Prior to the promulgation of IAS 37, in the absence of clear-cut rules of recognition and measurement, entities could charge huge provisions to the income statement (often referred to as big bath provisions) and thereby manipulate earnings or financial performance. It is worth noting that previously the term “provisions” was used very loosely in financial reporting. With the enactment of IAS 37, rules with respect to recognition and measurement of provisions, contingent liabilities, and contingent assets have been codified. Since then, entities preparing financial statements in accordance with International Financial Reporting Standards (IFRS) used these terms strictly based on their prescribed definitions under IAS 37. Furthermore, IAS 37 also has clarified certain misconceptions about the term “provision”. For instance, “provisions” that are envisioned by this Standard are now “liabilities” [of uncertain timing or amount]. The “provision for depreciation” and the “provision for doubtful debts” are really not provisions according to this Standard but are contra accounts or adjustments to the carrying value of assets. This post describes recognitioan and measurement of provision that adapted from IAS 37 with case examples and practical insights, as I always make.
Recognition of Provisions
Those liabilities that are of uncertain timing or amount are “provisions“, according to the standard [IAS 37]. Creditors [trade payables] and accrued expenses are therefore not considered “provisions” by this standard because they do not meet the above criteria. Similarly, as explained, the term “provision” is used in some countries in the context of “depreciation” and “doubtful debts”, but these are not the type of provisions that are envisaged by this standard.
Provisions should be recognized if, AND ONLY IF, all of these conditions are met:
- An entity has a present obligation resulting from a past event;
- It is probable that an outflow of resources embodying economic benefits would be required to settle the obligation; and
- A reliable estimate can be made of the amount of the obligation.
Not all obligations would make it incumbent upon an entity to recognize a provision. Only present obligations resulting for a past obligating event give rise to a provision. An obligation could either be a legal obligation or a constructive obligation.
A legal obligation is an obligation that could:
- Be contractual; or
- Arise due to a legislation; or
- Result from other operation of law.
A constructive obligation, however, is an obligation that results from an entity’s actions where:
- By an established pattern of past practice, published policies, or a sufficiently specific current statement, the entity has indicated to other (third) parties that it will accept certain responsibilities; and
- As a result, the entity has created a valid expectation in the minds of those parties that it will discharge those responsibilities.
It should be “probable that the outflow of resources embodying economic benefits would occur”. The term “probable” is interpreted, for the purposes of this Standard, as “more likely than not” [i.e., the chances of occurrence are more than 50%].
Perfectly Inc. is an oil entity that is exploring oil off the shores of Seaoil Islands. It has employed oil exploration experts from around the globe. Despite all efforts, there is a major oil spill that has grabbed the attention of the media. Environmentalists are protesting and the entity has engaged lawyers to advise it about legal repercussions. In the past, other oil entities have had to settle with the environmentalists, paying huge amounts in out-of-court settlements. The legal counsel of Perfectly Inc. has advised it that there is no law that would require it to pay anything for the oil spill; the parliament of Seaoil Islands is currently considering such legislation, but that legislation would probably take another year to be finalized as of the date of the oil spill.
However, in its television advertisements and promotional brochures, Perfectly Inc. often has clearly stated that it is very conscious of its responsibilities toward the environment and will make good any losses that may result from its exploration. This policy has been widely publicized, and the chief executive officer has acknowledged this policy in official meetings when members of the public raised questions to him on this issue.
The Question is: does the above give rise to an obligating event that requires Perfectly Inc. to make a provision for the cost of making good the oil spill?
Here is the answer:
- Present obligation as a result of a past obligating event. The obligating event is the oil spill. Because there is no legislation in place yet that would make cleanup mandatory for any entity operating in Seaoil Islands, there is no legal obligation. However, the circumstances surrounding the issue clearly indicate that there is a constructive obligation since the company, with its advertised policy and public statements, has created an expectation in the minds of the public at large that it will honor its environmental obligations.
- An outflow of resources embodying economic benefits in settlement. “Probable“.
Conclusion: A provision should be recognized for the best estimate of the cost to clean up the oil spill.
Measurement of Provisions
The amount to be recognized as a provision is the best estimate of the expenditure required to settle the present obligation at the balance sheet date. While a reliable estimate is usually possible, in rare circumstances, it may not be possible to obtain a reliable estimate. In such cases, the liability is to be disclosed as a contingent liability (and not recognized as a provision).
“Best estimate” is a matter of judgment and is usually based on past experience with similar transactions, evidence provided by technical or legal experts, or additional evidence provided by events after the balance sheet date.
Risks and uncertainties surrounding events and circumstances should be considered in arriving at the best estimate of a provision:
- If a group of items is being measured, it is the “expected value”.
- If a single obligation is being measured, it the “most likely outcome”.
A car dealership also owns a workshop that it uses for servicing cars under warranty. In preparing its financial statements, the car dealership needs to ascertain the provision of warranty that it would be required to provide at year-end. The entity’s past experience with warranty claims is:
- 60% of cars sold in a year have zero defects.
- 25% of cars sold in a year have normal defects.
- 15% of cars sold in a year have significant defects.
The cost of rectifying a “normal defect” in a car is $10,000. The cost of rectifying a “significant defect” in a car is $30,000.
The question is: How to measure [compute] the amount of “provision for warranty” needed at year-end?
Here is how:
The expected value of the provision for warranty needed at year-end is:
[60% x 0] + [25% x $10,000] + [15% × $30,000] = $7,000
Where the effect of time value is material, the amount of provision is to be discounted to its present value using a pretax discount rate that reflects current market assessments of time value of money and the risks specific to the liability.
Future events that are expected to affect the measurement of the provision should be taken into account in arriving at the amount of the provision if there is sufficient objective evidence that the future events will occur.
Gains from expected future disposals should not be considered in arriving at the amount of the provision to be recognized. However, if amounts are expected to be reimbursed by another party, these should be taken into consideration in arriving at the amount of the provision (only when it is virtually certain that the reimbursement will be received).
Changes in Provisions and Use of Provisions
Changes in provisions shall be reviewed at each balance sheet date, and the amount of the provision should be adjusted accordingly to reflect the current best estimate. When it is no longer probable that outflow of resources would be required to settle the obligation, the provision should be reversed. A provision should be used only for the purpose for which it was originally recognized or set up.
In the past, entities used to rationalize a shortfall in a provision based on the premise that for the same time period, there were more than required amounts provided as provisions in other cases. In other words, a shortfall in one provision was justified (and not adjusted) because it was balanced by excess in another provision. This practice would not be possible now since IAS 37 categorically states that a provision should be used for the purpose for which it was initially created or recognized. Furthermore, IAS 37 also mandates that changes in provisions shall be reviewed at each balance sheet date and the amount of provision should be adjusted accordingly to reflect the current best estimate.
Based on these rules promulgated under IAS 37, if, after recognizing a provision, say, for bonus, it is believed that it is excessive, an entity cannot justify the excess under the plea that there is a shortfall in another provision, say, provision for warranty, and considering them together, on an overall basis, the total provisions at a given point in time are adequate. Instead, under IAS 37, the excess provision for the bonus should be written back or released to the income statement and the shortfall in the provision for warranty should be supplemented through an additional provision.
Future Operating Losses
It is not permissible to recognize a provision for future operating losses, because they do not meet the criteria for recognition of a provision. As future losses are not present obligations arising from past obligating events and could be avoided by a future action of the entity (say, by disposing of the business), they do not clearly meet the recognition criteria for provisioning.
IAS 37 does not allow for them to be provided for at year-end. An expectation of future losses may, however, lead one to believe that certain assets of the operations may be impaired; in this case, an entity should test assets for impairment under IAS 36.
Provision Recognition Under Onerous Contracts
Although executory contracts are outside the general purview of IAS 37, it is permissible to recognize a provision under an executory contract that is “onerous.” An onerous contract that is covered under IAS 37 is an executory contract where the unavoidable costs exceed the benefits expected.
Example (i): An onerous contract is an agreement that an entity cannot get out of legally even though it has signed another parallel agreement under which it is able to undertake the same activities at a better price. As it is locked into the existing agreement, it would need to incur costs under both contracts but derive economic benefits from only one of them. The next example explains this better.
Example (ii): An entity is bound under the terms of a franchise agreement for a local brand that it has marketed for years. Based on market survey and a cost-benefit study, the entity decided to stop marketing the local brand and entered into a new agreement to market an international brand. Although the entity does not derive any economic benefit from the franchise agreement for the local brand, there is an obligation to pay a lump-sum amount to the franchiser under the noncancellable franchise agreement for a period of two more years. Thus the entity would need to make a provision for the commitment under the franchise agreement (since it is an onerous contract).
XYZ Inc. is getting ready to move its factory from its existing location to a new industrial free zone specially created by the government for manufacturers. To avail itself of the preferential licensing offered by the local governmental authorities as a reward for moving into the free trade zone and the savings in costs that would ensue (since there are no duties or taxes in the free trade zone), XYZ Inc. has to move into the new location before the end of the year. The lease on its present location is non-cancelable and is for another two years from year-end. The obligation under the lease is the annual rent of $100,000.
Required: Advise XYZ Inc. what amount, if any, it needs to provide at year-end toward this lease obligation!
Here are advises needed by XYZ Inc.:
The lease agreement is an executory onerous contract because after moving to the new location, XYZ Inc. would derive no economic benefits from the existing factory building but would still need to pay rent under the agreement since the lease is noncancelable. Thus the unavoidable costs exceed the benefits expected under the lease contract.
Conclusion: Based on the annual lease obligation under the lease agreement, the total amount needed to be provided at year-end is the present value of the total commitment under the lease = PV of [$100,000 × 2 (years)].
Provisions For Restructuring
In the past, entities used to accrue lump-sum provisions for restructuring, because there were no Standards governing this important area. In some cases, this led to abusive practices of manipulation and creative accounting referred to as big bath provisions. In order to control the practice of dumping of all kinds of provisions under the banner of provision for restructuring, IAS 37 prescribed rules to regulate it. First and foremost, it defined the term, thereby restricting restructuring to a structured program that is planned and controlled by the management that materially changes either the scope of a business of an entity or the manner in which that business is conducted.
To provide guidance on this contentious issue, IAS 37 provides these examples of events that may qualify as restructuring:
- Sale or termination of a line of business
- Closure of business locations in a region or relocation of business activities from one location to another
- Changes in management structure, such as elimination of a layer of management
- Fundamental reorganization of the entity such that it has a material and a significant impact on its operations.
Although many fundamental structural changes to an entity’s operations would be significant enough to warrant disclosure in footnotes to the financial statements, not all of these changes qualify as restructuring that necessitates recognition (as opposed to disclosure), because they do not meet the criteria for recognizing a provision.
Recognition of the provision is required because a constructive obligation may arise from the decision to restructure. In other words, a constructive obligation may not arise in all cases. A constructive obligation arises when, and only when, an entity:
- Has a detailed formal plan for the restructuring outlining at least the business or part of the business being restructured; the principal locations affected by the restructuring; the location, function, and approximate number of employees who will be compensated for terminating their employment; when the plan will be implemented and the expenditures that will be undertaken; and
- Has raised valid expectations in the minds of those affected that the entity will carry out restructuring by starting to implement that plan or announcing its main features to those affected by it.
A decision taken by the board of directors of an entity contemplating embarking on a restructuring program but not communicated to the parties affected by the decision (such that it creates a valid expectation in their minds that the restructuring decision will in reality be implemented) would not by itself give rise to a constructive obligation. Thus communication of the decision of the board of directors to parties affected is a prerequisite if an entity wants to make a provision for “restructuring” on the basis of a constructive obligation.
A restructuring provision should include only direct expenditures arising from the restructuring, which are those that are necessarily entailed by the restructuring and not associated with the ongoing activities of the entity.
The Standard has specifically excluded certain types of expenditures as expenditure arising from restructuring:
- Costs of retraining or relocating continuing staff
- Investment in new systems and distribution networks
The board of directors of ABC Inc. at their meeting held on December 15, 20X1, decided to close down the entity’s international branches and shift its international operations and consolidate them with its domestic operations. A detailed formal plan for winding up the international operations was also formalized and agreed by the board of directors in that meeting. Letters were sent out to customers, suppliers, and workers soon thereafter. Meetings were called to discuss the features of the formal plan to wind up international operations, and representatives of all interested parties were presenting those meetings.
The question is: Do the actions of the board of directors create a constructive obligation that needs a provision for restructuring?
The conditions prescribed by IAS 37 are:
- There should be detailed formal plan of restructuring;
- Which should have raised valid expectations in the minds of those affected that the entity would carry out the restructuring by announcing the main features of its plans to restructure.
The board of directors did discuss and formalize a formal plan of winding up the international operations. This plan was communicated to the parties affected and created a valid expectation in their minds that ABC Inc. will go ahead with its plans to wind up international operations. Thus there is a constructive obligation that needs to be provided at year-end.
Disclosures For Provision
For each class of provision, an entity should disclose:
- The carrying amount at the beginning and the end of the period
- Additional provisions made in the period, including increases to existing provisions
- Amounts utilized during the period
- Unused amounts reversed during the period
- The increase during the period in the discounted amount arising from the passage of time and the effect of any change in the discount rate.
An entity should also disclose, for each class of provision:
- A brief description of the nature of the obligation and the expected timing of any resulting outflows of economic benefits
- An indication about the uncertainties about the amount and timing of those outflows (and, where necessary, major assumptions made concerning future events)
- The amount of any expected reimbursement, stating the amount of any asset that has been recognized for that expected reimbursement
In extremely rare circumstances, when disclosure of any or all this information is considered to be seriously prejudicial to the position of the entity in a dispute with other parties on the subject matter of the provision, an entity need not disclose the information but should disclose the general nature of the dispute, together with the fact that, and reason why, the information has not been disclosed.