v. Provision for severance pay to employees in a discontinued
operation 50,000
vi. Provision for relocation and retraining staff affected by
restructuring programme 60,000

REQUIRED:
Discuss with brief reasons in each of the above cases, whether provisions must be recognised at
31 December 2013 so as to comply with the requirements of the GAAP, Assume that all
amounts are material. [12 marks]

Question 15

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On 1 October 2017, Promoil acquired a newly constructed oil platform at a cost of $30 million
together will the right to extract oil an offshore oilfield under a government license. The terms
of the license are that Promoil will have to remove the platform (which will then have no value)
and restore the sea bed to an environmentally satisfactory condition in 10 years’ time when the
oil reserves have been exhausted. The estimated cost of this on 30 September 2027 will be $15
million. The present value of $1 receivable in 10 years at the appropriate discount rate for
Promoil of 8% is $0.46.
Required
i. Explain and quantify how the oil platform should be treated in the financial statements
of Promoil for the year ended 30 September 2018 [7 marks]
ii. Describe how your answer to (b) (i) would change if the government license did not
require an environmental clean-up. [3 marks]

Question 16
IAS 37 - Provisions, Contingent Liabilities and Contingent Assets requires a liability to be
recognised in which of the following situations?

(i) A detailed plan for a reorganisation has been agreed at board level, prior to the
reporting date. This will involve the future payment of $3 million in redundancy costs.
No announcement of this reorganisation has been made at the reporting date.
(ii) A customer was injured on the company’s premises prior to the reporting date, and has
sued for $1 million. Although the case has yet to come before the courts, legal advice
has been received to the effect that the company is likely to be found liable.

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