International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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[IAS 37.16(a)]. Where it is more likely than not that no present obligation exists, a
contingent liability is disclosed (unless the possibility is remote); [IAS 37.16(b)]
(b) a present obligation that has a less than 50+% chance of requiring an outflow of
economic benefits (i.e. it meets the definition of a liability but does not meet the
recognition criteria). Where it is not probable that there will be an outflow of resources,
an entity discloses a contingent liability (unless the possibility is remote); [IAS 37.23] or
(c) a present obligation for which a sufficiently reliable estimate cannot be made (i.e.
it meets the definition of a liability but does not meet the recognition criteria). In
these rare circumstances, a liability cannot be recognised and it is disclosed as a
contingent liability. [IAS 37.26].
Provisions, contingent liabilities and contingent assets 1883
The term ‘possible’ is not defined, but literally it could mean any probability greater than
0% and less than 100%. However, the standard effectively divides this range into four
components, namely ‘remote’, ‘possible but not probable’, ‘probable’ and ‘virtually
certain’. The standard requires a provision to be recognised if ‘it is more likely than not
that a present obligation exists at the end of the reporting period’. [IAS 37.16(a)]. Therefore,
IAS 37 distinguishes between a ‘probable’ obligation (which is more likely than not to
exist and, therefore requires recognition as a provision) and a ‘possible’ obligation (for
which either the existence of a present obligation is yet to be confirmed or where the
probability of an outflow of resources is 50% or less). [IAS 37.13]. Appendix A to IAS 37, in
summarising the main requirements of the standard, uses the phrase ‘a possible
obligation ... that may, but probably will not, require an outflow of resources’.
Accordingly, the definition restricts contingent liabilities to those where either the
existence of the liability or the transfer of economic benefits arising is less than 50+%
probable (or where the obligation cannot be measured at all, but as noted at 3.1.3 above,
this would be relatively rare).
The standard requires that contingent liabilities are assessed continually to determine
whether circumstances have changed, in particular whether an outflow of resources
embodying economic benefits has become probable. Where this becomes the case, then
provision should be made in the period in which the change in probability occurs (except
in the rare circumstances where no reliable estimate can be made). [IAS 37.30]. Other
changes in circumstances might require disclosure of a previously remote obligation on
the grounds that an outflow of resources has become possible (but not probable).
Example 27.4: When the likelihood of an outflow of benefits becomes probable
After a wedding in 2019, ten people died, possibly as a result of food poisoning from products sold by the
entity. Legal proceedings are started seeking damages from the entity. The entity disputes any liability and,
up to the date on which its financial statements for the year ended 31 December 2019 are authorised for issue,
its lawyers have advised that is probable that the entity will not be found liable. However, when the entity
prepares its financial statements for the year ended 31 December 2020, its lawyers advise that, owing to
developments in the case, it is probable that the entity will be found liable.
At 31 December 2019, no provision is recognised and the matter is disclosed as a contingent liability unless
the probability of any outflow is regarded as remote. On the basis of the evidence available when the financial
statements were approved, there is no obligation as a result of a past event.
At 31 December 2020, a provision is recognised for the best estimate of the amount required to settle the
obligation. The fact that an outflow of economic benefits is now believed to be probable means that there is
a present obligation. [IAS 37 IE Example 10].
3.2.2 Contingent
assets
A contingent asset is defined in a more intuitive way. It 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’. [IAS 37.10]. In this case, the word ‘possible’ is not confined to a level of probability
of 50% or less, which may further increase the confusion over the different meaning of
the term in the definition of contingent liabilities.
Contingent assets usually arise from unplanned or other unexpected events that give rise
to the possibility of an inflow of economic benefits to the entity. An example is a claim
that an entity is pursuing through legal process, where the outcome is uncertain. [IAS 37.32].
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The standard states that a contingent asset should not be recognised, as this could give
rise to recognition of income that may never be realised. However, when the realisation
of income is virtually certain, then the related asset is no longer regarded as contingent
and recognition is appropriate. [IAS 37.33].
Virtual certainty is not defined in the standard, but it is certainly a much higher hurdle
than ‘probable’ and indeed more challenging than the term ‘highly probable’, defined in
IFRS 5 as ‘significantly more likely than probable’. [IFRS 5 Appendix A]. We think it
reasonable that virtual certainty is interpreted as being as close to 100% as to make any
remaining uncertainty insignificant. What this means in practice requires each case to
be decided on its merits and any judgement should be made in the knowledge that, in
any event, it is rarely possible to accurately assess the probability of the outcome of a
particular event.
The standard requires disclosure of the contingent asset when the inflow of economic
benefits is probable. [IAS 37.34]. For the purposes of the standard ‘probable’ means that
the event is more likely than not to occur; that is, it has a probability greater than
50%. [IAS 37.23]. The disclosure requirements are detailed at 7.3 below.
As with contingent liabilities, any contingent assets should be assessed continually to
ensure that developments are appropriately reflected in the financial statements. If it
has become virtually certain that an inflow of economic benefits will arise, the asset and
the related income should be recognised in the period in which the change occurs. If a
previously unlikely inflow becomes probable, then the contingent asset should be
disclosed. [IAS 37.35].
The requirement to recognise the effect of changing circumstances in the period in
which the change occurs extends to the analysis of information available after the end
of the reporting period and before the date of approval of the financial statements. In
our view, such information would not give rise to an adjusting event after the reporting
period. In contrast to contingent liabilities (in respect of which IAS 10 includes as a
specific example of an adjusting event ‘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’ [IAS 10.9]), no adjustment should be made to reflect the subsequent
settl
ement of a legal claim in favour of the entity. In this instance, the period in which
the change occurs is subsequent to the reporting period. There is also no suggestion that
the example in IAS 10 is referring to anything but liabilities. An asset could only be
recognised if, at the end of the reporting period, the entity could show that it was
virtually certain that its claim would succeed.
3.2.2.A
Obligations contingent on the successful recovery of a contingent asset
Entities may sometimes be required to pay contingent fees to a third party dependent
upon the successful recovery of a contingent asset. For example, the payment of fees to
a legal advisor in a contract agreed on a ‘no win, no fee’ basis will depend upon the
successful outcome of a legal claim. In such cases, we believe that the obligation for the
success fee arises from an executory contract that should be evaluated separately from
the legal claim. The liability for the success fee would therefore only be recognised by
the entity upon winning the claim.
Provisions, contingent liabilities and contingent assets 1885
IAS 37 uses the term executory contracts to mean ‘contracts under which neither party
has performed any of its obligations, or both parties have partially performed their
obligations to an equal extent’. [IAS 37.3]. When a contract for services is wholly
contingent on recovering a contingent asset, no service requiring payment is deemed to
be provided until or unless the matter is resolved successfully. Unless the contract also
required payment to be made in the event of failure, the amount of work put in by the
lawyer to prepare a case and argue for recovery of the contingent asset is irrelevant to
the existence of a liability to pay fees.
If the entity has deemed it appropriate to recognise an asset in respect of the claim, it
would be appropriate to take account of any such fees in the measurement of that asset
(in determining the net amount recoverable); but no accrual should be made for the legal
fees themselves unless a successful outcome is confirmed.
This analysis is specific to a no win-no fee arrangement related to a contingent asset
and may not be appropriate in other circumstances.
3.2.3
How probability determines whether to recognise or disclose
The following matrix summarises the treatment of contingencies under IAS 37:
Accounting treatment:
Accounting treatment:
Likelihood of outcome
contingent liability
contingent asset
Virtually certain
Recognise
Recognise
Probable
Recognise
Disclose
Possible but not probable
Disclose
No disclosure permitted
Remote
No disclosure required
No disclosure permitted
The standard does not put a numerical measure of probability on either ‘virtually
certain’ or ‘remote’. In our view, the use of such measures would downgrade a process
requiring the exercise of judgement into a mechanical exercise. It is difficult to imagine
circumstances when an entity could reliably determine an obligation to be, for example,
92%, 95% or 99% likely, let alone be able to compare those probabilities objectively.
Accordingly, we think it reasonable to regard ‘virtually certain’ as describing a likelihood
that is as close to 100% as to make any remaining uncertainty insignificant; to see
‘remote’ as meaning a likelihood of an outflow of resources that is not significant; and
for significance to be a matter for judgement and determined according to the merits of
each case.
3.3
Recognising an asset when recognising a provision
In most cases, the recognition of a provision results in an immediate expense in profit
or loss. Nevertheless, in some cases it may be appropriate to recognise an asset. These
issues are not discussed in IAS 37, which neither prohibits nor requires capitalisation of
the costs recognised when a provision is made. It states that other standards specify
whether expenditures are treated as assets or expenses. [IAS 37.8].
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Whilst the main body of IAS 37 is silent on the matter, the standard contains the
following example which concludes that an asset should be recognised when a
decommissioning provision is established.
Example 27.5: When the recognition of a provision gives rise to an asset
An entity operates an offshore oilfield where its licensing agreement requires it to remove the oil rig at the
end of production and restore the seabed. 90% of the eventual costs relate to the removal of the oil rig and
restoration of damage caused by building it, with 10% expected to arise through the extraction of oil. At the
end of the reporting period, the rig has been constructed but no oil has been extracted.
A provision is recognised in respect of the probable costs relating to the removal of the rig and restoring
damage caused by building it. This is because the construction of the rig, combined with the requirement
under the licence to remove the rig and restore the seabed, creates an obligating event as at the end of the
reporting period. These costs are included as part of the cost of the oil rig.
However, there is no obligation to rectify any damage that will be caused by the future extraction of oil.
[IAS 37 IE Example 3].
This conclusion is supported by IAS 16, which requires the cost of an item of property,
plant and equipment to include the initial estimate of the costs of dismantling and
removing an asset and restoring the site on which it is located, the obligation for which
an entity incurs either when the item is acquired or as a consequence of having used the
item during a particular period for purposes other than to produce inventories during
that period. [IAS 16.16(c), 18]. The treatment of decommissioning costs is discussed further
at 6.3 below.
4 MEASUREMENT
4.1
Best estimate of provision
IAS 37 requires the amount to be recognised as a provision to be the best estimate of
the expenditure required to settle the present obligation at the end of the reporting
period. [IAS 37.36]. This measure is determined before tax, as the tax consequences of the
provision, and changes to it, are dealt with under IAS 12. [IAS 37.41].
The standard equates this ‘best estimate’ with ‘the amount that an entity would
rationally pay to settle the obligation at the end of the reporting period or to transfer it
to a third party at that time’. [IAS 37.37]. It is interesting that a hypothetical transaction of
this kind should be proposed as the conceptual basis of the measurement required,
rather than putting the main emphasis upon the actual expenditure that is expected to
be incurred in the future.
The standard does acknowledge that it would often be impossible or prohibitively
expensive to settle or transfer the obligation at the end of the reporting period.
However, it goes on to state that ‘the estimate of the amount that an entity would
rationally pay to settle or transfer the obligation gives the best estimate of the
expenditure required to settle the present obligation at the end of the reporting period’.
> [IAS 37.37].
The estimates of outcome and financial effect are determined by the judgement of the
entity’s management, supplemented by experience of similar transactions and, in some
Provisions, contingent liabilities and contingent assets 1887
cases, reports from independent experts. The evidence considered will include any
additional evidence provided by events after the reporting period. [IAS 37.38].
The standard suggests that there are various ways of dealing with the uncertainties
surrounding the amount to be recognised as a provision. It mentions three, an expected
value (or probability-weighted) method; the mid-point of the range of possible
outcomes; and an estimate of the individual most likely outcome. An expected value
approach would be appropriate when a large population of items is being measured,
such as warranty costs. This is a statistical computation which weights the cost of all the
various possible outcomes according to their probabilities, as illustrated in the following
example taken from IAS 37. [IAS 37.39].
Example 27.6: Calculation of expected value
An entity sells goods with a warranty under which customers are covered for the cost of repairs of any
manufacturing defects that become apparent within the first six months after purchase. If minor defects were
detected in all products sold, repair costs of £1 million would result. If major defects were detected in all
products sold, repair costs of £4 million would result. The entity’s past experience and future expectations
indicate that, for the coming year, 75 per cent of the goods sold will have no defects, 20 per cent of the goods
sold will have minor defects and 5 per cent of the goods sold will have major defects. In accordance with
paragraph 24 of IAS 37 (see 3.1.2 above) an entity assesses the probability of a transfer for the warranty
obligations as a whole.
The expected value of the cost of repairs is:
(75% of nil) + (20% of £1m) + (5% of £4m) = £400,000.
In a situation where there is a continuous range of possible outcomes and each point in
that range is as likely as any other, IAS 37 requires that the mid-point of the range is
used. [IAS 37.39]. This is not a particularly helpful way of setting out the requirement, as
it does not make it clear what the principle is meant to be. The mid-point in this case