The International Accounting Standards Committee (IASC) issued IAS37 Provisions, Contingent Liabilities and Contingent Assets in September 1998. It replaced parts of IAS10 Contingencies and became operative for annual financial statements covering periods beginning on or after 1 July 1999.
Before the announcement of IAS37, different countries use various ways to verify their provisions, which bring the problem of inconsistency. Some enterprises confirm their provisions, depending on whether to undertake current obligation or not. While some other enterprises are according to managers’ willingness of proceeding future payments to confirm their preparations. Therefore, the results are:
- Different types of business enterprises have different classification of provisions, so it creates inconsistency. This jeopardizes comparability of different enterprise’s financial statements.
- It provides the opportunity for certain enterprises to manipulate their profits. For example, the cost should be recognized in the period but may be moved to other period to confirm; the cost should be confirmed in future but may be moved to the current period. Therefore, to achieve the balance of profits in each period is one of purposes of this regulation.
- Some enterprises include some liabilities that do not meet the conditions of the requirements into their balance sheet. This apparently damages the current financial situation of the company.
‘The objective of this standard is to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets and that sufficient information is disclosed in the notes to enable users to understand their nature, timing and amount. The key principle of IAS37 is that a provision should be recognized only when a liability exists. Planned future expenditures are not recognized as provisions or contingencies, even if the board of directors has authorized them.
IAS 37 Major Requirements
An entity should recognize a provision as a liability based on the following three criteria met simultaneously:
- there is a present obligation or more likely than not that a present obligation exists at the end of the balance sheet date as a result of an obligating event;
- it is probable (i.e. more likely than not; i.e. 50%–95%) that an outflow of the economic benefit of the entity will exist;
- the amount of the outflow can be estimated reliably.
If the first criterion is met but it is possible (i.e.5%-50%) NOT probable that an outflow of economic benefit of the entity exists and the amount of the outflow cannot be measured reliably OR if possible obligation exists and the outflow of the economic benefit of the entity is not remote (i.e. 0%-5%), then contingent liability will arise.
In respect of contingent liability an entity should disclose it instead of recognizing unless the possibility of the outflow of the economic benefit of the entity is remote.
As regards a contingent asset, it should be just disclosed as well as contingent liability, unless the amount of the inflow of the contingent asset is virtually certain (i.e.95%-100%). When the inflow of the contingent asset is virtually certain, then it is appropriate to be recognized as an asset on the balance sheet.
When recognizing a provision, the amount of the outflow of the economic benefit of the entity should be based on the best estimate, i.e. this amount should be the same as the entity needs to pay to settle the obligation in due course.
When measuring a provision, things such as, risks and uncertainties, discounted provisions (if time value of money is material), changes in the law or other cases which can affect provisions, should be taken into account but do not take into account gains from the expected disposal of assets.
When reimbursement happens, an entity recognizes it if it is virtually certain and the amount recognized should not be more than the amount of the provision. The reimbursement should be recognized as a separate asset in the balance sheet. If the reimbursement and the expense relating to a provision are sustained in the same reporting period, then the expenses disclosed in the comprehensive P & L can be netted off by the amount recognized as a reimbursement.
The provision should be reviewed annually and adjusted according to latest best estimates. Changes in the provision can only be used for its original intention.
Provisions-three specific applications mentioned by this standard, namely: future operating losses, onerous contracts, restructurings. With regard to future operating losses no recognition should be made as a provision. In terms of onerous contracts, the unavoidable cost in excess of the benefit which can be received by the entity should be recognized as a provision. In related to restructurings, restructuring costs should be recognized when the criteria for provisions are met.
The Importance of IAS37 Requirements
According to Deloitte, IAS37 aims to ensure that recognition of provisions, contingent liabilities and contingent assets are made by using the best methods and measurements, to ensure that users of financial statements receive adequate and appropriate information for investment decision-making processes. In addition, IAS37 aims to ensure that it only deals with the real obligation in the financial statements and future expenditure, even if excluded from recognition by the responsible board.
The importance of taking the criteria into account, when the entity recognizes the provision, is to prevent any unnecessary provision from being recognized in order to enhance the entity’s value in subsequent periods in unsubstantiated ways, leading to provision of unreliable information to financial statement users. The importance of the liability and asset disclosure requirements could be viewed as returning to the Conservatism Principle in accounting which advises on ignoring profits not yet achieved, taking all expected losses into account and not registering potential gains until they occur. In other words this requirement prevents an entity from providing unrealized profits and subsequent information that might mislead users.
IAS37 provides guidelines regarding best estimates of provisions associated with its objectives, aiming to provide an appropriate way of measurement in order to represent sufficient and appropriate information. The standard requires the entity to take into account estimating process risks, uncertainties and other elements in order to achieve the best estimate for the provision. Following this requirement can prevent unrealistic values being reported in the entity’s financial statement. The requirements for solving the problem of reimbursement and illustrating the three specific applications are equally comprehensive, so that accountants know how to resolve them. Otherwise, it is likely that each entity might adopt its own method of troubleshooting which differs from others when facing such cases in reality, resulting in a lack of comparability among entities. In these instances investors may be misled when making investment decisions. In summary the importance of IAS37 is that it is intended to reduce the possibility of deliberate misstatement of an entity’s provisions, contingent assets and liabilities.