It will usually be straightforward to establish whether a legal obligation exists, because it derives either from a contract (through its explicit or implicit terms), from legislation or the operation of the law.

Proposed legislation moves through various stages before it is finally enacted. A proposed law only creates an obligation for which provision is made when it is virtually certain to be enacted as drafted. This means that an obligation to comply with legislation only arises when that legislation is enacted or virtually certain to be enacted. IAS 37 does not specify a single event to identify when the enactment of a law is virtually certain.

Implications of new legislation Environmental damage has occurred before period end, but there is no current law that requires clean-up, and the entity has not taken any action that creates a constructive obligation. However, a new law requiring the entity to rectify the damage will be passed shortly after the period end. The new legislation will create a present obligation that results from a past event (because the contamination has already taken place). Management should determine whether it is virtually certain, at the balance sheet date, that the new law will be enacted as drafted. There is an obligating event and a present obligation if the legislation is virtually certain to be enacted. However, there is no obligation where enactment is not virtually certain because, although the potentially obligating event has taken place (that is, the contamination of the land), there is no obligation that can be enforced by law.

Obligation arises as a result of changes in the law

It is possible that an event may not give rise to an obligation immediately, but may do so at a later date. This could be as a result of changes in the law or because an act (e.g. a sufficiently specific public statement) by the entity gives rise to a constructive obligation. For example, when an entity causes environmental damage, this may not give rise to an obligation for remedial costs if there is no applicable legislation. The causing of the damage will become an obligating event at a later date, however, if a new law requires the existing damage to be rectified or if the entity publicly accepts responsibility for rectification in a way that creates a constructive obligation.

When details of new legislation have yet to be finalised, an obligation arises only when the legislation is virtually certain to be enacted as drafted. Under IAS 37, such an obligation is treated as a legal obligation. In many cases, however, it will be impossible to be virtually certain of the enactment of a law until it is enacted.

Smoothing of results

IAS 37 seeks to prevent artificial ‘smoothing’ of results. By basing the recognition of a provision on the existence of a present obligation, it rules out the recognition of any provision made simply to allocate expenses over more than one period or otherwise to smooth the results reported. For example, entities are not permitted to provide on an annual basis for items such as future repairs to assets, so as to produce a reasonably level charge each year. Unless dealt with through a component approach to depreciation, such costs will instead generally be recognised in profit or loss when they are incurred, i.e. when the work is done.

Situations of uncertainty regarding present obligations

IAS 37 states that there will, on rare occasions, be circumstances when it is unclear whether a present obligation exists. To determine whether a present obligation exists under such circumstances (e.g. when the facts in a lawsuit are disputed), the Standard advises that account should be taken of all available evidence. Such evidence may include, for example, the opinion of experts. It will also include additional evidence contributed by events occurring after the reporting period. Preparers of financial statements should look at all of the available evidence and come to a reasoned judgment as to whether it is more likely than not that a present obligation exists. If it is more likely than not that a present obligation exists, a provision should be recognised. Otherwise, a contingent liability is disclosed, unless the possibility of any transfer of economic benefits in settlement is remote.

Probable outflow of economic benefits

An essential element of the definition of a liability is the existence of an obligation to transfer economic benefits. Recognition of a provision is conditional on the transfer of economic benefits being ‘probable’, for IAS 37, probable is taken to mean more likely than not to occur.

Interpretation of ‘probable’ in IAS 37 ‘More likely than not’ means that the probability that a transfer of economic benefits will occur is more than 50 per cent.

When several similar obligations exist (e.g. product warranties), the overall probability that a transfer of economic benefits will be made is determined by looking at the class of obligations as a whole. A typical situation will be that, despite the likelihood of an outflow of resources for any one item being small, it may well be probable that a transfer of some economic benefits will be needed to settle the class of obligations as a whole. When this is the case, assuming that the other recognition criteria are met, a provision is recognised.

Constructive obligations

A constructive obligation arises 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.”

Assessment of constructive obligations Some constructive obligations will be obvious – for example, some retailers have a policy of giving cash refunds to dissatisfied customers, whether or not the goods that they bought are faulty. Such a policy might be over and above any legal obligation, but a constructive obligation arises from the retailer’s established or published practice. It might be less clear whether there is an obligation for ad hoc refunds, and judgement is required. A constructive obligation might also arise where an entity has published its environmental policies, even though no legal obligation exists.

The expectation of other parties is critical to the existence of a past event, but it is not necessary to know the other party’s identity for an obligation to arise.

A constructive obligation might arise where a potentially obligating event has taken place (such as environmental damage), but where no legal obligation exists. The entity could create a constructive obligation by making a public statement that it will rectify the damage. The public announcement creates a constructive obligation if it is sufficiently specific that it leaves the entity no realistic alternative but to carry out the rectification work.

Uncertainty as to whether a present obligation exists

In rare circumstances, it might not be clear whether a past event results in a present obligation. In these situations, a past event gives rise to a present obligation if, after taking account of all the available evidence, it is more likely than not that a present obligation exists at the balance sheet date.

IAS 37 requires that:

• Where it is more likely than not that a present obligation exists at the balance sheet date, the entity should recognise a provision (if the recognition criteria are met).
• Where it is more likely that no present obligation exists at the balance sheet date, the entity should disclose a contingent liability, unless the possibility of an outflow of resources embodying economic benefit is remote, in which case no disclosure is required.
• It is sometimes unclear whether a present obligation exists in connection with litigation where the events are disputed by the parties. In this situation, it might be necessary for an entity to obtain an expert’s opinion to determine whether a present obligation exists.

Further information might become available between the balance sheet date and the date on which an entity’s financial statements are finalised. Where this happens, that information should be taken into account in determining whether or not a present obligation exists at the balance sheet date. A provision should not be made at the period end where the obligating event occurs after the balance sheet date.

Whether the past event gives rise to a present obligation Entity A has received notice from the governmental environment agency that it will investigate claims of pollution caused by the entity. Neighbours living near entity A’s factory claim that its operations have caused ground water contamination. The investigation will only consider whether entity A has caused contamination and, if so, what penalties and fines should be levied. Manufacturing operations have been conducted at the site for 150 years, but entity A acquired the factory only 50 years ago. Entity A has recently used toxins at the plant, but only to an extent that is unlikely to cause pollution. However, management is not sure whether it has all of the information about the entire history of the plant, so neither management nor external experts can assess whether entity A has a present obligation until the investigation is completed. How should management account for a situation where it is not possible to reliably assess whether a present obligation exists? The obligating event is the contamination in the past, not the outcome of the future investigation, and management cannot determine whether the obligating event has occurred until the investigation is complete. IAS 37 states that, in rare cases, it is not clear whether there is a present obligation. In these cases, a past event gives rise to a present obligation if, taking account of all available evidence, it is more likely than not that a present obligation exists at the balance sheet date. Management therefore considers all the available evidence, including evidence obtained after the balance sheet date, in assessing whether or not a present obligation exists. Management concludes that this evidence does not support a conclusion that a present obligation exists, so a liability is not recognised. Management should disclose the contingent liability for potential penalties and fines that might be imposed if past contamination is proved. Any new evidence about the existence of the obligating event that becomes available after the balance sheet date, up to the date when the financial statements are authorised for issue, is an adjusting event in assessing whether a present obligation existed at the balance sheet date. If, and to the extent that, the entity is obligated at the balance sheet date to perform an investigation, irrespective of the outcome of the investigation, and no other benefits will arise as a result of the investigation, the entity recognises a liability for such costs at the balance sheet date.

A liability exists only when something has happened in the past (a ‘past event’) to trigger a present obligation. The past event is known in IAS 37 as the ‘obligating event’. 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”. Many obligating events are obvious; for example, the obligating event giving rise to the need to make a warranty provision is the original sale of the warrantied goods. Similarly, with the contamination of land, the obligating event is the original contamination.

No obligation arises from a past event if there is a realistic possibility that the entity can avoid settlement. An entity has no realistic alternative to settling an obligation only where:

• the settlement of the obligation can be enforced by law; or
• the event, in the case of a constructive obligation, creates a valid expectation in others that the entity will discharge the obligation.

Only past events existing independently of an entity’s future actions will trigger provisions.

Implications of costs arising from future operation An entity might be required to operate in a particular way or to take specific actions in the future, but these do not create a legal or constructive obligation if they can be avoided. For example, an airline might be required, by local legislation, to undertake major engine overhauls on all of its aircraft at regular intervals. The airline cannot renew its licence and continue to fly each aircraft without completing the overhaul. There is no present obligation, because no obligating event arises before the overhaul is carried out. The airline can avoid the cost of the overhaul by, for example, selling the aircraft or otherwise discontinuing its use. Accounting for overhaul costs in connection with owned assets is dealt with in IAS 16. A provision is not recognised, but the costs of each overhaul are capitalised and depreciated over the period to the next overhaul.

Probable outflow of economic benefits

Once it has been established that a present obligation exists as a result of a past event, it is necessary to determine whether it will result in a probable outflow of resources embodying economic benefits to settle the obligation. IAS 37 states that “an outflow of resources or another event is regarded as probable if the event is more likely than not to occur …”. No provision is necessary where the outflow is not probable, but a contingent liability exists and should be disclosed unless the possibility of an outflow is remote.

Obligations arising from a group of similar transactions should be considered together. IAS 37 requires the probability that an outflow of resources will be required in settlement to be determined by considering the class of obligations as a whole. A typical example of this is product warranties.

Reliable estimate

In extremely rare cases, it will not be possible to make a reliable estimate of the obligation. In such cases, the liability is disclosed as a contingent liability. IAS 37 does not provide further guidance on what might be ‘extremely rare cases.

IAS 37 states that, in nearly all cases, an entity will be able to determine a range of possible outcomes and to make an estimate of an obligation that will be sufficiently reliable to use in recognising a provision. Judgement will be needed where the amount is uncertain. A variety of estimation techniques might be used to make the estimate.

Continued recognition and reversal

Provisions should be based on circumstances at the balance sheet date but adjusted to reflect the current best estimate. The current best estimate will be based on information available up to the date when the financial statements are authorised for issue. If it is no longer probable that an outflow of economic benefits will be required to settle the obligation, the provision should be reversed.

A provision should only be used for the expenditures for which it was originally recognised. Where the original provision was charged as an expense, any subsequent reversal should be credited to the same line in the income statement.

Reversing a provision in the income statement During 20X1, 15 customers of a food manufacturer suffered from severe food poisoning, allegedly from products that the entity sold. Management withdrew the product from supermarket shelves as a precaution. Legal action for damages was brought against the entity before the end of 20X1. At 31 December 20X1, the entity’s lawyers advised management that the manufacturer was more likely than not to be required to pay the damages. Management recognised a provision for damages in the 31 December 20X1 balance sheet. At 31 December 20X2, the entity’s lawyers advised management that the chances of being required to pay the damages were now negligible, as a result of a favourable decision made in a similar case. How should this change in assessment be reflected in the financial statements? Management should reverse the provision and recognise the reversal in the income statement where the expense was charged. Management should also disclose the litigation as a contingent liability, unless the possibility of an outflow of economic benefits is remote. The disclosure should explain the reasons for the change in the assessment and the amount of the reversal.

Reimbursements

Where some or all of the expenditure required to settle a provision is expected to be reimbursed by another party, the reimbursement should be recognised only when it is virtually certain that reimbursement will be received if the entity settles the obligation. The entity typically remains liable for the entire obligation, and reimbursements are therefore presented separately as assets. The amount recognised should not exceed the amount of the related provision.

Recognition of provisions and related reimbursements An entity should recognise an obligation (and an expense) before recognising a related reimbursement (for example, insurance recoveries). This is because entities must provide for an outflow that is probable, but the right to be reimbursed is recognised only when the recovery is virtually certain in the event that the entity settles the obligation.

Implications of post balance sheet events for the recognition of insurance recoveries It might not be clear at the balance sheet date whether there is an obligation (and a related reimbursement asset). Evidence that becomes available after the balance sheet date that confirms that the entity had a present obligation at the balance sheet date is an adjusting event, so a liability is recognised. A reimbursement asset is also recognised if it is virtually certain at the year-end that the reimbursement will be received if the entity settles the obligation. For example, legal action against an entity was in progress at the year-end and an outflow was probable. The entity was also negotiating a reimbursement with its insurer. The insurer had agreed that reimbursement would be made if the entity lost the case, although the amount was uncertain until the settlement was agreed. Management concludes that credit risk is negligible. An asset for the reimbursement should be recognised, because it is virtually certain at the balance sheet date that reimbursement will be received if the entity settles the obligation. The post-year-end settlement confirms the existence and amount of the liability and the related reimbursement asset. The reimbursement asset cannot exceed the liability. The provision for the obligation and the receivable for the expected recovery are presented gross on the balance sheet, but could be netted in the income statement. This presentation in the income statement better reflects the substance of the transaction and is consistent with the guidance in IAS 1.

Expenses relating to a provision can be presented net of the amount recognised for a reimbursement in the income statement.

An entity is sometimes able to transfer the obligation to another party and, as a result, it will no longer be liable for the loss, even if the party assuming the obligation fails to pay. The entity no longer has a liability for the costs arising under the obligation or bears the credit risk of the counterparty assuming the obligation, so those costs should not be included in the provision.

Recognition of reimbursement expected from insurance company – example An entity has a high probability of losing a lawsuit in which it is the defendant. The entity’s insurance company is expected to cover any loss incurred. The outflow of resources expected on the loss of the lawsuit and the amounts expected to be recovered from the insurance company arise from the same past event. When the conditions of IAS 37 are met, the entity should recognise a liability for the expected outflow of resources, measured at the best estimate of the expenditure required to settle the obligation at the end of the reporting period as stated in IAS 37. In respect of the expected recovery from the insurance company, the entity should assess the effectiveness of its insurance policy. Under IAS 37, it should recognise the amount expected to be reimbursed (as a separate asset) when, and only when, it is virtually certain that the reimbursement will be received if the entity is required to settle the lawsuit (i.e. if it is virtually certain that a valid claim can be made). The amount recognised for the reimbursement should not exceed the amount of the provision. Offset of a provision and the related reimbursement is never appropriate. If a reporting entity can avoid making payment in respect of an obligation in all circumstances (i.e. there can never be any recourse to the entity), then it has no liability and hence neither a provision nor a reimbursement asset should be recognised. In most cases, however, the entity will remain liable for the whole amount in question and will have to settle the full amount if the third party fails to pay for any reason. In these circumstances, no offset is permitted, irrespective of how unlikely it is that the entity will have to settle the obligation directly. If a reporting entity is jointly and severally liable for an obligation, it should provide for that part of the obligation which it is probable will be settled by the entity. The remainder, expected to be paid by other parties, is a contingent liability.

Measurement of reimbursements – impact of the time value of money If an entity has a provision and a matching reimbursement, and the time value of money is material to both, the question arises as to whether both should be discounted. In principle, both the asset and the liability should be discounted. If there will be a significant interval between the cash outflows and receiving the reimbursement, the reimbursement will be more heavily discounted; in such circumstances, if the gross inflows and outflows are the same, on initial recognition there will be a net cost. If (presumably rarely) the reimbursement will be received first, IAS 37 will restrict the discounted amount of the reimbursement so that it does not exceed the discounted amount of the provision. In profit or loss, the unwinding of the discount on the reimbursement may be offset against that on the provision. When a reimbursement will not be received until some significant time after the outflows to which it relates, it is possible (though perhaps rare) that it may carry interest, or in some other way be increased, so as to reimburse the entity for the lost time value of money. The only restriction in IAS 37 is that the asset recognised (i.e. the discounted amount) must not exceed the provision recognised. It is, in principle, possible for the gross amount of reimbursement used in the discounting calculation to exceed the gross outflows expected (i.e. for the undiscounted asset to be greater than the undiscounted liability).

Collateralised or guaranteed loan commitments – example (entities applying IAS 39) Entity A has issued a non-cancellable loan commitment at market terms to Entity B. The loan commitment cannot be settled net, and Entity A has no past practice of selling the assets resulting from its loan commitments shortly after origination. Entity A did not designate this loan commitment at fair value through profit or loss; therefore, in accordance with paragraphs 2(h) and 4 of IAS 39, this loan commitment is scoped out of IAS 39 and should be accounted for under IAS 37. In general, a provision should be recognised when the conditions set out in IAS 37 are met. That is, if Entity A has assessed at the end of the reporting period that Entity B will not be able to repay the loan that it has committed to grant to Entity B, a provision should be recognised. Scenario 1 The loan subject to the loan commitment is guaranteed by another party (e.g. the parent of the borrowing entity or an insurer). That party will reimburse Entity A for any loss incurred if Entity B fails to make payments when due (i.e. if there is a breach of contract). The loan commitment has not been settled at the end of the reporting period; however, Entity A assesses that Entity B will not be able to repay the loan that it has committed to grant to Entity B. Entity A should account for the loan commitments as follows under Scenario 1. The provision should be measured according to IAS 37 at “the best estimate of the expenditure required to settle the present obligation at the end of the reporting period”. In accordance with IAS 37, Entity A should not take into account the guarantee provided by the parent or insurer when assessing the amount of the provision necessary at the end of the reporting period. The guarantee provided by the parent or insurer is a reimbursement right because Entity A “is able to look to another party to pay part or all of the expenditure required to settle a provision”. The guarantee, therefore, should be recognised as a separate asset. However, this should only be done when the criteria in IAS 37 are met, which requires that a reimbursement from another party is recognised only when it is virtually certain that reimbursement will be received if Entity B fails to make payment when due. If the guarantee was part of the same contractual arrangement (e.g. when the loan commitment issued to Entity B is guaranteed by the parent of Entity B, and the guarantee is part of the same contractual arrangement), then it would be bundled and an alternative treatment would be appropriate (see the answer for scenario 2 below). Scenario 2 The loan subject to the loan commitment is a collateralised loan; that is, if Entity B fails to make payments when due, the legal ownership of the collateral (e.g. property) will be transferred to Entity A. The loan commitment has not been settled at the end of the reporting period; however, Entity A assesses that Entity B will not be able to repay the loan that it has committed to grant to Entity B. Entity A should account for the loan commitments as follows under Scenario 2. Collateral held on the loan is not a reimbursement right because Entity A is not ‘able to look to another party to pay part or all of the expenditure required to settle a provision’. IAS 37 Accordingly, this collateral is not separate from the loan commitment and, when accounting for the provision, it should be treated as a net arrangement with a single counterparty (i.e. the collateral should be taken into account when measuring the provision amount). The provision is measured in accordance with IAS 37. Although the loan commitment is within the scope of IAS 37, in practice, a provision will be recognised at the amount equivalent to the impairment that would have been required under IAS 39, which states that ‘the amount of the loss is measured as the difference between the asset’s carrying amount and the present value of estimated future cash flows’. Additionally, IAS 39 indicates that ‘the calculation of the present value of the estimated future cash flows of a collateralised financial asset reflects the cash flows that may result from foreclosure, less costs for obtaining and selling the collateral, whether or not foreclosure is probable.’ Accordingly, the provision is recognised for the present value of the net non-recoverable amount (taking into account the value of the collateral, less the cost for obtaining and selling it).

Because expected credit losses on loan commitments are similar to those on loan assets, the scope of the IFRS 9 impairment requirements includes issued loan commitments not measured at fair value through profit or loss. Consequently, entities that have adopted IFRS 9 do not apply IAS 37 for the recognition and measurement of impairment on issued loan commitments.