IAS 37 – Provisions, Contingent Liabilities and Contingent Assets
Why is accounting for provisions and contingencies particularly sensitive to uncertainty?
The accounting treatment of provisions, contingent liabilities and contingent assets is one of the clearest examples of how accounting standards confront the effects of uncertainty in the business environment. In such cases, financial reporting must rely heavily on management’s estimates and judgments, and actual outcomes may differ significantly. This is especially true for provisions, which represent obligations whose amount or timing is uncertain and are therefore exposed to greater uncertainty than other line items in the statement of financial position.
How do IFRS Accounting Standards distinguish between provisions and contingent liabilities?
In IFRS Accounting Standards, the term “provisions” is used to describe certain obligations that, although their amount or timing is uncertain, are recognised in the financial statements because they meet the essential elements for recognition. Conversely, the term “contingent liabilities” is used to describe items that are not recognised in the financial statements because they represent possible obligations for which it has not yet been determined whether the reporting entity has a present obligation that may lead to an outflow of economic resources in the future. Contingent liabilities also include obligations that do not meet the recognition criteria, because an outflow of economic resources is not probable, or the amount cannot be measured reliably.
How do probability thresholds operate in accounting for uncertainty?
To deal with the uncertainties involved, generally accepted accounting principles typically adopt probability thresholds—a recognition threshold and a disclosure threshold.
How has the conceptual approach to contingencies evolved over time?
Over the past decades there has been a shift in the conceptual approach, in line with the definitions of assets and liabilities in the Conceptual Framework for Financial Reporting. Whereas in the past the standards focused on recognising and measuring contingent losses or contingent gains (an income statement view), today the standards focus on recognising and measuring liabilities or assets (a balance sheet view). IFRS Accounting Standards adopt this balance sheet perspective. By contrast, US GAAP, as reflected in FAS 5 (issued in 1975) on accounting for contingencies, still adopts an income statement approach — recognition of contingent losses or contingent gains.
What conditions must be met to recognise a liability under the balance sheet approach?
Under the balance sheet perspective, to recognise a liability (including a provision) or an asset, the item must meet the essential elements in the definition of a liability and an asset, as well as the recognition criteria. According to the Conceptual Framework for Financial Reporting, a liability is recognised in the statement of financial position when the reporting entity has a present obligation arising from a past event, an outflow of resources embodying economic benefits is expected (probable) to settle it, and the amount can be measured reliably.
What is the scope and objective of IAS 37?
IAS 37 provides comprehensive guidance on recognition and measurement of provisions, contingent liabilities and contingent assets, as well as the disclosure requirements, so that users of financial statements can understand the nature, timing, and amount of such items. Issued in the late 1990s, the Standard adopts the modern balance sheet approach and therefore distinguishes between provisions and contingent liabilities. The guiding principles are as follows:
A. Use of probability thresholds for recognition and disclosure
To address the uncertainties inherent in settling an obligation, the Standard adopts a probability threshold for recognition of provisions and a probability threshold for disclosure. Accordingly, a necessary condition for recognising a provision is that it is probable that an outflow of economic resources will be required to settle the obligation. If this recognition threshold is not met, the obligation is classified as contingent and is not recognised in the financial statements. If the likelihood of the contingent liability materialising is remote, no disclosure in the notes is required.
B. Interpretation of the term “probable”
The Standard interprets “probable” in the liability definition as “more likely than not.” This differs from the parallel U.S. standard (FAS 5), which interprets “probable” as “likely to occur,” a term open to interpretation — some take it to mean above 80%, others above 70%. Surveys of auditors and others in the U.S. indicate that the average threshold used for recognition of a contingent loss exceeds roughly 70%. By contrast, under IAS 37 “probable” describes an event whose likelihood of occurring is greater than the likelihood of not occurring (i.e., above 50%).
C. Measurement basis for provisions
The measurement basis for provisions under the Standard is similar to fair value basis. In US GAAP the basis is expected cost. Consequently, unlike IAS 37, the U.S. standard does not address the time value of money or the use of statistical tools to estimate the amount of the contingent loss and its probability. Under the expected cost (cost accumulation) approach, the amount recognised as a provision is generally the single most likely outcome within the range of possible outcomes.
D. Ability to make a reliable estimate of the obligation
A necessary condition for recognising a provision is that a reliable estimate of the obligation can be made. However, the Standard notes that except in extremely rare cases, the reporting entity can determine a range of possible outcomes and therefore make a sufficiently reliable estimate for recognition.
E. Distinguishing the recognition criteria for liabilities from those for assets
In accordance with the principle of prudence, the Standard introduces asymmetry between contingencies on the asset side and on the liability side. While the reporting entity must recognise a provision when an outflow of economic resources is probable (assuming the other recognition criteria are met), contingent assets are not recognised in the financial statements unless the inflow of economic resources is virtually certain, in which case the related item is no longer contingent and should be recognised.
What alternative theoretical view exists regarding probability thresholds?
An alternative view in accounting theory regarding a probability threshold as a condition for recognising a provision
There is an alternative theoretical view to the Standard’s use of a probability threshold for recognition. Under this view, no probability threshold should be applied to recognising provisions as long as a present obligation exists. The term “contingent” would then describe uncertainty about the amount of the obligation, not uncertainty about whether the asset or liability exists at all.
The logic is that due to the probability threshold, present obligations may sometimes go unrecognised and be classified as “contingent,” even though they may possess the essential characteristics of a liability. Consider this simple example: a reporting entity has a present obligation under which there is a 25% probability that a payment of $1,000 will be required to settle it. Under the Standard, no provision is recognised because an outflow is not probable. However, the expected value of the cash outflow is $250. A third party would therefore demand at least $250 to assume this present obligation, even though an outflow is not probable (but possible). The fair value of the obligation is at least the expected cash outflow, assuming market participants are risk averse.
Moreover, suppose the same entity has three additional, unrelated and dissimilar obligations, each with a 25% probability of requiring $1,000 payment. Under the Standard, no provision is recognised in this case either, even though the expected value of the cash outflow is $1,000 (= 0.25 × 4,000).
Thus, the alternative view is that, given a present obligation, it is not necessarily appropriate to interpret “expected outflow of economic resources” only where there is a single cash outflow that is itself “probable,” but rather when the expected value of cash flows indicates a future outflow of economic resources. Under this view, the uncertainties can be addressed and quantified through measurement. The fair value of a liability (as with other items) reflects uncertainties and market expectations regarding the obligation, including uncertainties as to its settlement, timing, and amount. Consequently, a probability threshold for outflows as the recognition criterion for provisions is not appropriate when the measurement basis is fair value.
According to the alternative view, the fair value of a present obligation whose timing or amount is uncertain should be recognised initially at the time the obligation arises, provided its fair value can be measured with sufficient reliability.
However, when a present obligation does not exist, e.g., when a lawsuit is filed against the reporting entity and it disputes the fact that past event occurred and considers it unlikely that it did, no provision is recognised in the financial statements.