IAS 37 — Provisions, Contingent Liabilities and Contingent Assets
Provisions and contingent liabilities
When an obligation is recognised, and when it is only disclosed.
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The idea
A provision is a present obligation of uncertain timing or amount. The difference between it and a contingent liability is not wording but placement: a provision enters the statement of financial position, while a contingent liability stays in the notes. That classification decision is what separates honest statements from optimistic ones.
Recognition requires three conditions together: a present obligation from a past event, a probable outflow of resources to settle it, and a reliable estimate of the amount. If any condition fails the item moves from recognition to disclosure, or drops out entirely when the outflow is remote.
The treatment
Present obligation and past event
The obligation may be legal, arising from a contract or legislation, or constructive, arising from an established practice or published policy that created a valid expectation in others that the entity will accept responsibility. A published replacement policy beyond the legal warranty is a constructive obligation. What matters is that the obligating event occurred before the reporting date, so no provision is made for future operating costs.
Measurement
A provision is measured at the best estimate of the expenditure required to settle the obligation at the reporting date. Where there is a large population of similar items, the probability-weighted expected value is used; a single item is normally measured at its most likely outcome. If the time value of money is material, the amount is discounted to present value.
Contingent liability and contingent asset
A contingent liability is a possible obligation confirmed by future events outside the entity's control, or a present obligation not recognised because the outflow is not probable or the amount cannot be measured reliably. It is not recognised but is disclosed, unless the outflow is remote. A contingent asset is never recognised until the inflow becomes virtually certain, at which point it stops being contingent. The asymmetry is deliberate: caution over assets is stricter than over liabilities.
Onerous contracts and restructuring
An onerous contract is one where the unavoidable costs exceed the expected economic benefits, and the present obligation under it is recognised as a provision. Restructuring needs more than a management decision: it requires a detailed formal plan and a valid expectation among those affected that it will be carried out, either by starting it or by announcing its main features. Restructuring costs exclude retraining remaining staff or marketing the continuing business.
Worked example
A claim of SAR 500,000 was filed against the entity. Counsel considers a loss probable and the best estimate of settlement to be SAR 120,000. In the same matter the entity is claiming SAR 40,000 in reimbursement from a third party, which counsel considers possible but not virtually certain.
- The three conditions are met for the claim: a present obligation from a past event, a probable outflow, and a reliable estimate of SAR 120,000. A provision is recognised at that amount, not at the SAR 500,000 claimed.
- The reimbursement claimed is a contingent asset: possible but not virtually certain, so it is not recognised and is not netted against the provision; it is only disclosed. Netting it would present the obligation as smaller than it is.
- If the estimate later changes, the provision is adjusted in the period the estimate changed, without restating prior periods, because this is a change in an accounting estimate rather than the correction of an error.
Synthetic teaching amounts; the example is not a legal opinion.
Recognise the litigation provision
When the loss is probable and a reliable best estimate of the settlement exists.
| Account | Debit (SAR) | Credit (SAR) |
|---|---|---|
| Litigation provision expense | 120,000.00 | — |
| Litigation provision | — | 120,000.00 |
| Total | 120,000.00 | 120,000.00 |
Actual settlement below the provision
On final settlement at SAR 100,000, with the surplus released in the period it arises.
| Account | Debit (SAR) | Credit (SAR) |
|---|---|---|
| Litigation provision | 120,000.00 | — |
| Bank | — | 100,000.00 |
| Unused provision released | — | 20,000.00 |
| Total | 120,000.00 | 120,000.00 |
Common errors
- Recognising a provision at the full amount claimed instead of the best estimate of settlement.
- Netting an expected third-party reimbursement against the provision before recovery is virtually certain.
- Providing for future operating costs where no present obligation has arisen from a past event.
- Recognising a restructuring provision on a management decision alone, without a detailed plan or a valid expectation among those affected.
Interview question
What is the difference between a provision and a contingent liability, and why is a contingent asset not recognised by the same logic?
A provision is a present obligation with a probable outflow and a reliable estimate, so it is recognised. A contingent liability fails one of those conditions or depends on a future event outside the entity's control, so it is only disclosed unless the outflow is remote. A contingent asset is not recognised until the inflow is virtually certain, and the asymmetry is deliberate: recognising an unrealised gain misleads a reader more than disclosing an uncertain obligation does.