## Learning Outcomes

After studying this article, you will be able to state and apply the recognition criteria for provisions under IAS 37, distinguish between legal and constructive obligations, measure provisions using appropriate estimation and discounting, and explain when to disclose rather than recognise contingent liabilities and assets. You will also be able to handle typical FR scenarios involving warranties, onerous contracts, decommissioning costs, and restructuring, increasing your readiness for exam questions on IAS 37.

## ACCA Financial Reporting (FR) Syllabus

For ACCA Financial Reporting (FR), you are required to understand the requirements of IAS 37: Provisions, Contingent Liabilities and Contingent Assets. Your revision should emphasise:

- The reason an accounting standard on provisions is necessary
- The distinction between legal and constructive obligations
- The three recognition criteria for provisions
- How to measure provisions, including the use of best estimates and present value
- The definition and disclosure of contingent liabilities and contingent assets
- Identifying and accounting for warranties, onerous contracts, environmental and restructuring provisions

## Test Your Knowledge

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

1. In accordance with IAS 37, which of the following is not required for recognising a provision?
   a) It is probable that an outflow of resources will be needed
   b) There is a present obligation resulting from a past event
   c) The amount can be reliably estimated
   d) Management intends to make future payments

2. Briefly explain the difference between a legal obligation and a constructive obligation.

3. True or false? A contingent liability should always be recognised as a provision.

4. A company expects to spend \$500,000 rectifying a product defect, but no customers are yet aware of the issue. Should the company make a provision or only disclose?

## Introduction

IAS 37 sets out how to account for obligations where there is uncertainty about amount or timing. Before this standard was issued, companies sometimes manipulated profits by creating or reversing large provisions when it suited them. IAS 37 restricts the recognition of provisions and prescribes clear measurement criteria, supporting comparability and faithful representation in financial statements. It is regularly examined in the ACCA FR paper and appears in complex scenarios involving warranties, environmental costs, contracts, and legal claims.

> **Key Term: provision**
> A liability of uncertain timing or amount, recognised when an entity has a present obligation as a result of a past event, it is probable that an outflow of resources will be required to settle it, and the amount can be estimated reliably.
>
> **Test Tip:**
> When revising Recognition criteria and measurement, connect each definition, method, or rule to the kind of question the assessment is likely to ask.

### Recognising Provisions under IAS 37

IAS 37 allows a provision to be recognised only if all three criteria below are met:

![Sources of obligations under IAS 37, distinguishing legal and constructive obligations from situations with no present obligation before recognition assessment.](https://static.pastpaperhero.com/images/acca-fr-provisions-and-contingencies-ias-37-recognition-criteria-and-measurement_00.png)

_Contractual, statutory, and customary sources of obligation are mapped to legal or constructive obligations and then to provision recognition._

1. There must be a **present obligation** (legal or constructive) arising from a past event.
2. It must be **probable** that an outflow of resources embodying economic benefits will be required to settle the obligation.
3. A **reliable estimate** of the amount can be made.

If any condition fails, then recognition is not permitted.

> **Key Term: liability**
> A present obligation of the entity to transfer an economic resource as a result of past events.
> **Key Term: legal obligation**
> An obligation that arises from a contract, legislation, or other operation of law.
> **Key Term: constructive obligation**
> An obligation arising from an entity’s actions (such as published policies or past practice) where the entity has created a valid expectation among other parties that it will discharge certain responsibilities.

### Present Obligation

The obligation must exist at the reporting date. This can be legal, as created by contract or statute, or constructive, created by an entity’s own published policies or public statements, leading stakeholders to expect a particular course of action.

Management intention or planned actions, in isolation, do **not** create a present obligation. The obligation must result from a **past event** where the entity can no longer avoid the sacrifice of resources.

### Probable Outflow

For recognition, the outflow must be **more likely than not** to occur (i.e. >50% probability). If an outflow is only possible but not probable, recognition is not permitted—consider instead disclosure as a contingent liability.

### Reliable Estimate

If no reliable estimate can be made of the obligation’s value, a provision cannot be recognised, but a contingent liability may have to be disclosed.

> **Key Term: contingent liability**
> (a) A possible obligation resulting from past events whose existence will be confirmed only by the occurrence of uncertain future events, not wholly within the entity’s control;
> (b) A present obligation not recognised because either it is not probable a payment will be required, or no reliable estimate can be made.
> **Key Term: contingent asset**
> A possible asset arising from past events whose existence will be confirmed only by the occurrence of future events not wholly within the entity’s control.

### Distinguishing Legal and Constructive Obligations

A **legal obligation** is imposed by contract or law (e.g. required restoration, statutory fines). A **constructive obligation** arises from a company’s actions and can include statements of intent, published policies, or established patterns of behaviour that lead third parties to expect the entity will accept responsibility.

### Worked Example 1.1

Company Beta has a stated environmental policy pledging to restore all sites after use, although there is no legal requirement. Beta closes a site and the community expects restoration.

**Question:** Should Beta recognise a provision for restoration costs?

> **Answer:**
> Yes. The published policy and past practice create a constructive obligation; it is probable Beta will incur the costs, and a reliable estimate can be made.

### Measurement of Provisions

A provision shall be measured at the **best estimate** of the expenditure required to settle the obligation at the reporting date.

- For a single obligation (e.g. settlement of a lawsuit), use the **most likely outcome**.
- For a population of items (e.g. product warranties), use the **expected value** (probability-weighted sum).
- If timing is material, **discount** the provision to present value using a pre-tax rate reflecting current market conditions.

Costs included are only those **required** to settle the obligation present at the reporting date, not future costs for unrelated activities.

Provisions must be reviewed at each reporting date and adjusted if required.

> **Key Term: best estimate**
> The amount an entity would rationally pay to settle or transfer the obligation at the reporting date.

### Discounting Provisions

If the obligation will be settled in the future and the effect of the time value of money is material, discount expected cash flows to present value. Unwind the discount each year as a finance cost.

### Worked Example 1.2

A company estimates it will need to pay \$1 million to decommission a plant in 5 years. The appropriate discount rate is 8% and the present value factor for 5 years at 8% is 0.68.

**Question:** What is the provision at initial recognition? How is it treated?

> **Answer:**
> Initial recognition: \$1 million × 0.68 = \$680,000.
> Each year, the discount is unwound using the discount rate and recognised as a finance cost in profit or loss.

### When Not to Recognise a Provision

If there is no present obligation, or if an outflow is possible (not probable), or no reliable estimate can be made, then a **provision cannot be recognised**. Instead, the obligation may be a **contingent liability** and must be disclosed unless the chance of outflow is remote.

Contingent liabilities are not recognised in the statement of financial position, only explained in the notes. Contingent assets are **never** recognised and are only disclosed when the inflow is probable (but not virtually certain).

### Worked Example 1.3

Omega Ltd is being sued by a customer for \$100,000 for a faulty product. Its lawyers state there is only a 30% chance the case will be lost.

**Question:** What is the correct accounting treatment?

> **Answer:**
> No provision; outflow is possible, not probable. Disclose a contingent liability in the notes explaining the claim and its uncertainties.

### Common Types of Provisions and Application

IAS 37 applies to a range of real-world situations. Each type has specific requirements:

### Warranties and Guarantees

A provision is recognised for the expected cost of making good under warranty if experience suggests claims are likely and the amount can be estimated.

### Onerous Contracts

A contract is onerous if the unavoidable costs of meeting obligations exceed expected benefits. The provision equals the lower of the cost to fulfil the contract or the penalty for non-fulfilment.

### Environmental and Decommissioning Provisions

These are recognised where a legal or constructive obligation exists to rectify environmental damage, including restoration at the end of asset use. Initial measurement should reflect the best estimate, discounted if material.

### Restructuring Provisions

A restructuring provision can only be recognised where there is a **detailed formal plan** and those affected have a valid expectation that the restructuring will take place (e.g. after announcing the plan publicly or starting implementation). Only direct costs of restructuring are included, not costs of future operations or retraining.

### Worked Example 1.4

Delta Co enters a contract to supply goods for \$30,000, but unavoidable fulfilment costs are \$36,000.

**Question:** What provision, if any, should be recognised?

> **Answer:**
> Recognise a provision of \$6,000 for the onerous portion of the contract (\$36,000 - \$30,000).
>
> **Exam Warning:**
> Overprovisioning by management to reduce profit ("big bath" provisioning) is not permitted. IAS 37 is strict: provisions are only recognised when all criteria are met. The intention alone or market expectation is not enough.

### Treatment of Contingent Assets

Contingent assets are not recognised in the financial statements. They are disclosed only if the inflow of economic benefits is probable (but not virtually certain). If recovery is virtually certain, an asset is recognised.

### Worked Example 1.5

Beta Ltd is suing a supplier and expects a high chance of winning \$50,000, but success is not certain.

**Question:** How should Beta account for this potential inflow?

> **Answer:**
> Do not recognise an asset; disclose a contingent asset in the notes if inflow is probable.

## Summary

IAS 37 ensures that provisions are accounted for only when there is a present obligation, a probable outflow, and a reliable estimate. Provisions are measured at the best estimate and discounted if material. If criteria are not all met, the obligation is disclosed only as a contingent liability or contingent asset.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- The three conditions for recognising a provision under IAS 37
- How to distinguish legal from constructive obligations
- When and how to measure a provision at best estimate, including discounting for time value
- When to recognise typical provisions (warranties, onerous contracts, decommissioning, restructuring)
- The definition and disclosure of contingent liabilities and contingent assets
- The difference between recognising and disclosing obligations under IAS 37

## Key Terms and Concepts

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


Provisions and contingencies (IAS 37) - Recognition criteria and measurement