Provisions – recognition
IAS 37 defines provision as a liability of uncertain timing or amount. So, provision is a type of liability the timing and amount of which is uncertain. Liability is defined in the Conceptual Framework for Financial Reporting which is repeated by IAS 37 as well, as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
A provision should be recognized when an only when:
- An entity has a present obligation (legal or constructive) as a result of past event
- It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation, and
- A reliable estimate can be made of the amount of the obligation.
The key terms of the definition have been identified for further discussion.
A present obligation can stem from a legal agreement (a ‘legal obligation’) or might be constructive in nature (a ‘constructive obligation’).
Legal obligation – It derives from a contract (through its explicit or implicit terms), or legislation, or from the operation of law. e.g. a goods sold with standard warranty clause creates a legal obligation for the seller, even when the defect arises several years after the original sales (if the warranty is still effective). Obligation arising from onerous contracts are also examples of legal obligation (Onerous contract is explained in detail).
Constructive obligation – A constructive obligation will often be more difficult to discern in practice than a legal obligation because it derives from an entity’s action”
- By an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and
- As a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.
E2: Constructive obligation
A company may operate in a country where there is no requirement for environmental clean-up requirements. However, the company has an established environmental policy for clean-up and has done so in the past. Therefore, the company has a constructive obligation for clean-up costs because its policy and past practice creates a valid expectation that it will clean-up the contamination.
A liability exists only when something has happened in the past (a ‘past event’) to trigger a present obligation. The past event is known as IAS 37 as the ‘obligating event’. An obligating event is an event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation. e.g. the obligating event giving rise to make a warranty provision is the original sale of the warrantied goods. Similarly, with the contamination of land, the obligating event is the original contamination.
Probable outflow of economic benefits
Once the present obligation is established it is necessary to determine whether this will result in a probable outflow of resources embodying economic benefits to settle the obligation. the probable outflow is described as more likely than not i.e. more than 50% chance of occurring. Where the probability of outflow of economic benefits is below 50%, no provision is necessary, but a contingent liability exists and should be disclosed in the financial statements unless the contingency is remote.
In extremely rare cases, the reliable estimate of the obligation is not possible. The standard emphasis that, in nearly all cases, an entity will be able to determine a range of possible outcomes and to make an estimate of an obligation that will be sufficiently reliable to use in recognizing a provision.