Summary of illustrative examples from the implementation guidance accompanying IAS 37

The examples set out in Section C of the implementation guidance accompanying IAS 37 are summarised below, but in a tabular format, in order to identify reasons for particular items meeting, or not meeting, the definition of a provision. In all cases, it is assumed that a reliable estimate can be made.

Type of risk or cost Present obligation as a result of a past event? Probable transfer of benefits? Conclusion Warranty ✓ ✓ Provide at date of sale for legal obligation. Example 1: Warranty given by a manufacturer under the terms of a contract for sale. Past experience shows that it is probable that claims will be received. Contaminated land (1) ✓ ✓ Provide for expected legal obligation. Example 2A: Contaminated land – entity cleans up only to meet legal requirements, which are virtually certain to be enacted soon after the end of the reporting period. Contaminated land (2) ✓ ✓ Provide for constructive obligation. Example 2B: Contaminated land – entity has no legal obligation, but meets widely publicised clean-up policy. Decommissioning ✓ ✓ Provide on commissioning of asset and include in cost of oil rig. Example 3: Decommissioning – terms of a licence impose a legal obligation to remove an oil rig at the end of its life. Refunds policy ✓ ✓ Provide for constructive obligation. Example 4: Refunds – retail store follows a published policy of providing refunds, even though there is no legal obligation. Closure of a division (1) ✗ No obligating event before the end of the reporting period. Example 5A: Closure of a division – board decision taken before the end of the reporting period, but not communicated to those affected and plan not commenced. Closure of a division (2) ✓ ✓ Provide for expected costs of closure. Example 5B: Closure of a division – board decision, detailed plan completed, staff and customers notified before the end of the reporting period. Legal requirement to fit smoke filter Example 6: Introduction of legal requirement to fit smoke filters by 30 June 20X1. (a) At 31 December 20X0, the end of the reporting period. ✗ No obligating event at the end of the reporting period. (b) At 31 December 20X1, the end of the reporting period (assuming filters not yet fitted). ✗ – no obligating event in respect of filters, but ✓ ✓ – provision may be required for any fines and penalties likely to be suffered. Staff retraining ✗ No obligating event until training occurs. Example 7: Staff retraining – need to retrain staff to meet new system requirements imposed by change in the law. Onerous contract ✓ ✓ Provide for unavoidable lease payments. Example 8: Onerous contract – operating lease rental payments on vacated property.   Note: This example is deleted for entities that have adopted IFRS 16. Guarantee Example 9: Guarantee – provided for another entity’s borrowings. Although such guarantees were within the scope of IAS 37 when the Standard was originally issued, they are now within the scope of IFRS 9 (or, for entities that have not yet adopted IFRS 9, IAS 39), except in limited circumstances in which IFRS 4 applies. Example 9 provides an example of an accounting policy that IFRS 4 permits and that also complies with the requirements in IFRS 9 (or IAS 39) for financial guarantee contracts within the scope of IFRS 9 (or IAS 39). With effect for annual periods beginning on or after 1 January 2023, IFRS 17 will replace IFRS 4. Consequential amendments to IFRS 9 are not reflected in this manual, which assumes IFRS 4 continues to be applied. Court case Example 10: Unsettled court case (a) At 31 December 20X0, the end of the reporting period – lawyers advise that no liability will be proved. ✗ No obligation exists based on evidence. (b) At 31 December 20X1, the end of the reporting period – lawyers advise that liability will be proved. ✓ ✓ Provide for estimated settlement. Repairs and maintenance ✗ No obligation exists independently of future actions. Expenditure capitalised when incurred and depreciated. Example 11A: Repairs and maintenance – a furnace has a lining that needs to be replaced every five years for technical reasons. At the end of the reporting period, the lining has been in use for three years. Refurbishment costs ✗ No obligation exists independently of future actions (the entity could sell the aircraft). Expenditure capitalised when incurred and depreciated. Example 11B: Refurbishment costs – legislative requirement – an airline is required by law to overhaul its aircraft once every three years.

Self-insurance – cost of accidents When an entity self-insures (e.g. a retailer might decide not to insure itself in respect of the risk of minor accidents to its customers), it should recognise a provision each year for the costs of accidents that have occurred prior to the end of the reporting period. This provision should cover not only those claims that have been made prior to the end of the reporting period, but also claims potentially incurred but not reported (IBNR) at that date. It will be common that an accident has happened but the entity does not know of its occurrence. This in itself does not preclude the entity from recognising a provision – as long as a reliable estimate can be made of IBNR claims, probably based on past experience. Because the IBNR provision is, by definition, in respect of claims incurred before the end of the reporting period, the obligating event will have occurred by that date. IAS 37 does not, however, permit the recognition of a provision for the excess of the ‘normal annual cost’ over the cost of actual accidents in the year. In other words, a self-insuring entity is prevented from ‘smoothing’ the cost of accidents by making a buffer provision in a year when actual costs are low. When a group self-insures by setting up a separate captive insurance subsidiary, any intragroup premiums charged or received will be eliminated on consolidation, reflecting the fact that, for the group, this is not external insurance cover.

Adjustment of insurance premiums – example Entity A has an insurance policy with premiums that are adjusted on the basis of actual losses incurred in that year. For example, if losses for a specific period exceed 100, Entity A will have to pay the insurer 80 per cent of the excess losses in the form of additional premiums in that year. Entity A should recognise a provision at the end of each reporting period for the additional premiums due as a result of losses in that year. In measuring that provision, Entity A should consider not only known losses but also losses incurred but not yet reported.

Vouchers issued for no consideration A reporting entity may, for no consideration, distribute vouchers that can be used, sometimes within a set period, to obtain discounts on the entity’s products and/or a third party’s products. (Note that when such vouchers are issued as part of a sales transaction, it will be necessary to consider the unbundling implications of IFRS 15) Applying IAS 37’s recognition criteria, the questions to be considered are as follows. Is there a present obligation? Generally, the answer will be yes. However, if the reporting entity reserves the right to terminate the scheme at any time, thus invalidating existing vouchers, there may or may not be a constructive obligation. In the absence of evidence that schemes have been terminated (and existing vouchers invalidated) in the past, it should be presumed that an obligation exists. Is it probable that economic benefits will be transferred? If, after vouchers are deducted, the entity’s products are still being sold at a profit, the answer will be no – in which case no provision will be recognised. To the extent that products will be sold at a loss, however, or that a third party will be reimbursed for discounts, there will be a transfer of economic benefits. Can a reliable estimate be made? The answer here should be presumed to be yes, but in making the estimate the entity should consider how many vouchers are expected to be used. In summary, if the criteria are met, provision should be recognised for the best estimate of the cost to the entity (which may not be the face value of the discounts). The entity will need to form a view as to how many vouchers are expected to be used and should also consider whether discounting is appropriate.

Costs of decommissioning an oil rig

Commissioning of a new oil rig creates an obligation to incur costs of decommissioning in the future, but also gives access to future economic benefits. A provision for the present value of costs of decommissioning should be recognised at the time of commissioning the oil rig and the amount recognised should be added to the cost of the rig. The provision should only include the costs that are an obligation resulting from commissioning the rig. The provision should not include any additional costs that will only be triggered by further drilling until that further drilling occurs.

Assets used to fulfil a decommissioning activity The expected expenditures included in a decommissioning provision may include those attributable to the cost of an asset to be used to fulfil the decommissioning activity. For example, this may be the case if a specific asset is required for the decommissioning activity. This asset may be acquired outright at the beginning of the decommissioning period or may be leased by the entity over the decommissioning period. In such circumstances, the decommissioning provision is settled by performance of the decommissioning activity rather than by the mere acquisition of the asset or right-of-use asset. For example, if the entity leases the required asset, at lease commencement it would recognise a right-of-use asset and a lease obligation applying IFRS 16 and would continue to recognise separately the decommissioning provision. As it performs the decommissioning activity using the acquired asset (or right-of-use asset), the entity recognises the depreciation of the asset (or right-of-use asset) and adjusts the carrying amount of the decommissioning provision to reflect the expected remaining costs to settle its decommissioning obligation.

Employment disputes – example An entity employs three professional seamen. Maritime law prescribes that registered professionals are paid a premium over unregistered professionals. The entity subsequently discovers that the professionals are not registered and, therefore, have been overpaid. The entity consequently reduces the salaries of these professionals who then take the matter to court. One employee wins the case and is awarded a CU70,000 retrenchment package. The other two lose on a technicality, but will appeal the decision. Lawyers are certain that the appeal will be successful. A provision should be recognised for the best estimate of the costs to settle the appeal. The past event is the underpayment of the employees (after it was thought they were overpaid), and therefore occurred during the year. As a result of the court proceedings, a legal obligation to compensate one employee exists in the current year (for CU70,000). With regard to the other two seamen, the past event is the constructive dismissal (i.e. the reduction in salaries) that occurred during the year. Because it is probable (more likely than not) that the entity will be found liable, a present obligation exists. It is probable that economic benefits will flow from the entity.

Recognition of assets and liabilities arising from ‘cap and trade’ schemes for emission rights ‘Cap and trade schemes’ for emission rights are designed to encourage reductions in greenhouse gas emissions. Typically in cap and trade schemes, a government (or government agency) issues rights (allowances) to participating entities to emit a specified level of emissions. (The government may issue the allowances free of charge or the participant may be required to pay for them). Participants in the scheme are able to buy and sell allowances and, therefore, in many schemes, there is an active market for the allowances. At the end of a specified period, participants are required to deliver allowances equal to their actual emissions. Other schemes designed to encourage reduced levels of emissions share some of the features of cap and trade schemes. IFRS Standards do not contain any specific requirements regarding the accounting by participants in a cap and trade scheme. In December 2004, IFRIC 3 Emission Rights was issued to deal with these issues; as a result of perceived problems with its application, IFRIC 3 was withdrawn in 2005. Entities participating in cap and trade schemes will need to give careful thought to how they account for the assets and liabilities arising from these schemes. One possible approach would be to follow the guidance previously set out in IFRIC 3. Two other possible approaches are also outlined below. The accounting policy adopted should be applied to all emission allowances and related liabilities on a consistent basis. Although emission rights are typically regarded as intangible assets for most entities, if an entity is acting as a broker or trader, such that it acquires rights from one market participant and sells them on to another, the emission rights are likely to be inventories for that entity. In the event that an entity acquires emission rights far in excess of the emissions it is likely to make, with the intention of selling those rights, those excess rights may qualify as inventories. Approach 1: apply IFRIC 3 Emission rights are intangible assets that are accounted for in accordance with IAS 38 Intangible Assets and would be recognised initially at fair value. When allowances are issued for less than fair value, the difference between the amount paid (if any) and fair value would be accounted for as a government grant within the scope of IAS 20. As emissions are made, a liability would be recognised for the obligation to deliver allowances equal to emissions that have been made. This liability would be a provision within the scope of IAS 37, and would be measured at the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. This would usually be the present market price of the number of allowances required to cover emissions made up to the end of the reporting period. Offset of the asset (emission credits held) and the liability (to deliver credits to the value of emissions made) would not be permitted. Approach 2: government grant and an intangible asset initially at fair value, emission liability reflects carrying amounts Intangible asset Allowances allocated free of charge or for nominal consideration would be measured under the alternatives permitted in IAS 20 and IAS 38. It would seem preferable for allowances to be recognised as an asset only when issued. But an acceptable alternative would be for the entire period allocation to be recognised as an asset at the point at which the relevant authority finalises the allocation plan for the allowances. Allowances allocated represent an intangible asset acquired by an entity free of charge or for nominal consideration. IAS 38 sets out two possible treatments. The entity could choose to recognise both the intangible asset and the government grant initially at fair value; alternatively, nominal value could be used. The fair value approach might be considered as providing better accounting information, in that it results in a better representation of the economic resources and obligations of the entity. Subsequent to initial recognition, the general requirements for intangible assets in IAS 38 would apply. IAS 38 permits an intangible asset to be remeasured at fair value when this can be measured by reference to an active market. Remeasurements are recognised in other comprehensive income. The revalued amount is subject to amortisation and impairment testing between remeasurements. This accounting treatment precludes any reclassification to profit or loss of fair value increments accumulated in equity. IAS 38 also permits an intangible asset to be measured at cost less amortisation/impairment. If an entity were to use this method, any difference between the carrying amount of the asset and the liability would be recognised in profit or loss upon settlement of the obligation (or sale of the allowances). For most allowances traded in an active market, no amortisation will be required because the residual value will be the same as cost and, therefore, the depreciable amount will be zero. If the market value of the allowances falls below cost, or other indications of impairment exist, then the guidance in IAS 36 should be followed to determine whether the assets are impaired. Government grant Allowances represent a non-monetary government grant and could be recognised at the fair value of the related asset or at a nominal amount. For the reasons noted above, it might be preferable for the government grant to be measured initially at fair value. The grant would be recognised as deferred income and recognised in profit or loss on a systematic basis over the compliance period, regardless of whether the allowances received continue to be held by the entity. Emission liability A liability for emissions would be recognised as incurred and measured 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. Under cap and trade schemes, entities generally can settle the obligation created by the emission of pollutants only by surrendering allowances to the appropriate authority and cannot settle their obligations by making a cash payment or by transferring other assets. When an entity measures allowances at fair value, the liability would be measured at the same amount, because this is the best estimate of the expenditure (economic resources) required to settle the obligation. When an entity measures allowances at cost, provided that it has sufficient allowances to satisfy the emission liability, the liability would be measured at the same amount (i.e. as the sum of the cost of the initial allowances received and the cost of any additional allowances purchased). If at the end of the reporting period the liability to deliver allowances exceeds the amount of allowances on hand, then the shortfall would be measured at the current fair (market) value of the short position. Consequently, if an entity chose to sell allowances during the year, and in doing so created a shortfall in the number of allowances held as compared to the total pollutants emitted at that date, it would remeasure the portion of the obligation related to the shortfall at the current market value of the allowances. Approach 3: government grant and an intangible asset measured at nominal amounts (net liability approach) Under this approach, when allowances are allocated free of charge or for nominal consideration, an intangible asset would be recognised and measured at a nominal amount when allowances are issued or allocated (i.e. the cost/nominal amount alternatives are adopted in IAS 20 and IAS 38). A credit entry for the government grant would be recognised in the statement of financial position at a nominal amount equal to the carrying amount of the allowances in accordance with IAS 20. No liability for emissions would be recognised provided that the entity has sufficient allowances to satisfy the emission liability, because the allowances granted (which are recognised only at a nominal amount) will be used to settle the liability. Therefore, no entries are required as long as the entity holds sufficient allowances to meet its emission obligations. If, at the end of the reporting period, the liability to deliver allowances exceeds the amount of allowances on hand, then the shortfall should be measured at the current fair (market) value of the short position.

Deposits relating to taxes other than income tax – example Entity A and a tax authority dispute whether Entity A is required to pay tax. The tax is not income tax and so is not within the scope of IAS 12. Any liability or contingent liability to pay the tax is instead within the scope of IAS 37. Based on its assessment of facts and circumstances, Entity A determines that it is probable that it will not be required to pay the tax because it is more likely than not that the dispute will be resolved in Entity A’s favour. Applying IAS 37, Entity A discloses a contingent liability and does not recognise a liability. To avoid possible penalties, Entity A has deposited the disputed amount with the tax authority. Upon resolution of the dispute, the tax authority will be required to either refund the tax deposit to Entity A (if the dispute is resolved in Entity A’s favour) or use the deposit to settle Entity A’s liability (if the dispute is resolved in the tax authority’s favour). IFRS Standards do not clearly address whether the tax deposit in this scenario is an asset. There is also no IFRS Standard which Entity A could analogise to in assessing whether the right arising from the tax deposit meets the definition of an asset. Accordingly, applying IAS 8, Entity A refers to the definition of an asset in the Conceptual Framework for Financial Reporting. The right arising from the tax deposit meets that definition. The tax deposit gives Entity A a right to obtain future economic benefits, either by receiving a cash refund or by using the payment to settle the tax liability. The nature of the tax deposit, whether voluntary or required, does not affect this right and therefore does not affect the conclusion that there is an asset. The right is not a contingent asset as defined by IAS 37 because it is an asset, and not a possible asset, of Entity A. Consequently, in the fact pattern described above, Entity A recognises an asset when it makes the tax deposit to the tax authority. In the absence of an IFRS Standard that specifically applies to the asset, Entity A also applies IAS 8 in developing and applying an accounting policy for the asset. Entity A uses its judgement in developing and applying a policy that results in information that is relevant to the economic decision-making needs of users of financial statements and reliable. To the extent that issues that need to be addressed in developing and applying an accounting policy for the tax deposit are similar or related to those that arise for the recognition, measurement, presentation and disclosure of monetary assets, Entity A refers to requirements in IFRS Standards dealing with those issues for monetary assets. This conclusion was confirmed by the IFRS Interpretations Committee in the January 2019 IFRIC Update.