is under no legal obligation to do so.
In these circumstances, the sale of its products gives rise to a constructive obligation because the entity
(through its reputation for providing refunds) has created a valid expectation on the part of customers that a
refund will be given if they are dissatisfied with their purchase. [IAS 37 IE Example 4].
These examples demonstrate that the essence of a constructive obligation is the
creation of a valid expectation that the entity is irrevocably committed to accepting and
discharging its responsibilities.
The standard states that in almost all cases it will be clear whether a past event has given
rise to a present obligation. However, it acknowledges that there will be some rare cases,
such as a lawsuit against an entity, where this will not be so because the occurrence of
certain events or the consequences of those events are disputed. [IAS 37.16]. When it is
not clear whether there is a present obligation, a ‘more likely than not’ evaluation (taking
into account all available evidence) is deemed to be sufficient to require recognition of
a provision at the end of the reporting period. [IAS 37.15].
The evidence to be considered includes, for example, the opinion of experts together
with any additional evidence provided by events after the reporting period. If on the
basis of such evidence it is concluded that a present obligation is more likely than not
to exist at the end of the reporting period, a provision will be required (assuming that
the other recognition criteria are met). [IAS 37.16]. This is an apparent relaxation of the
standard’s first criterion for the recognition of a provision as set out at 3.1 above, which
requires there to be a definite obligation, not just a probable one. It also confuses slightly
the question of the existence of an obligation with the probability criterion, which
strictly speaking relates to whether it is more likely than not that there will be an outflow
of resources (see 3.1.2 below). However, this interpretation is confirmed in IAS 10 –
Events after the Reporting Period, which includes ‘the settlement after the reporting
period of a court case that confirms that the entity had a present obligation at the end
of the reporting period’ as an example of an adjusting event. [IAS 10.9].
The second half of this condition uses the phrase ‘as a result of a past event’. This is based
on the concept of an obligating event, which the standard defines as ‘an event that creates
a legal or constructive obligation and that results in an entity having no realistic alternative
to settling that obligation’. [IAS 37.10]. The standard says that this will be the case only:
(a) where the settlement of the obligation can be enforced by law; or
(b) in the case of a constructive obligation, where the event (which may be an action
of the entity) creates valid expectations in other parties that the entity will
discharge the obligation. [IAS 37.17].
Provisions, contingent liabilities and contingent assets 1879
This concept of obligating event is used in the standard when discussing specific
examples of recognition, which we consider further at 6 below. However, it is worth
mentioning here that this concept, like that of a constructive obligation, is open to
interpretation and requires the exercise of judgement, as the obligating event is not
always easy to identify.
The standard emphasises that the financial statements deal with the financial position
of an entity at the end of its reporting period, not its possible position in the future.
Accordingly, no provision should be recognised for costs that need to be incurred to
operate in the future. The only liabilities to be recognised are those that exist at the end
of the reporting period. [IAS 37.18]. It is not always easy to distinguish between the current
state at the reporting date and the entity’s future possible position, especially where
IAS 37 requires an assessment to be made based on the probability of obligations and
expectations as to their outcome. However, when considering these questions it is
important to ensure that provisions are not recognised for liabilities that arise from
events after the reporting period (see Chapter 34 at 2).
Example 27.2: No provision without a past obligating event
The government introduces a number of changes to the income tax system. As a result of these changes, an
entity in the financial services sector will need to retrain a large proportion of its administrative and sales
staff in order to ensure continued compliance with financial services regulation. At the end of the reporting
period, no training has taken place.
In these circumstances, no event has taken place at the reporting date to create an obligation. Only once the
training has taken place will there be a present obligation as a result of a past event. [IAS 37 IE Example 7].
IAS 37 prohibits certain provisions that might otherwise qualify to be recognised by
stating that it ‘is only those obligations arising from past events existing independently
of an entity’s future actions (i.e. the future conduct of its business) that are recognised
as provisions’. In contrast to situations where the entity’s past conduct has created an
obligation to incur expenditure (such as to rectify environmental damage already
caused), a commercial or legal requirement to incur expenditure in order to operate in
a particular way in the future, will not of itself justify the recognition of a provision. It
argues that because the entity can avoid the expenditure by its future actions, for
example by changing its method of operation, there is no present obligation for the
future expenditure. [IAS 37.19].
Example 27.3: Obligations must exist independently of an entity’s future actions
Under legislation passed in 2018, an entity is required to fix smoke filters in its factories by 30 June 2020.
The entity has not fitted the smoke filters.
At 31 December 2019, the end of the reporting period, no event has taken place to create an obligation. Only
once the smoke filters are fitted or the legislation takes effect, will there be a present obligation as a result of
a past event, either for the cost of fitting smoke filters or for fines under the legislation.
At 31 December 2020, there is still no obligating event to justify provision for the cost of fitting the smoke
filters required under the legislation because the filters have not been fitted. However, an obligation may exist
as at the reporting date to pay fines or penalties under the legislation because the entity is operating its factory
in a non-compliant way. However, a provision would only be recognised for the best estimate of any fines
and penalties if, as at 31 December 2020, it is determined to be more likely than not that such fines and
penalties will be imposed. [IAS 37 IE Example 6].
1880 Chapter 27
The standard expects strict application of the requirement that, to qualify for
recognition, an obligation must exist independently of an entity’s future actions. Even if
a failure to incur certain costs would result in a legal requirement to discontinue an
entity’s operations, no provision can be recognised. As discussed at 5.2 below, IAS 37
considers the example of an airline required by law to overhaul its aircraft once every
three y
ears. It concludes that no provision is recognised because the entity can avoid
the requirement to perform the overhaul, for example by replacing the aircraft before
the three year period has expired. [IAS 37 IE Example 11B].
Centrica plc describes its interpretation of the group’s obligations under UK legislation
to install energy efficiency improvement measures in domestic households in a manner
consistent with Example 27.3 above.
Extract 27.1: Centrica plc (2017)
Notes to the Financial Statements [extract]
3.
Critical accounting judgements and key sources of estimation uncertainty [extract]
(a)
Critical judgements in applying the Group’s accounting policies [extract]
Energy Company Obligation
The Energy Company Obligation (ECO) order requires UK-licensed energy suppliers to improve the energy efficiency
of domestic households from 1 January 2013. Targets are set in proportion to the size of historic customer bases. ECO
phase 1 and ECO phase 2 had delivery dates of 31 March 2015 and 31 March 2017, respectively. ECO phase 2 (now
ECO phase 2t) has been extended to 30 September 2018. The Group continues to judge that it is not legally obligated by
this order until 30 September 2018 for ECO phase 2t. Accordingly, the costs of delivery are recognised as incurred, when
cash was spent or unilateral commitments made, resulting in obligations that could not be avoided.
Significantly, however, such considerations do not apply in the case of obligations to
dismantle or remove an asset at the end of its useful life, where an obligation is
recognised despite the entity’s ability to dispose of the asset before its useful life has
expired. Such costs are required to be included by IAS 16 – Property, Plant and
Equipment – as part of the measure of an asset’s initial cost. [IAS 16.16]. Decommissioning
provisions are discussed at 6.3 below. Accordingly, the determination of whether an
obligation exists independently of an entity’s future actions can be a matter of
judgement that depends on the particular facts and circumstances of the case.
There is no requirement for an entity to know to whom an obligation is owed. The
obligation may be to the public at large. It follows that the obligation could be to one
party, but the amount ultimately payable will be to another party. For example, in the
case of a constructive obligation for an environmental clean-up, the obligation is to the
public, but the liability will be settled by making payment to the contractors engaged to
carry out the clean-up. However, the principle is that there must be another party for
the obligation to exist. It follows from this that a management or board decision will not
give rise to a constructive obligation unless it is communicated in sufficient detail to
those affected by it before the end of the reporting period. [IAS 37.20]. The most
significant application of this requirement relates to restructuring provisions, which is
discussed further at 6.1 below.
The standard discusses the possibility that an event that does not give rise to an
obligation immediately may do so at a later date, because of changes in the law or an act
Provisions, contingent liabilities and contingent assets 1881
by the entity (such as a sufficiently specific public statement) which gives rise to a
constructive obligation. [IAS 37.21]. Changes in the law will be relatively straightforward
to identify. The only issue that arises will be to determine exactly when that change in
the law should be recognised. IAS 37 states that an obligation arises only when the
legislation is virtually certain to be enacted as drafted and suggests that in many cases,
this will not be until it is enacted. [IAS 37.22].
The more subjective area is the possibility that an act by the entity will give rise to a
constructive obligation. The example given is of an entity publicly accepting responsibility
for rectification of previous environmental damage in a way that creates a constructive
obligation. [IAS 37.21]. This seems to introduce a certain amount of flexibility to
management when reporting results. By bringing forward or delaying a public
announcement of a commitment that management had always intended to honour, it can
affect the reporting period in which a provision is recognised. Nevertheless, the existence
of a public announcement provides a more transparent basis for recognising a provision
than, for example, a decision made behind the closed doors of a boardroom.
3.1.2
‘It is probable that an outflow of resources embodying economic
benefits will be required to settle the obligation’
This requirement has been included as a result of the standard’s attempt to incorporate
contingent liabilities within the definition of provisions. This is discussed at 3.2 below.
The meaning of probable in these circumstances is that the outflow of resources is more
likely than not to occur; that is, it has a probability of occurring that is greater than
50%. [IAS 37.23]. The standard also makes it clear that where there are a number of similar
obligations, the probability that an outflow will occur is based on the class of obligations as
a whole. This is because in the case of certain obligations such as warranties, the possibility
of an outflow for an individual item may be small (likely to be much less than 50%) whereas
the possibility of at least some outflow of resources for the population as a whole will be
much greater (almost certainly greater than 50%). [IAS 37.24]. With regard to the measurement
of a provision arising from a number of similar obligations, the standard refers to the
calculation of an ‘expected value’, whereby the obligation is estimated by weighting all the
possible outcomes by their associated probabilities. [IAS 37.39]. Where the obligation being
measured relates to a single item, the standard suggests that the best estimate of the liability
may be the individual most likely outcome. [IAS 37.40]. For the purposes of recognition, a
determination that it is more likely than not that any outflow of resources will be required
is sufficient. The measurement of provisions is discussed at 4 below.
3.1.3
‘A reliable estimate can be made of the amount of the obligation’
The standard takes the view that a sufficiently reliable estimate can almost always be made
for a provision where an entity can determine a range of possible outcomes. Hence, the
standard contends that it will only be in extremely rare cases that a range of possible
outcomes cannot be determined and therefore no sufficiently reliable estimate of the
obligation can be made. [IAS 37.25]. In these extremely rare circumstances, no liability is
recognised. Instead, the liability should be disclosed as a contingent liability (see disclosure
requirements at 7.2 below). [IAS 37.26]. Whether such a situation is as rare as the standard
asserts is open to question, especially for entities trying to determine estimates relating to
potential obligations that arise from litigation and other legal claims (see 6.11 below).
1882 Chapter 27
3.2 Contingencies
IAS 37 says that contingent liabilities and contingent assets should not be recognised,
but only disclosed. [IAS 37.27-28, 31, 34].
Contingent liabilities that are recognised separatel
y as part of allocating the cost of a
business combination are covered by the requirements of IFRS 3. [IFRS 3.23]. Such
liabilities continue to be measured after the business combination at the higher of:
(a) the amount that would be recognised in accordance with IAS 37, and
(b) the amount initially recognised less, if appropriate, the cumulative amount of
income recognised in accordance with the principles of IFRS 15. [IFRS 3.56].
The requirements in respect of contingent liabilities identified in a business
combination are discussed in Chapter 9 at 5.6.1.
3.2.1 Contingent
liabilities
A contingent liability is defined in the standard as:
(a) a possible obligation 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; or
(b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits
will be required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability.
[IAS 37.10].
At first glance, this definition is not easy to understand because a natural meaning of
‘contingent’ would include any event whose outcome depends on future circumstances.
The meaning is perhaps clearer when considering the definition of a liability and the
criteria for recognising a provision in the standard. A possible obligation whose
existence is yet to be confirmed does not meet the definition of a liability; and a present
obligation in respect of which an outflow of resources is not probable, or which cannot
be measured reliably does not qualify for recognition. [IAS 37.14]. On that basis a
contingent liability under IAS 37 means one of the following:
(a) an obligation that is estimated to be less than 50+% likely to exist (i.e. it does not
meet the definition of a liability). Where it is more likely than not that a present
obligation exists at the end of the reporting period, a provision is recognised.
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 370
