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Title
IAS 37 “Provisions”
Coverage
This session will cover IAS 37 Provisions, Contingent
Liabilities and Contingent Assets; IAS 10 Events after
the Reporting Period and IAS 2 Inventory
IAS 37 Provisions is an interesting standard that
requires judgment in its application and is subject to
critical evaluation meaning that it is a current issue.

Exam context
These standards may be familiar to those who recently
studied FR, however these can all feature in SBR so it is
very worthwhile for everyone to study them to ensure
that the right depth of technical knowledge for SBR. It is
also important that you have exposure to problem
solving and applications in mini case studies, rather than
just been tested by MCQs

Tom Clendon
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IAS 37 Provisions, Contingent Liabilities and

Contingent Assets
Definition of a provision
A provision is a liability of uncertain timing or amount.
A liability is a present obligation as a result of past
events, the settlement of which is expected to result in
an outflow of resources (payment).
Recognition of a provision
An entity must recognise a provision if, and only if at the
reporting date there is
• a present obligation (legal or constructive) has
arisen as a result of a past event (the obligating
event),
• payment is probable, and
• the amount can be estimated reliably.

Comment
The basic definition of a liability and its recognition
criteria are now inconsistent with the revised conceptual
framework.

Tom Clendon
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Present obligation
An obligating event is an event that creates a legal or
constructive obligation and, therefore, results in an entity
having no realistic alternative but to settle the obligation.
A constructive obligation arises if past practice creates a
valid expectation on the part of a third party.
A possible obligation (a contingent liability) is disclosed
but not accrued. However, disclosure is not required if
payment is remote.

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Measurement of provisions
The amount recognised as a provision should be the
best estimate of the expenditure required to settle the
present obligation at the reporting date, that is, the
amount that an entity would rationally pay to settle the
obligation at the reporting date or to transfer it to a third
party.
This means:
• Provisions for one-off events (restructuring,
environmental clean-up, settlement of a lawsuit) are
measured at the most likely amount.

• Provisions for large populations of events

(warranties, customer refunds) are measured at a
probability-weighted expected value.
Both measurements are at discounted present value
using a pre-tax discount rate that reflects the current
market assessments of the time value of money and the
risks specific to the liability.
Counter claims
If some or all of the expenditure required to settle a
provision is expected to be reimbursed by another party,
the reimbursement should be considered entirely
separately and is never off set against the provision.

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Contingent asset
This is a possible asset that arises from past events,
and whose existence will be confirmed only by the
occurrence or non-occurrence of one or more uncertain
future events not wholly within the control of the entity.
e.g. a counter claim or insurance claim.
It would only be recognised as an asset if was virtually
certain that reimbursement will be received if the entity
settles the obligation.
If judged probable then disclosure is made in the notes.

Contingent liability
This is a possible obligation depending on whether
some uncertain future event occurs, (e.g. a guarantee)
or is a present obligation but payment is not probable or
the amount cannot be measured reliably.
Disclosure is made in the notes of contingent liabilities -
unless judged remote; in which case they are ignored.

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Q Beach
An oil company has erected an oil rig on the first day of
the accounting period. The installation costs are $50
million and the cost of construction $400 million. Under
the terms of the license to drill for oil the company is
under an obligation to dismantle the oil rig at an
estimated cost $200 million in ten years’ time. The
relevant discount rate is 5%.

Required
Explain why a provision should be recognised at the
year-end for the dismantling costs and prepare
extracts from the financial statements one year after
the installation.

Tom Clendon
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A Beach

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Q Lockfine

The Lockfine board has agreed two restructuring

projects during the year to 30 April 20X1:

Plan A involves selling 50% of its off-shore fleet in one

year’s time. Additionally, the plan is to make 40% of its
seamen redundant. Lockfine will carry out further
analysis before deciding which of its fleets and related
employees will be affected. In previous announcements
to the public, Lockfine has suggested that it may
restructure the off-shore fleet in the future.

Plan B involves the reorganisation of the headquarters

in 18 months time, and includes the redundancy of 20%
of the headquarters’ workforce. The company has made
announcements before the year-end but there was a
three month consultation period which ended just after
the year end, whereby Lockfine was negotiating with
employee representatives. Thus individual employees
had not been notified by the year end.

Lockfine proposes recognising a provision in respect of

Plan A but not Plan B.

Required:
Discuss the principles and practices to be used by
Lockfine in accounting for the above valuation and
recognition issues.

Tom Clendon
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A Lockfine

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Restructuring provisions

According to the standard, a constructive obligation to

restructure arises only when an entity:

Has a detailed formal restructuring plan identifying at

least:

(i) the business activities, or part of the business

activities, concerned;
(ii) the principal locations affected;
(iii) the location, function and approximate number of
employees who will be compensated for terminating
their services;
(iv) the expenditure that will be undertaken;
(v) the implementation date of the plan;

and, has raised a valid expectation among the affected

parties that it will carry out the restructuring by starting to
implement that plan or announcing its main features to
those affected by it.

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A board decision alone does not create a constructive

obligation unless:
• the plan is already being implemented. For
example, assets are being sold, redundancy
negotiations have begun
• the plan has been announced to those affected by
it. The plan must have a strict timeframe without
unreasonable delays
• the board itself contains representatives of
employees or other groups affected by the decision.

An announcement to sell an operation does not create a

constructive obligation. An obligation only exists when a
purchaser is found and there is a binding sale
agreement.

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Examples of provisions
Circumstance Recognise a provision?
Restructuring by Only when the entity is
sale of an committed to a sale, i.e. there is
operation a binding sale agreement
Restructuring by Only when a detailed form plan
closure or is in place and the entity has
reorganisation started to implement the plan, or
announced its main features to
those affected. A Board decision
is insufficient
Land A provision is recognised as
contamination contamination occurs for any
legal obligations of clean up, or
for constructive obligations if the
company's published policy is to
clean up even if there is no legal
requirement to do so (past event
is the contamination and public
expectation created by the
company's policy)

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Offshore oil rig Recognise a provision for removal

must be costs arising from the construction
removed and of the oil rig as it is constructed,
sea bed and capitalise. Obligations arising
restored from the production of oil are
recognised as the production
occurs
Firm must train No provision is recognised (there is
staff for recent no obligation to provide the
changes in tax training)
law
Major overhaul No provision is recognised (no
or repairs obligation)
Onerous (loss- Recognise a provision
making)
contracts
Future No provision is recognised (no
operating liability)
losses

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Current issues
There are a number issues / problems with IAS 37
1 Recognition criteria
The “probable and reliable” and recognition criteria of
IAS 37 is now inconsistent with the new framework’s
recognition criteria of being relevant and faithful
presentation.

2 There is an all or nothing approach.

At present to recognise a provision there has to be a

probable outflow i.e. more than 50% but other standards
do not apply this is criteria and instead use fair value
e.g. IFRS 3 Business Combinations
e.g. IFRS 9 Financial Instruments

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3 Timing of the recognition of restructuring costs.

At present these are recognised when the restructuring
is announced i.e. there is a valid expectation.
It would reduce creative accounting if this was delayed
until the individual costs have been incurred.

4 Measurement issues relating to decommissioning

At present there is a lack of guidance on what costs to
account for on a decommissioning.
For example whether to provide for only incremental
costs or to include overheads or to use the price that
they would pay contractors to fulfil the obligation on their
behalf.
It would be better if the standard required that the
outflows would be the amounts that the entity estimates
it would pay a contractor at the future date to undertake
the service on its behalf.

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IAS 10 Events after the Reporting Period

Tom Clendon
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IAS 10 Events after the Reporting Period

Events after the reporting period occur between the end
of the reporting period and the date that the financial
statements are authorised for issue.

Adjusting events Non-adjusting events

Provide additional All other events

evidence of conditions
existing at the end of
the reporting period.

e.g. receipt of the e.g. the issue of

notification of the shares
bankruptcy of a
receivable

The accounts are If material, a

updated disclosure is made in
the notes

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Going concern issues arising after end of the

reporting period

An entity shall not prepare its financial statements on a

going concern basis if management determines after the
end of the reporting period either that it intends to
liquidate the entity or to cease trading, or that it has no
realistic alternative but to do so.

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Adjusting Non-
adjusting
1 The receipt of a valuation of
an asset

2 A fire in the warehouse

which destroyed some of
the inventory, and no
insurance claim can be
made
3 Proposal of a final equity
dividend

4 Entering into a new lease

5 The final agreement by an

insurance company to settle
a long standing claim at an
exact amount

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IAS 2 Inventory
Inventory are items bought for trading; for resale in
the ordinary course of business.
Inventories are valued at the lower of cost and net
realisable value (NRV).
Cost

Cost is the cost of bringing items of inventory to their

present location and condition (including cost of
purchase and costs of conversion).

Cost of purchase comprises

• purchase price including import duties, transport

and handling costs
• any other directly attributable costs, less trade
discounts, rebates and subsidies.

Cost of conversion comprises

• costs which are specifically attributable to units of

production, e.g. direct labour, direct expenses
• normal production overheads
• other overheads, if any, attributable in the particular
circumstances of the business to bringing the
product or service to its present location and
condition.

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The following costs should be excluded and charged as

expenses of the period in which they are incurred

• abnormal waste
• storage costs
• administrative overheads which do not contribute to
bringing inventories to their present location and
condition
• selling costs.

Net realisable value (NRV)

This is the estimated selling price, in the ordinary course

of business less the estimated costs of completion and
the estimated costs necessary to make the sale.

Valuation methods

IAS 2 deals with three methods of arriving at cost

• actual unit cost - suitable for bespoke item

• first in, first out (FIFO)
• weighted average cost (AVCO).

Changes in the valuation method represent a change in

accounting policy and should be accounted for
retrospectively.

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Q Cheng
Cheng has inventory that is equipment constructed for a
customer for an agreed price of $30,000. This has
recently been completed at a cost of $27,000. It has now
been discovered that, in order to meet certain
regulations, conversion with an extra cost of $10,000 will
be required. The customer has accepted partial
responsibility and agreed to meet half the extra cost.

Required

Determine the stock valuation

Tom Clendon
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A Cheng

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A Beach & Dismantling the oil rig

The oil company has a legal obligation to dismantle the oil rig and accordingly, a
provision should be made. The relevant past event that creates the obligation is the
initial erection of the oil rig.

Provisions should be made for the full cost, albeit measured at present value to
reflect the time value of money.

The provision is capitalised as part of the cost of the oil rig. The overall cost of the
oil rig will be depreciated over its useful life.

The provision, because it has been measured at present value, will give rise to an
annual finance cost in respect of the unwinding of the discount.

The original provision that is capitalised $200 m x 0.6139 = $123m

Dr Asset $123m
Cr Provision for decommissioning (NCL) $123m

The asset will be depreciated over 10 years

($400m + $50m + $123m) $573m @ 10 years = $57.3 m depreciation expense and
a reduction in the asset

The liability will attract a finance cost

$123m x 5% = $6.15m finance cost and an increase in the liability

Statement of financial position

PPE (573 - 57.3) 515.7

NCL (123 + 6.15) 129.15

Statement of profit or loss

Depreciation expense 57.3

Finance cost 6.15

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A. Lockfine

The restructuring plans should be considered separately as they relate to separate

and different events.

According to IAS 37, Provisions, Contingent Liabilities and Contingent Assets, a

constructive obligation to restructure arises only when an entity:

(a) Has a detailed formal restructuring plan identifying at least:

(i) the business activities, or part of the business activities, concerned;

(ii) the principal locations affected;
(iii) the location, function and approximate number of employees who will be
compensated for terminating their services;
(iv) the expenditure that will be undertaken;
(v) the implementation date of the plan; and, in addition,

(b) Has raised a valid expectation among the affected parties that it will carry out the
restructuring by starting to implement that plan or announcing its main features to
those affected by it.

For a plan to be sufficient to give rise to a constructive obligation when

communicated to those affected by it, its implementation needs to be planned to
begin as soon as possible and to be completed in a timeframe that makes significant
changes to the plan unlikely (IAS 37).

In the case of Plan A, even though Lockfine has made a decision to sell 50% of the
operation and has announced that decision publicly, Lockfine is not committed to the
restructure until both (a) and (b) above have been satisfied. A provision for
restructuring should not be recognised. A constructive obligation arises only when a
company has a detailed formal plan and makes an announcement of the plan to
those affected by it. The plan to date does not provide sufficient detail that would
permit Lockfine to recognise a constructive obligation. Neither the specific fleet nor
employees have been identified as yet.

In the case of Plan B, Lockfine should recognise a provision. At the date of the
financial statements, there has to be a detailed plan and the company has to have
raised a valid expectation in those affected by starting to implement that plan or
announcing its main features to those affected by it. A public announcement
constitutes a constructive obligation to restructure only if it is made in such a way
and in such detail that it gives rise to a valid expectation. It is not necessary that the
individual employees of Lockfine be notified as the employee representatives have
been notified. It will be necessary to look at the nature of the negotiations and if the
discussions are about the terms of the redundancy and not a change in plans, then a
provision should be made.

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A Events after the reporting period

1 The receipt of a valuation after the reporting date is an adjusting event. This
assumes that the valuation was valuing the asset as at the reporting date and
this it gives us new information about the conditions existing at the year-end.

2 A fire in the warehouse which destroyed some of the inventory, and no

insurance claim can be made is a non-adjusting event. The fire and so the
destruction of the inventory arises after the year-end. The inventory is in
perfectly good condition at the year-end so the fire does not give any new
information about conditions at the year-end.

3 The proposal of a final equity dividend is a non-adjusting event. As at the year-

end no dividend has been proposed so there is no past event and no liability at
the year-end exists.

4 Entering into a new lease is a non-adjusting event. Put simply at the year-end
there is no lease to report.

5 The final agreement by an insurance company to settle a long standing claim is

an adjusting event. The claim exists at the year-end, it is just the amount that is
in dispute. Accordingly the receipt of notification of the agreed final amount
gives additional information about the conditions existing at the year-end.

A Cheng

Cost is $27,000 but NRV is lower at $25,000.

Value at NRV, i.e. $25,000, as this is below cost of $27,000.

The NRV is the contract price, $30,000 plus the extra $5,000 that will be paid,
less the company’s additional costs of $10,000 that will have to be incurred to
make the sale.

Tom Clendon