IAS 37, Provisions, contingent liabilities and contingent assets

IAS 37 represents an important development for the accounting profession and as such is likely to feature prominently on both papers 10 and 13. Steve Scott the paper 10 examiner stated that it is necessary to be aware of the principle of past obligating events, the transfer of economic benefits and the principles of estimation. For paper 10 the application of discounting and unwinding of it is not required.

The standard was approved by the IASC Board in July 1998 and becomes effective for periods beginning on or after 1 October 1999. It replaces the parts of IAS 10 and SAS 10 that related to contingencies.

The arrival of this standard means that for the first time in Singapore there is detailed guidance on accounting for provisions. The lack of any such guidance in the past has allowed companies to use provisions to window dress the accounts. The so called "big bath provisions".

The example below illustrates how a company may have made use of the opportunities afforded by the lack of precise guidance.

Assume that you are considering the results of two companies (A and B) and are thinking of investing in one of them.

Company A

Company B

The investor faced with this decision in 1999 may initially be influenced by a much higher profit in that year. However, assuming that investors are risk averse he is likely to be even more influenced by the fear that the poor performance shown in 1998 may be repeated. After all the profits achieved in 1999 are only being considered to form an idea of potential profits in 2000 and beyond. What the investor would really like to see is profits that are steadily growing.

However, consider the following possibility. In 1997 company B could have decided to restructure its operations and made a provision for the potential costs of $3 million. The following year the company may now decide that there is no need to restructure and the provision is no longer needed and can be released back to the profit and loss account.

If that were the case B's results would now become:

Now company B can show the investor the steadily increasing profits he is looking for.

This simple example serves to illustrate the potential problem that could exist if there was no regulation. Companies could smooth their profits by making general provisions, which could be used in future years if results were poor.

What is required from the standard, therefore, is some precise guidance on what a provision is and when they can be recognised.

IAS 37 gives the following key definitions:

• A

  provision is a liability of uncertain timing or amount.

The definition of a liability is in line with the Framework Document:

• Liabilities are an

  obligation to transfer economic benefits as a result of

  past transactions or events.

Crucially then a provision should only be recognised when:

• there is an

  obligation (legal or construed);

• it is probable (more likely than not) that an outflow of resources will be required to settle the obligation;
• a reliable estimate can be made of the amount of the obligation.

  An obligation can be construed where a company has created a valid expectation that it will accept responsibilities by:

• an established pattern of past practice (e.g., past redundancy payments in excess of the minimum requirement);
• the company's published policies;
• or a sufficiently specific current statement.

As a result of the requirements of IAS 37 provisions can still be made but only where there is some degree of obligation on the part of the company. A mere board decision is no longer sufficient.

The aim is to prevent unnecessary provisions that can be used to artificially enhance profits in subsequent periods.

The standard also gives some guidance on how provisions should be measured. A provision should be the best estimate of the expenditure required to settle a present obligation.

The entity should take into account:

• the risks and uncertainties surrounding the event;
  * uncertainty does not justify excessive provisions;
• future events where there is sufficient objective evidence that they will occur;
• the time value of money i.e., it may be necessary to discount the provision.

It is worth reiterating the point that uncertainty does not justify excessive provisions, which would seem to contradict the prudence concept.

Provisions should be reviewed at each balance sheet date and adjusted if necessary.

A provision should only be used for expenditure for which it was originally intended.

IAS 37 also gives guidance on the following specific situations.

Future operating losses

Provisions should not be recognised for future operating losses unless required by another accounting standard e.g., SAS 11, losses on construction accounts.

Onerous contracts

This is a contract where:

• the unavoidable costs of meeting an obligation exceed the economic benefits expected to be received under it;

A provision should be recognised for the present obligation under the contract, e.g., an operating lease where:

• the unavoidable costs associated with the lease exceed the expected benefits.

So a provision is required where it is probable that there will be an obligation. If the obligation is not probable then there may be a contingent liability.

Contingent liabilities

A contingent liability is a possible

obligation arising from past events whose existence will only be confirmed by the occurrence of future events not wholly within the entity's control.

So a provision is required if it is probable that there will be an obligation i.e., if it is more than 50% likely to occur. If it is only a possible obligation i.e., it is less than 50% likely to occur it is a contingent liability and no provision is required.

The required treatment of a contingent liability is that the details of the liability should be disclosed unless the possibility of a transfer of economic benefit is remote.

A contingent liability could also include an obligation arising from past events which is not recognised because it is not probable that a transfer of economic benefits will be required, or because the amount of the obligation cannot be measured with sufficient reliability.

Contingent assets

A contingent asset is a possible asset arising from past events whose existence will only be confirmed by future events not wholly within the entities control. Contingent assets may require disclosure but should not be recognised in the accounts.

The terms of IAS 37 make it unlikely that disclosure of contingent assets will arise in practise. Details of the asset should be not be disclosed unless the possible inflow of economic benefit is probable, at which point it is no longer contingent.