## **Learning Outcomes**

After reading this article, you will be able to define and distinguish between provisions, contingent liabilities, and contingent assets according to IAS 37. You will understand the recognition criteria for each, know when provisions should and should not be made, and describe the accounting and disclosure requirements for contingent liabilities and assets. You will also be able to apply these principles in typical exam scenarios.

## **ACCA Financial Reporting (FR) Syllabus**

For ACCA Financial Reporting (FR), you are required to understand the rules and guidance related to provisions and contingencies. In particular, revision of the following areas is important for your exam preparation:

- Explain why an accounting standard on provisions is necessary
- Distinguish between legal and constructive obligations
- State when provisions may and may not be made and demonstrate how they should be accounted for
- Describe how provisions should be measured
- Define contingent assets and contingent liabilities and describe their accounting treatment and required disclosures

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Which of the following does NOT require recognition as a provision under IAS 37?
   a) An obligation arising from a past court judgement, payment probable, cost reliably estimated  
   b) An intention to restructure a business, not yet announced  
   c) A warranty on goods sold, with probable future claims and cost reliably estimated  
   d) Legal costs for a lawsuit about to be lost

2. According to IAS 37, when is a contingent liability disclosed in the notes to the accounts?
   a) Only if it is virtually certain  
   b) Only if it is remote  
   c) When it is possible but not probable  
   d) When it is probable and reliably measurable

3. Briefly explain the difference between a provision and a contingent liability.

4. True or false? A contingent asset is recognised in the statement of financial position when an inflow of economic benefits is probable.

## **Introduction**

Provisions, contingent liabilities, and contingent assets all deal with uncertainties in timing or amount when preparing financial statements. IAS 37 provides essential guidance to ensure that such items are accounted for consistently and transparently, avoiding misuse and providing users with clear information about risks and obligations.

Without clear rules, companies could smooth profits by creating or releasing provisions at their discretion. It is therefore critical for ACCA exam candidates to understand the definitions, recognition criteria, measurement principles, and disclosure requirements for provisions, contingent liabilities, and contingent assets.

> **Key Term: provision**
> A liability of uncertain timing or amount, recognised when there is a present obligation arising from past events, an outflow of resources is probable, and the amount can be estimated reliably.
>
> **Key Term: contingent liability**
> A possible obligation from past events depending on uncertain future events not fully within the entity’s control, or a present obligation not recognised due to lack of probability or inability to measure reliably.
>
> **Key Term: contingent asset**
> A possible asset arising from past events, the outcome of which will only be confirmed by future events not within the entity’s control.

## **Recognition and Accounting Treatment**

### Provisions: Definition and Criteria

To recognise a provision under IAS 37, **all three** of the following must be met:

- A present obligation exists (legal or constructive) as a result of a past event
- It is probable that an outflow of economic benefits will be required to settle the obligation
- The amount can be estimated reliably

Intentions or future events alone are insufficient; an actual present obligation is required.

### Legal vs Constructive Obligations

A **legal obligation** arises from contracts, legislation, or other operation of law.

A **constructive obligation** arises from an entity’s actions where it has indicated to others it will accept certain responsibilities, creating a valid expectation in those parties.

> **Key Term: legal obligation**
> An obligation deriving from a contract, legislation, or other legal means.
>
> **Key Term: constructive obligation**
> An obligation that arises from an entity’s actions where it has created a valid expectation in other parties that it will discharge certain responsibilities.

### Measurement of Provisions

A provision is measured at the best estimate of the expenditure required to settle the obligation at the reporting date. If a single obligation exists, use the most likely outcome. For a large population of events (e.g., warranty claims), expected value is used.

When settlement will occur after the reporting date, provisions are discounted to present value if material.

### Common Examples: When to Recognise a Provision?

**Recognise a provision for:**

- Warranties/guarantees on goods sold (if probable outflow and reliable estimate)
- Onerous contracts (unavoidable costs exceed expected benefits)
- Decommissioning, environmental restoration, or similar obligations (legal/constructive)
- Legal claims when probable outcome is loss and reliably measurable

**Do NOT recognise a provision for:**

- Future operating losses (no current obligation)
- Planned restructurings not announced
- General repairs not yet required by a present obligation

### Contingent Liabilities: Definition and Disclosure

A contingent liability is **NOT** recognised in the financial statements. Instead, it is disclosed in the notes unless the possibility of outflow is remote.

Disclose:

- A brief description
- Estimate of financial effect (if practicable)
- An indication of uncertainties and possibility of reimbursement

No disclosure is needed if the chance of outflow is remote.

### Contingent Assets: Definition and Disclosure

Contingent assets are **never recognised** in the accounts. Disclose only if an inflow of benefits is probable (not virtually certain). If the inflow becomes virtually certain, the asset is recognised in the financial statements.

Disclose:

- Nature of the contingent asset
- Estimate of possible financial effect (if possible)

### **Worked Example 1.1**

A manufacturing company offers 1-year warranties on its products. Based on experience, it expects that warranty repairs will cost \$30,000 on current year sales. At year end, only \$7,000 of repairs have actually been made.

**Question:** How should the company account for warranty costs at year end?

> **Answer:**  
> The company should recognise a provision of \$30,000 for expected warranty claims, as it has a present legal or constructive obligation from selling the goods, a probable outflow, and a reliable estimate. The \$7,000 already incurred reduces the provision made, but the end-of-year provision should cover the remaining expected claims.

### **Worked Example 1.2**

ABC Ltd is being sued by a customer for an allegedly faulty product, claiming \$500,000. At the year end, legal advice says that losing the case is possible but not probable.

**Question:** Should ABC Ltd recognise a provision or a contingent liability, and what disclosure is required?

> **Answer:**  
> No provision is recognised because a probable outflow is not present. Instead, a contingent liability should be disclosed with a description of the claim and an estimate of its effect, unless the chance of losing is remote.

### **Worked Example 1.3**

XYZ Ltd suffered flood damage to inventory after the year end, but before accounts approval. The inventory was valued at cost at the year end and not damaged until after.

**Question:** Is this an adjusting or non-adjusting event after the reporting period and what does this mean for provisions or contingencies?

> **Answer:**  
> This is a non-adjusting event since the condition (the flood) did not exist at the reporting date. No provision or adjustment is made in the statements, but disclosure may be required if the event is material.

### **Exam Warning**

> Many exam mistakes are caused by failing to apply the correct recognition criteria. For provisions, all three elements (obligation, probability, reliable estimate) must be met. If not, disclosure as a contingent liability may be required, but recognition is wrong.

## **Summary**

IAS 37 clearly separates provisions, contingent liabilities, and contingent assets by the likelihood and measurability of resulting cash flows. Only provisions that meet strict criteria are recognised. Contingent liabilities and assets are generally disclosed, not recognised. Judgement is required—always apply the standard’s definitions and thresholds, and make sure you also understand the distinction between legal and constructive obligations.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Define and distinguish between provisions, contingent liabilities, and contingent assets under IAS 37
- State the conditions required for the recognition of a provision
- Differentiate legal from constructive obligations
- Outline the measurement requirements for provisions, including discounting
- Explain when and how to disclose contingent liabilities and contingent assets
- Apply these principles to exam scenarios and real-life situations

## **Key Terms and Concepts**

- provision
- contingent liability
- contingent asset
- legal obligation
- constructive obligation

Provisions and contingencies (IAS 37) - Contingent liabilities and assets