IAS 37 Provisions, Contingent Liabilities and Contingent Assets: Summary, Practice Questions & Decision Tree

A provision is recognised when — and only when — three conditions are all met (IAS 37.14): a present obligation (legal or constructive) as a result of a past event; a probable outflow of economic benefits, where probable means more likely than not; and a reliable estimate of the amount. The past event — the obligating event — must leave the entity no realistic alternative to settling: selling goods with a warranty creates the obligation at the point of sale, not when defects appear (IAS 37.17–19).

Constructive obligations widen the net beyond contracts and legislation: an established pattern of past practice or a sufficiently specific public commitment can create a valid expectation that the entity will act, and with it a present obligation (IAS 37.10). A retailer with a well-publicised no-questions refund policy has an obligation for expected refunds even where the law demands none. What never qualifies: future operating losses — they lack a past event and may even signal an impairment test instead (IAS 37.63).

The amount recognised is the best estimate of the expenditure required to settle the obligation at the reporting date — what the entity would rationally pay to settle or transfer it (IAS 37.36–37). The technique depends on the population: for large populations of similar items, like warranty claims, the estimate is an expected value — each outcome weighted by its probability. For a single obligation, like one lawsuit, the most likely individual outcome is the starting point, adjusted where other outcomes are skewed to one side (IAS 37.39–40).

Where the time value of money is material, the provision is discounted at a pre-tax rate reflecting the liability's risks; the unwinding of the discount each year is a finance cost, not an operating expense (IAS 37.45, 60). Risks and uncertainties are reflected in the estimate — but deliberate overstatement is prohibited: prudence is not a licence for hidden buffers (IAS 37.42–43). Reimbursements (insurance recoveries) are recognised as a separate asset, only when virtually certain, capped at the provision amount (IAS 37.53).

A contingent liability is either a possible obligation whose existence awaits confirmation by uncertain future events, or a present obligation that fails the probability or measurement test (IAS 37.10). Contingent liabilities are never recognised — they are disclosed, unless the possibility of outflow is remote, in which case the notes stay silent too (IAS 37.27–28). Contingent assets face a higher bar: disclosed when an inflow is probable, recognised only when it becomes virtually certain — at which point it stops being contingent at all (IAS 37.31–35). The asymmetry is deliberate: the framework tolerates early recognition of losses far more readily than early recognition of gains.

• Outflow probable + reliable estimate → recognise a provision
• Outflow possible (or present obligation unmeasurable) → disclose a contingent liability
• Outflow remote → no recognition, no disclosure
• Inflow probable → disclose a contingent asset; inflow virtually certain → recognise the asset

A contract becomes onerous when the unavoidable costs of meeting it exceed the economic benefits expected from it (IAS 37.68). The provision equals the lower of the cost of fulfilling the contract and any compensation or penalty for exiting it — the rational choice between two bad options. Unavoidable costs of fulfilling comprise the costs that relate directly to the contract: both incremental costs and an allocation of other directly related costs (IAS 37.68A). Before providing, any assets dedicated to the contract are first tested for impairment (IAS 37.69).

Restructurings — sale or termination of a business line, closures, relocations, fundamental reorganisations — get deliberately strict criteria, because managements historically used 'big bath' restructuring provisions to smooth profits. A constructive obligation arises only when the entity has a detailed formal plan (identifying the business, locations, employees affected, timing and expenditure) AND has raised a valid expectation in those affected — by starting implementation or announcing the plan's main features (IAS 37.72). A board decision alone is not enough (IAS 37.75).

Even then, the provision includes only direct expenditures necessarily entailed by the restructuring: redundancy costs, lease terminations. Costs of the continuing business — retraining, relocating staff, marketing, new systems — are future operating costs and are excluded (IAS 37.80–81).