IAS 37: Provisions and contingencies
When to recognise a provision, how to measure it, and when to disclose a contingent liability instead.
ACCA exams this helps with: FR Financial Reporting SBR Strategic Business Reporting See the ACCA map
New to this topic?
What it is: A provision is a liability where the amount or the timing is not certain.
When to include one: All three must be true. (1) There is an obligation now because of something that has already happened. (2) It is probable (more likely than not) that money will be paid. (3) The amount can be estimated reliably.
If not all three are true: Do not include it. If a payment is possible, describe it in the notes as a contingent liability.
Example. A shop sells kettles with a 1-year guarantee. Past records show repairs cost about 2% of sales. Sales this year are £500,000. Provision = £500,000 × 2% = £10,000. It is an expense this year, the year the kettles were sold.
Key words
- Provision
- A liability where the amount or the timing is not certain, such as expected warranty repairs or a legal claim the company will probably lose.Example: A warranty provision of £22,500 for expected repairs on products already sold.
- Contingent liability
- A possible obligation that depends on a future event, or one that is not probable. It is described in the notes to the accounts, but not included in the figures.Example: A customer is suing the company, and lawyers say the company will probably win. The claim is disclosed as a contingent liability.
- Constructive obligation
- A duty to pay that comes from how the company has behaved, not from the law or a contract. Other people reasonably expect the company to pay.Example: A shop has always refunded unhappy customers and says so in its adverts. It has a constructive obligation to keep doing it.
- Onerous contract
- A contract where the costs the business cannot avoid are more than the benefits it will get. The expected loss is provided for now.Example: A company is locked into renting an empty office for £50,000 more than it can earn from subletting it.
- Best estimate
- The amount a company would realistically have to pay to settle an obligation today. It is used to measure a provision.Example: Lawyers think a claim will cost between £80,000 and £120,000, most likely £100,000. The best estimate is £100,000.
Learn
A provision is a liability where the amount or the timing is not certain. Examples: warranty repairs, a court case, cleaning up a site.
When to include a provision
All three must be true:
- There is an obligation now (legal or constructive) because of something that has already happened.
- It is probable (more likely than not) that money will be paid.
- The amount can be estimated reliably.
A legal obligation comes from a contract or the law. A constructive obligation comes from the company’s own behaviour. Example: A shop has a published policy of refunding goods for any reason. It does not have to by law, but customers expect it. So it has a constructive obligation.
Provision, a note, or nothing?
| How likely is a payment? | What to do |
|---|---|
| Probable (over 50%) and can be estimated | Include a provision in the figures |
| Possible, but not probable | Describe it in the notes as a contingent liability |
| Remote (very unlikely) | Nothing |
| Money coming in (contingent asset): virtually certain | Include the asset |
| Money coming in (contingent asset): probable | Describe it in the notes only |
How much to provide
- Use the best estimate of the cost to settle it.
- For many similar items, such as warranties, use the expected value: each outcome × its probability, added up.
- For one single obligation, use the most likely outcome.
- If it will be paid a long time in the future, discount it to present value. Each year, the discount unwinds, and this is a finance cost.
Example (expected value): 1,000 items sold. 80% will have no fault. 15% will need a £50 repair. 5% will need a £200 repair. Per item: (15% × £50) + (5% × £200) = £7.50 + £10 = £17.50. Provision = 1,000 × £17.50 = £17,500.
Special cases
- Future operating losses: no provision. Nothing has happened yet, so there is no past event.
- Onerous contracts (the costs you cannot avoid are more than the benefit): provide for the loss.
- Restructuring: provide only when there is a detailed formal plan and it has been announced to the people affected. A board decision on its own is not enough.
What’s the debit entry? (workshop)
Usually an expense. But sometimes the provision is part of the cost of an asset: for example the obligation to remove an offshore oil rig, close a mine or decommission a power plant is added to the asset when it is built (Dr PPE, Cr Provision).
Using and reviewing provisions
- A provision can only be used for the purpose it was created for.
- Review every provision at each year end and adjust it to the current best estimate.
- If payment is no longer probable, reverse the provision.
- Discounting uses a pre-tax rate reflecting the time value of money and the risks of the liability.
Provision or not? Lecturer’s examples
| Situation | Provision? |
|---|---|
| Restructuring by selling an operation | Only when there is a binding sale agreement |
| Restructuring by closure or reorganisation | Only with a detailed formal plan, started or announced to those affected. A board decision alone is not enough |
| Warranty | Yes: the sale with a warranty is the obligating event |
| Land contamination | Yes if there’s a legal duty to clean up, or a published policy to do so (constructive) |
| Customer refunds (established policy) | Yes: constructive obligation |
| Offshore oil rig to be removed | Yes as it is built, added to the asset’s cost |
| Empty leased building, 4 years left, can’t be relet | Yes: the unavoidable lease payments (onerous) |
| Staff training needed for a new tax law | No: no obligation until the training happens |
| Major overhaul or repairs | No: no obligation |
| Onerous (loss-making) contract | Yes |
| Future operating losses | No: no liability |
Watch it explained
Press play to watch the animation, or step through it at your own pace with the arrows.
Videos from YouTube tutors
These videos are made by independent tutors on YouTube, not by Trial Balance. Some use US terms or older exam names (for example F7 for FR), but the principles are the same.
Worked example
A company sold 1,000 appliances with a one-year warranty. Past experience shows that 80% will need no repairs, 15% will need minor repairs costing £50, and 5% will need major repairs costing £300.
| Outcome | Units | Cost each £ | Expected cost £ |
|---|---|---|---|
| No repairs (80%) | 800 | 0 | 0 |
| Minor repairs (15%) | 150 | 50 | 7,500 |
| Major repairs (5%) | 50 | 300 | 15,000 |
| Warranty provision | 22,500 |
| Account | Dr £ | Cr £ |
|---|---|---|
| Warranty expense | 22,500 | |
| Provisions | 22,500 | |
| (Warranty provision for appliances sold in the year) | ||
Workshop examples
Expected value (warranty). If all goods had minor defects, repairs would cost 1m; if all had major defects, 4m. Expected: 75% none, 20% minor, 5% major.
| Outcome | Probability | Expected £ |
|---|---|---|
| 0 | 75% | 0 |
| 1,000,000 | 20% | 200,000 |
| 4,000,000 | 5% | 200,000 |
| Provision | 400,000 |
Most likely amount, discounted (lawsuit). At 31 December 20X1 there is a 70% chance of paying 300,000 and 30% of paying 2,000,000, with the ruling in 2 years. Discount rate 5%. One-off event, so use the most likely amount: 300,000. Provision now = 300,000 ÷ 1.05² = 272,109.
| Year | Provision at start | Interest (finance cost) 5% | Provision at end |
|---|---|---|---|
| 20X2 | 272,109 | 13,605 | 285,714 |
| 20X3 | 285,714 | 14,286 | 300,000 |
| Account | Dr £ | Cr £ |
|---|---|---|
| Finance costs | 13,605 | |
| Provisions | 13,605 | |
| (Unwinding of the discount in 20X2) | ||
Practice questions
Type or choose your answers, then press Check answer. Questions with a New numbers button can be repeated with different figures.