By Irene Peter Atolo, FCA, FCIIN
The topic is arranged in the following headings to ease understanding.
IAS 37 was issued in 1998 by the International Accounting Standards Board superseding IAS 10: Contingencies and Events after balance sheet date; and as its name implies it deals with three very important areas known as Provisions , Contingent Liabilities and Contingent
Contingent Assets. I intend to do a trilogy on this Standard starting from Provisions and thereafter talk about the other two. Before this Standard, Provisions were used indiscriminately by preparers of financial statements to mostly engage in creative accounting and since one of the main aims of IFRS is to allow for comparability of Financial Statements this Standard was issued. Some examples of the wrong use of Provisions will suffice here. In those days Preparers used Provisions for profit smoothing; that is if the entity believes that the profit for a particular year was excessive , provisions could be created to spread the profits to lean years. Provisions could also be made for future expenditures which are not due yet just to mention a few. So the objective is IAS 37 is to ensure that appropriate recognition criteria and measurement bases are applied to provisions, and that sufficient information is disclosed in the notes to enable users to understand the nature, timing and amount.
The Standard defines a provision as a liability of uncertain timing or amount. It only deals with provisions that are shown as liabilities in a statement of financial position. The term ‘provision’ is also used widely in the context of items such as depreciation, impairment of assets and doubtful debts. These are not addressed in IAS 37, as they are adjustments to the carrying amounts of assets.
IAS 37 requires three criteria before a provision should be recognized:
1. an entity has a present obligation (legal or constructive) as a result of past event;
2. It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
3. A reliable estimate can be made of the amount of the obligation.
No provision should be recognized unless all these conditions are met. The standard prohibits the recognition of provision in the following: future operating losses, repairs and maintenance of own assets,and staff training costs. If it is not clear whether there is a present obligation, then assume that there is an obligation if it is highly probable. This assessment will include any additional evidence after the current year has ended. If it is highly probable recognize it as a provision. If it more likely that no obligation exists at the end of the reporting period, then disclose as a contingent liability. In possibility is remote don’t do anything. A past event creates an obligation for payment if there is no reasonable alternative to settling obligation. This is the case only when settlement can be enforced by law or if there is a constructive obligation. A constructive obligation derived from an entity’s prior indications that it will accept certain responsibilities which creates an expectation that it would fulfill those obligations. There must be a probability of payment to settle the obligation and there must be a way of measuring the obligation as shown below.
IAS 37 requires the amount to be recognized as a provision to be the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. This measure is usually determined before tax, as the tax consequences of the provision and changes to it are dealt with under IAS 12- Income Taxes. The standard further states that the estimate of the amount that entity would rationally pay to settle or transfer the obligation at the end of the reporting period gives the best estimate of the amount required. The estimates of outcome and financial effect are determined by judgement of the entity’s management, supplemented by experience of similar transactions and , in some cases report from independent experts. The standard suggest various ways of dealing with uncertainties arising from estimates: an expected value method, the mid-point of range of possible outcomes and an estimate of the individual most likely outcome.
After recognition a provision will be re-estimated used and released over the period up to the eventual determination of a settlement amount for the obligation. Provisions should be reviewed at the end of each year and adjusted to reflect the current best estimate. These presentation is done in the Statement of Financial Position. The standard do not permit provisions to be redesigned or otherwise used for expenditures for which the provision was not originally recognized. In such circumstances, a new provision is created and the amount no longer needed is reversed. This means that the questionable practice of charging costs against a provision that was set up for a different purpose is specifically prohibited.
IAS 37 states that for each class of provision an entity should provide a reconciliation of the carrying amount of the provision at the beginning and the end of the period showing:
1. Additional provisions made in the period including increases to existing provisions.
2. Amounts used, an charged against the provision during the period
3. Unused amounts reversed during the period.
4. 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. In addition, for each class of provision an entity should disclose the following:
1. A brief description of the nature of the obligation and the expected timing of of any resulting outflow of economic benefits.
2. An indication of the uncertainties about the amount and timing of those outflows.
3. The amount of any expected reimbursement, stating the amount of any asset that has been recognized for that expected reimbursement.
It should be noted that this is a very wide area of IFRS and only a brief summary is necessary. Next week I will discuss Contingent Liabilities.
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