PROVISIONS: RECOGNITION AND MEASUREMENT

Recognition

Under IAS 37 Provisions, contingent liabilities and contingent assets, an entity must recognise a provision if, and only if:

• a present obligation (legal or constructive) has arisen as a result of a past obligating event;
• it is probable that an outflow of economic resources will be required to settle the obligation; and
• the amount can be reliably estimated.

Let's look at these criteria in more detail.

Present obligation

There must be a present obligation as a result of a past obligating event. An obligating event is an event that creates an obligation that results in an entity having no realistic alternative but to settle the obligation. This means that something must have happened in the past that gives rise to an obligation now that the entity has to settle.

For instance, an entity sold faulty goods to a customer and the customer is now suing the entity for damages. The entity is said to have an obligation (i.e. to pay for the damages if it loses the case) as a result of a past event (i.e. the sale of faulty goods).

The present obligation can be legal or constructive. A legal obligation is simply an obligation that arises by law. On the other hand, a constructive obligation arises if past practice, published policies or a sufficiently specific current statement has created a valid expectation on the part of a third party.

Let's say Entity A that sells electrical goods gives warranty cards to its customers for a one-year warranty. By doing so, Entity A has a legal obligation to provide warranty claims as it is legally stipulated in the terms of the warranty cards.

Conversely, Entity B also sells electrical goods but does not give warranty cards to its customers. However, for the past ten years in business, Entity B has been giving refunds, free repairs or replacements to its customers for faulty goods returned within one year from the date of purchase. By doing so, Entity B has a constructive obligation to provide warranty claims as its past practice has created a valid expectation on its customers that it will continue to do the same in the future. A constructive obligation would also arise if Entity B has advertised or made a public announcement about its policy of giving warranties.

Probable outflow of economic resources

There must be a reasonable probability that some transfer of economic resources will be required to settle the obligation. In this case, the term 'probable' would mean a likelihood of 'more than 50%'. Therefore, an entity needs to determine whether there is such a likelihood that it needs to transfer cash or assets in order to settle the obligation that has arisen.

It is almost certain that a transfer of economic resources will be required if an obligation is to be settled. The key here is to determine the probability criteria.

Reliable estimation of amount

The amount required to settle the obligation must be capable of being estimated reliably. Otherwise, the amount of provision may be materially misstated.

Note that these three recognition criteria will apply to general provisions (such as provisions for legal claims, bad debts, etc.), environmental provisions and provisions for onerous contracts.

Illustration

Petrochem accidentally spilled petrol into Russian sea, causing damage that will cost $8m to clean. There is no
environmental legislation but the company has clear green policies on its websites.

Required:
Discuss whether a provision should be made by Petrochem in respect of the item above.

Solution

Petrochem has no legal obligation to rectify the damage as there is no environmental legislation in that country. However, by publishing green policies on its websites, it has created a valid expectation on third parties that it will clean up the spill. Therefore, Petrochem has a constructive obligation.

It is probable that Petrochem needs to pay for the clean up costs which is reliably estimated at $8 million.

Therefore, a provision should be recognised in the financial statements.


Derecognition
Provisions should be reviewed at the end of each reporting period. They should be reversed if it is no longer probable that an outflow of economic resources will be required to settle the obligation.


Measurement
The amount recognised as a provision should be the best estimate of the expenditure required to settle the obligation that existed at the reporting date. The estimate should take into account various factors such as the risks and uncertainties associated with the cash flows, expected future events (e.g. new technology or new legislation) and more importantly, the time value of money.

If the effect of the time value of money is material, then the provision should be discounted to its present value using a risk adjusted rate. The unwinding of the discount is a finance cost, and should be disclosed separately in the Statement of comprehensive income.

If some or all of the expenditure required to settle a provision is expected to be reimbursed by another party, then the reimbursement should be recognised as a separate asset when, and only when, it is virtually certain (a likelihood of 'more than 95%') that the reimbursement will be received if the entity settles the obligation (e.g. an insurance policy to cover the costs of a lawsuit). However, the amount recognised should not be greater than the provision itself.

Where there is a population of items, the provision is measured by using the statistical method of 'expected values'.

For example, if an entity believes that there is a 75% chance that warranties for Product A will cost $30,000 and a 25% chance that warranties for Product B will cost $60,000, then the expected value of the liability is calculated as:

(75% x $30,000) + (25% x $60,000) = $37,500