Snapshot

Overview of IAS 37

Differences from Canadian GAAP

© CGA-Canada 2009

International Accounting Standard 37 (IAS 37), Provisions, Contingent Liabilities and Contingent Assets By BRIAN FRIEDRICH, MEd, CGA, FCCA(UK), CertIFR and LAURA FRIEDRICH, MSc, CGA, FCCA(UK), CertIFR Updated By STEPHEN SPECTOR, MA, FCGA This article is part of a series by the Friedrichs and Stephen Spector on the move to International Financial Reporting Standards to be published on PD Net.

Snapshot First released September 1998

Subsequent amendments 2003, 2004, 2005, 2007, and 2008 (to reflect changes in a variety of standards)

Effective date (IASB basis) fiscal periods beginning on or after July 1, 1999

Effective date (Canadian basis) fiscal periods beginning on or after January 1, 2011

Outstanding Exposure Drafts and issues under consideration

ED of substantial revisions was released June 30, 2005; no revised standard has yet been released — the IASB has been unable to reach a final position regarding the measurement requirements and the removal of the probability recognition criterion in the ED. A new Non-financial Liabilities exposure draft is expected late in 2009

Overview of IAS 37 Objective The objective of IAS 37 is to ensure that provisions, contingent liabilities, and contingent assets are recognized based on appropriate criteria and measured using appropriate bases. Furthermore, the standard aims to ensure that the notes to financial

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statements provide sufficient information so that users can understand the nature, timing, and amount of any provisions, contingent liabilities, and contingent assets. The key underlying principle is that a provision should be recognized only when a liability exists; accordingly, planned future expenditures are not recognized as provisions or contingencies, even if the board of directors has authorized them.

Scope IAS 37 does not deal with provisions, contingent liabilities, and contingent assets that fall into the following two broad categories (¶1 to ¶5):

1. Items arising from non-onerous executory contracts An executory contract is one where neither party to the contract has performed any of their obligations, or where both parties have performed a portion of their obligations to an equal extent. IAS 37 applies to an executory contract only if the contract is “onerous,” meaning that the unavoidable costs of fulfilling the contract or exiting from it exceed the economic benefits expected to be received under it.

2. Items covered by another standard Items that are specifically addressed in another standard are scoped out of IAS 37. For example, some types of provisions are addressed in IAS 11 Construction Contracts, IAS 12 Income Taxes, IAS 17 Leases, and IAS 19 Employee Benefits. In addition, the standard does not apply to financial instruments (including guarantees) that are covered under IAS 39 Financial Instruments: Recognition and Measurement. Finally, IAS 37 does not cover provisions, contingent liabilities, and contingent assets arising from insurance contracts (IFRS 4 Insurance contracts covers them), but it does deal provisions, contingent liabilities, and contingent assets of the insurer (unless these elements arise from contractual obligations and rights under insurance contracts within the scope of IFRS 4).

Highlights of the standard

Definitions Paragraph 10 provides definitions for the following key terms (among others):

• A constructive obligation is an obligation that derives from an entity's actions where:

(a) 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

(b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.

• A contingent asset is a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.

• A contingent liability is:

(a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or

(b) a present obligation that arises from past events but is not recognized because:

(i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or

(ii) the amount of the obligation cannot be measured with sufficient reliability.

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• 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.

• A provision is a liability of uncertain timing or amount. Provisions are distinguished from accruals because, although both may require estimates, there is much less uncertainty with accruals than with provisions.

Recognition of provisions and contingencies Contingent assets (¶31 to ¶35) IAS 37 prohibits the recognition of contingent assets, based on the perspective that including a contingent asset on the balance sheet might result in the recognition of income that is never realized. However, if an inflow of economic benefits is probable (that is, more likely than not1), the contingent asset should be disclosed. Note that if an inflow of economic benefits is virtually certain, then the related asset is not “contingent” on an event occurring and, therefore, it should be recognized in the financial statements. Contingent liabilities (¶27 to ¶30) Contingent liabilities are also not recognized in the financial statements, but they must be disclosed unless the possibility of an outflow of economic resources is remote. Contingent liabilities should be continually monitored, and if the outflow of resources becomes probable, they should be recognized as provisions. Provisions A provision is recognized in the financial statements when (¶14)

a) an entity has a present obligation as a result of a past event (the “obligating event”);

b) it is probable that an outflow of economic resources will be required to settle the obligation; and

c) the amount of the obligation can be reliably estimated. Note from the definition of a contingent liability (in paragraph 10, above) that if an item meets the first criterion for recognition as a provision, but does not meet either the second or third criteria, it is treated as a contingent liability. When a provision is recognized, the debit side of the entry is not always an expense; IAS 37 recognizes that in some cases the amount may be debited to an asset account (this would be the case, for example, when recognizing an obligation for environmental cleanup on a new mine site). In determining whether a provision should be recognized, the “present obligation” does not need to be a legal obligation; constructive obligations also give rise to provisions if the other two criteria are met. In rare cases, such as some lawsuits, it may not be clear whether a present obligation exists. Accordingly, a provision is recognized if the outflow of economic benefits is more likely than not. If this test is not met, the item would be treated as a contingent liability, and would be disclosed unless remote. IAS 37 clearly states that no provision is recognized for future operating losses or for costs that need to be incurred to operate in the future. Financial statements represent the financial position of the company at the end of its reporting period and not its possible position in the future. IAS 37 provides the following example to illustrate this point:

1 The interpretation of “probable” in this standard as “more likely than not” does not necessarily

apply in other standards.

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[A]n entity recognizes a provision for the decommissioning costs of an oil installation or a nuclear power station to the extent that the entity is obliged to rectify damage already caused. In contrast, because of commercial pressures or legal requirements, an entity may intend or need to carry out expenditure to operate in a particular way in the future (for example, by fitting smoke filters in a certain type of factory). Because the entity can avoid the future expenditure by its future actions, for example by changing its method of operation, it has no present obligation for that future expenditure and no provision is recognized. (¶19)

With respect to obligations under contracts, if an entity has a contract that is onerous, the present obligation is recognized as a provision. However, before a separate provision for an onerous contract is established, an entity first must recognize any impairment losses that have occurred on assets that are dedicated to that contract, in accordance with IAS 36 (¶66 to ¶69). Restructuring IAS 37 gives specific guidance as to provisions for restructuring. A restructuring is

a programme that is planned and controlled by management, and materially changes either:

(a) the scope of a business undertaken by an entity; or

(b) the manner in which that business is conducted. (¶10)

This would include, for example, the sale or termination of a business line, the relocation or closure of a business location, a change in management structure, or a reorganization that materially impacts the nature and focus of operations. With these types of events, the difficulty is in determining when a present obligation exists. For the sale of a business line, a provision would be recognized once there is a binding sale agreement (¶78). In the case of a closure or reorganization, however, the obligation arising from the event is more likely to be constructive, rather than legal. A constructive obligation to restructure arises only when an entity has a detailed formal plan for restructuring, and has raised a valid expectation in those affected that it will carry out the restructuring. A valid expectation would be raised by either starting to implement the plan, or by announcing the plan’s main features to those affected by it (¶72). Whether arising from a legal or a constructive obligation, a restructuring provision should include only the direct expenditures that result from the restructuring, not costs that are associated with ongoing activities of the enterprise. Consequently, expenditures for marketing or for relocating and retraining continuing staff would not be included in a restructuring provision (¶80 to ¶81).

Measurement of a provision The amount recognized as a provision is the best estimate of the amount required to settle the obligation at the end of the reporting period — in other words, the amount that the entity would rationally pay to settle the obligation or to transfer it to a third party at that time (¶36 and ¶37). Determining the best estimate may involve expected value calculations, where possible outcomes are weighted by their likely probabilities. This technique is particularly useful where the provision being measured involves a large population of items (such as warranties). For an individual obligation (such as the settlement of a lawsuit or environmental cleanup), the best estimate of the liability may be the single most likely outcome, adjusted as appropriate to consider risk and uncertainty. Provisions are measured on a pre-tax basis, taking into account the time value of money, if material. The discount rates used should be pre-tax rates that reflect the current market assessment of the risks specific to the liability. The discount rate(s) should not, however, reflect risks for which future cash-flow estimates have already been adjusted (¶45 to ¶47).

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Future events that may affect the amount required to settle the present obligation (for example, expected changes in technology that would reduce cleanup costs) should be reflected in the amount of a provision only if there is sufficient objective evidence that they will occur. The effect of changes in legislation should be reflected only if the legislation is virtually certain to be enacted (¶48 to ¶50). Gains on the expected disposal of assets are not taken into account when estimating provisions; instead, the entity recognizes any gains on the expected disposal of assets as specified by the standard dealing with the assets concerned (¶51). If all or part of the amount required to settle a provision is expected to be reimbursed by a third party, the reimbursement should be recognized only when it is virtually certain that if the enterprise settles the obligation, the reimbursement will be received. The amount recognized should not exceed the amount of the provision. The reimbursement should be treated as a separate asset, but in the statement of comprehensive income, the related expense may be presented net of the amount recognized as a reimbursement (¶53 to ¶58). Provisions should be reviewed at the end of each reporting period and adjusted to reflect the current best estimate. The provision is reversed if it is no longer probable that an outflow of economic resources will be required to settle the obligation (¶59). The challenge associated with measurements is dealing with risks and uncertainties. Paragraph 42 stipulates that the risks and uncertainties surrounding the events and circumstances related to the provision need to be taken into account when reaching the best estimate of the provision. The danger is that in deriving the best estimate, the adjustments for risk and uncertainty can “double up” with consequent overstatement of a provision.

Presentation and disclosure Provisions Disclosure requirements under IAS 37 include reconciliations for each class of provision, which include (¶84)

• opening carrying amount

• additions during the period, including increases to existing provisions

• amounts charged against provisions during the period

• unused amounts reversed during the period

• unwinding of the discount (that is, the increase during the period in the discounted amount arising from the passage of time and the effect of any change in the discount rate)

• closing carrying amount. Comparative information is not required for these reconciliations. In addition, for each class of provision, the entity is required to disclose (¶85)

• a brief description of the nature of the obligation and the expected timing of any resulting economic outflows

• an indication of the uncertainties surrounding the amount or timing of outflows

• the major assumptions made concerning any future events that are reflected in the amount of a provision because of their expected impact on the amount required to settle an obligation

• information on any expected reimbursements Contingent liabilities Unless the possibility of any outflow in settlement is remote, the entity is required to provide a brief description of the nature of each class of contingent liability and, where practicable,

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a) an estimate of the financial effect, using the guidance on measurement discussed above

b) an indication of the uncertainties surrounding the amount or timing of outflows

c) the possibility of partial or full reimbursement from another party (¶86) Contingent assets If an inflow of economic benefits is probable, the entity should provide a brief description of the nature of the contingent asset, and, where practicable, an estimate of its financial effect, using the guidance on measurement discussed above. General If any of the required information on contingent assets or liabilities is not disclosed because it is not practicable to do so, that fact must be stated. IAS 37 recognizes that, in extremely rare cases, disclosure of some or all of the required information would seriously prejudice the entity’s position in a dispute with another party. In such cases, the entity is not required to disclose the information, but it must disclose the general nature of the dispute, the fact that the information has not been disclosed, and the reasons for non-disclosure.

Appendix B of IAS 37 provides the following decision tree for addressing potential provisions and contingencies. Note that this appendix accompanies, but is not part of, the standard.

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Differences from Canadian GAAP Accounting for provisions and contingencies follows the same fundamental principles under both Canadian GAAP and IFRS, although IAS 37 is somewhat more conservative. In addition, the terminology differs somewhat, as the CICA Handbook refers to both recognized and unrecognized uncertain liabilities as “contingent liabilities,” rather than separating out recognized amounts as “provisions.” Specific differences are as follows:

• Under Canadian GAAP, provisions are generally recognized based on either legal or constructive obligations (which is the same as under IAS 37), although Canadian GAAP does not specifically define a provision. However, the term “contingent liability” under Canadian GAAP refers to both recognized and unrecognized uncertain obligations. Canadian GAAP does not have separate terms to describe contingent liabilities that meet the recognition criteria versus those that do not.

• Liabilities for restructuring and asset retirement obligations are recognized under Canadian GAAP only when there is a legal obligation (unlike IAS 37). Furthermore, under IFRSs,

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restructuring provisions arising from a business combination are recognized only when it is an existing liability of the acquiree at the acquisition date.

• Under Canadian GAAP, a provision is recognized if it is “likely” that a future event will confirm that a liability has been incurred and the amount can be reasonably estimated. IAS 37 requires provisions based on whether the outflows are “more likely than not,” which may be interpreted to provide a lower threshold. Similarly, contingent assets are disclosed under IAS 37 if they are “more likely than not,” whereas Canadian GAAP requires gain contingencies to be “likely” before disclosure is made.

• To estimate a provision based on a large population with a continuous range of equally possible outcomes, IAS 37 states that the obligation is measured at the mid-point in the range, whereas under Canadian GAAP it would be measured at the low end of the range.

• Under Canadian GAAP, an obligation is generally measured at the single most likely outcome, even if the possible outcomes are mostly higher or lower than that amount, whereas under IAS 37 the single estimate would be adjusted.

• IAS 37 requires that cash flows related to provisions be discounted if the effect is material. Under Canadian GAAP, provisions are generally not discounted (unless specifically required by a standard).

• IAS 37 requires “virtual certainty” before a reimbursement is recognized; Canadian GAAP requires only that recovery is “likely.”

• Under Canadian GAAP, provisions based on onerous contracts are made only if required by a specific standard.

• Unlike Canadian GAAP, IAS 37 allows exemptions to some specific disclosure requirements if the entity’s position in a dispute would be seriously prejudiced.

• Under IAS 37, if a contingent asset becomes virtually certain, then it is no longer contingent and is recognized. Canadian GAAP does not allow for such recognition until the asset is actually realized, with one exception: recoveries in respect of recognized losses are recognised when receipt is likely.

Articles in this series will discuss:

IFRS 1 First-time Adoption of IFRS

IFRS 3 Business Combinations

IFRS 7 Financial Instruments: Disclosures

IAS 1 Presentation of Financial Statements

IAS 16 Property, Plant and Equipment

IAS 27 Consolidated and Separate Financial Statements

IAS 32 Financial Instruments: Presentation

IAS 36 Impairment of Assets

IAS 37 Provisions, Contingent Liabilities and Contingent Assets

IAS 38 Intangible Assets

IAS 39 Financial Instruments: Recognition and Measurement For a more comprehensive introduction to the adoption of IFRSs, see the online course IAS 36/IAS 37 on PD Net. You must be registered to access and purchase the course. If you are not registered on PD Net, register now — it’s fast, easy, and free.

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Brian and Laura Friedrich are the principals of friedrich & friedrich corporation, an accounting research, standards, and education firm. The firm provides policy, procedure, and governance guidance; develops courses, examinations, and other assessments; and supports the development of regional public accounting standards in Canada and internationally. Brian and Laura have served as authors, curriculum developers, lecturers, exam developers, and markers for numerous CGA and university courses in Canada, China, and the Caribbean. Their volunteer involvement has earned them CGA-BC’s inaugural Ambassador of Distinction Award (2004) and the J.M. Macbeth Award for service at the chapter level (Brian in 2006 and Laura in 2007). Brian and Laura are also Fellows of the Association of Chartered Certified Accountants. Stephen Spector is a Lecturer currently teaching Financial and Managerial Accounting at Simon Fraser University. He became a CGA in 1985 after obtaining his Master of Arts in Economics from SFU in 1982. In 1997, CGA-BC presented him with the Harold Clarke Award of Merit for recognition of his service to the By-Laws Committee for 1990-1996. In 1999, Stephen received the Fellow Certified General Accountant (FCGA) award for distinguished service to the Canadian accounting profession. He has been on SFU’s Faculty of Business Administration’s Teaching Honour Roll for May 2004 to April 2005 and May 2006 to April 2007. In August 2008, he was one of the two annual winners of the Business Faculty’s TD Canada Trust Distinguished Teaching Award. Stephen has held a number of volunteer positions with CGA-BC; he currently sits on CGA-BC’s board of governors where he is CGA-BC’s President.