lease. The specific event that gives rise to the obligation is each flown hour or cycle
completed by the aircraft as these determine the timing and nature of the overhaul that
must be carried out. Provision should therefore be made for the costs of overhaul as the
obligation towards the lessor arises (typically based upon the specific requirements of
each aircraft type, such as each flown hour or cycle), with a corresponding expense
recognised in the statement of comprehensive income. For certain aircraft types and
aircraft leases it is likely that the provision for the costs will be built up and then released,
as the expenditure is incurred, a number of times during the term of the operating lease.
However, if the lease does not require the overhaul to be undertaken prior to the return
of the aircraft (or require the lessee to make a contribution towards the next overhaul),
then no provision should be made as the lessee does not have a contractual obligation
to incur these costs that is independent of its own future actions.
1944 Chapter 27
For a lessee reporting under IFRS 16, the accounting for contractual overhaul obligations
will require careful consideration. IFRS 16 requires the depreciation requirements of
IAS 16 to be applied in the subsequent measurement of a right-of-use asset. [IFRS 16.31].
Under the depreciation requirements of IAS 16, each part of an asset with a cost that is
significant in relation to the total cost of the item must be depreciated separately. [IAS 16.44].
The application of this ‘component approach’ to the right-of-use asset could imply an
approach similar to that suggested in Example 27.12 at 5.2 above for owned assets. An
entity should apply judgement in determining an appropriate accounting policy for how
the application of component accounting for the right-of-use asset would interact with
the recognition of provisions for regulatory overhauls under IAS 37.
The fact that a provision for repairs can be made at all for leased assets might appear
inconsistent with the case where the asset is owned by the entity. In that case, as
discussed at 5.2 above, no provision for repairs could be made. There is, however, a
difference between the two situations. Where the entity owns the asset, it has the choice
of selling it rather than repairing it, and so the obligation is not independent of the
entity’s future actions. However, in the case of an entity leasing the asset, it can have a
contractual obligation to repair any damage from which it cannot walk away.
6.10 Warranty
provisions
Warranty provisions are specifically addressed in one of the examples appended to IAS 37.
However, as noted at 2.2.1.B above, an entity would apply IFRS 15 to separately purchased
warranties and to those warranties determined to provide the customer with a service in
addition to the assurance that the product complies with agreed-upon specifications. Only
if a customer does not have the option to purchase a warranty separately and the warranty
is determined only to provide assurance that the product complies with agreed-upon
specifications would an entity consider IAS 37. [IFRS 15.B30]. The requirements for
warranties falling within the scope of IFRS 15 are considered further in Chapter 28.
The following example illustrates how warranty costs are addressed if IAS 37 applies.
Example 27.22: Recognition of a provision for warranty costs
A manufacturer gives warranties at the time of sale to purchasers of its product. Under the terms of the
contract for sale, the manufacturer undertakes to make good, by repair or replacement, manufacturing defects
that become apparent within three years from the date of sale. On past experience, it is probable (i.e. more
likely than not) that there will be some claims under the warranties.
In these circumstances the obligating event is the sale of the product with a warranty, which gives rise to a
legal obligation. Because it is more likely than not that there will be an outflow of resources for some claims
under the warranties as a whole, a provision is recognised for the best estimate of the costs of making good
under the warranty for those products sold before the end of the reporting period. [IAS 37 IE Example 1].
The assessment of the probability of an outflow of resources is made across the
population as a whole, and not using each potential claim as the unit of account.
[IAS 37.24]. On past experience, it is probable that there will be some claims under the
warranties, so a provision is recognised.
The assessment over the class of obligations as a whole makes it more likely that a provision
will be recognised, because the probability criterion is considered in terms of whether at
least one item in the population will give rise to a payment. Recognition then becomes a
matter of reliable measurement and entities calculate an expected value of the estimated
Provisions, contingent liabilities and contingent assets 1945
warranty costs. IAS 37 discusses this method of ‘expected value’ and illustrates how it is
calculated in an example of a warranty provision. [IAS 37.39]. See Example 27.6 at 4.1 above.
An example of a company that makes a warranty provision is Philips Group as shown below:
Extract 27.7: Koninklijke Philips N.V. (2017)
11.9 Notes [extract]
1 Significant
accounting
policies
[extract]
Provisions [extract]
Product warranty – A provision for warranties is recognized when the underlying products or services are sold. The
provision is based on historical warranty data and a weighing of possible outcomes against their associated probabilities.
19
Provisions [extract]
Product warranty [extract]
The provisions for product warranty reflect the estimated costs of replacement and free-of-charge services that will
be incurred by the Company with respect to products sold. The Company expects the provisions to be utilized mainly
within the next year.
6.11 Litigation and other legal claims
IAS 37 includes an example of a court case in its appendix to illustrate how its principles
distinguish between a contingent liability and a provision in such situations. See
Example 27.4 at 3.2.1 above. However, the assessment of the particular case in the
example is clear-cut. In most situations, assessing the need to provide for legal claims is
one of the most difficult tasks in the field of provisioning. This is due mainly to the
inherent uncertainty in the judicial process itself, which may be very long and drawn
out. Furthermore, this is an area where either provision or disclosure might risk
prejudicing the outcome of the case, because they give an insight into the entity’s own
view on the strength of its defence that can assist the claimant.
In principle, whether a provision should be made will depend on whether the
three conditions for recognising a provision are met, i.e.
(a) there is a present obligation as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; and
(c) a reliable estimate can be made of the amount of the obligation. [IAS 37.14].
In situations such as these, a past event is deemed to give rise to a present obligation if,
<
br /> taking account of all available evidence (including, for example, the opinion of experts),
it is more likely than not that a present obligation exists at the end of the reporting
period. [IAS 37.15]. The evidence to be considered includes any additional evidence
occurring after the end of the reporting period. Accordingly, if on the basis of the
evidence it is concluded that a present obligation is more likely than not to exist, a
provision will be required, assuming the other conditions are met. [IAS 37.16].
Condition (b) will be met if the transfer of economic benefits is more likely than not to
occur, that is, it has a probability greater than 50%. In making this assessment, it is likely
that account should be taken of any expert advice.
1946 Chapter 27
As far as condition (c) is concerned, the standard takes the view that a reasonable
estimate can generally be made and it is only in extremely rare cases that this will not
be the case. [IAS 37.25].
Clearly, whether an entity should make provision for the costs of settling a case or to
meet any award given by a court will depend on a reasoned assessment of the particular
circumstances, based on appropriate legal advice.
6.12 Refunds
policy
Example 27.1 at 3.1.1 above reflects an example given in the appendix of IAS 37 of a retail
store that has a policy of refunding goods returned by dissatisfied customers. There is no
legal obligation to do so, but the company’s policy of making refunds is generally known.
The example argues that the conduct of the store has created a valid expectation on the
part of its customers that it will refund purchases. The obligating event is the original sale
of the item, and the probability of some economic outflow is greater than 50%, as there
will nearly always be some customers demanding refunds. Hence, a provision should be
made, [IAS 37 IE Example 4], presumably calculated on the ‘expected value’ basis.
This example is straightforward when the store has a very specific and highly publicised
policy on refunds. However, some stores’ policies on refunds might not be so clear cut.
A store may offer refunds under certain conditions, but not widely publicise its policy.
In these circumstances, there might be doubt as to whether the store has created a valid
expectation on the part of its customers that it will honour all requests for a refund.
As with warranty costs (discussed at 6.10 above), the accounting treatment of refunds
impinges into the area of revenue recognition. Under IFRS 15, an entity recognises the
amount of expected returns as a refund liability, representing its obligation to return the
customer’s consideration. [IFRS 15.55]. As noted at 2.2.1.B above, other than contracts with
customers that are, or have become onerous, contracts in scope of IFRS 15 are outside
the scope of IAS 37. [IAS 37.5]. This is discussed further in Chapter 28.
6.13 Self
insurance
Another situation where entities sometimes make provisions is self insurance which arises
when an entity decides not to take out external insurance in respect of a certain category
of risk because it would be uneconomic to do so. The same position may arise when a
group insures its risks with a captive insurance subsidiary, the effects of which have to be
eliminated on consolidation. In fact, the term ‘self insurance’ is potentially misleading,
since it really means that the entity is not insured at all and will settle claims from third
parties from its own resources in the event that it is found to be liable. Accordingly, the
recognition criteria in IAS 37 should be applied, with a provision being justified only if
there is a present obligation as a result of a past event; if it is probable that an outflow of
resources will occur; and a reliable estimate can be determined. [IAS 37.14].
Therefore, losses are recognised based on their actual incidence and any provisions that
appear in the statement of financial position should reflect only the amounts expected to
be paid in respect of those incidents that have occurred by the end of the reporting period.
In certain circumstances, a provision will often be needed not simply for known
incidents, but also for those which insurance companies call IBNR – Incurred But Not
Provisions, contingent liabilities and contingent assets 1947
Reported – representing an estimate of claims that have occurred at the end of the
reporting period but which have not yet been notified to the reporting entity. We
believe that it is appropriate that provision for such expected claims is made to the
extent that such items can be measured reliably.
6.14 Obligations to make donations to non-profit organisations
When an entity promises to make donations to a non-profit organisation it can be difficult
to determine whether a past obligating event exists that requires a provision to be
recognised or whether it is appropriate instead to account for the gift as payments are made.
Example 27.23: Accounting for donations to non-profit organisations
An entity decides to enter into an arrangement to ‘donate’ €1m in cash to a university. A number of different
options are available for the arrangement and the entity’s management want to determine whether the terms of
these options make any difference to the timing, measurement or presentation of the €1m expenditure, as follows:
Option 1:
The entity enters into an unenforceable contract to contribute €1m for general purposes. The benefits to the
entity are deemed only to relate to its reputation as a ‘good corporate citizen’; the entity does not receive any
consideration or significant benefit from the university in return for the donation.
Option 2:
As per Option 1 except the entity publishes a press release in relation to the donation and announcing that
payment is to be made in equal instalments of €200,000 over 5 years.
Option 3:
As per Option 2, except that the contract is legally enforceable in the event that the entity does not pay all the
instalments under the contract.
Option 4:
As per Option 2, except that the entity is only required to make the donation if the university raises €4m from
other sources.
Option 5:
As per Option 2, except that the contract is legally enforceable and the funds will be used for research and
development activities specified by the entity. The entity will retain proprietary rights over the results of the research.
The following principles are relevant in determining when a promise to make a donation
should be recognised as an obligation:
• to the extent that there is an enforceable contract, the donor should recognise an
expense and a liability upon entry into that contract;
• where the agreement is not enforceable, the donor recognises an expense and a
liability when a constructive obligation arises. The timing of recognition depends
on whether the donation is conditional, whether it is probable that those
conditions are substantially met and whether a past event has occurred; and
• if the donor expects to receive benefits commensurate with the value of the
donation, the arrangement should be treated as an exchange transaction. Such
transactions are in some cases executory contracts and may also gi
ve rise to the
recognition of an asset rather than an expense.
In cases where the ‘donation’ is made under an enforceable contract, a present
obligation is created when the entity enters into that contract. When payment is
required in cash, the signing of an enforceable contract gives rise to a financial liability,
[IAS 32.11], which is measured initially at fair value. [IFRS 9.5.1.1].
1948 Chapter 27
Where there is no legal obligation to make the payments, a liability is recognised when a
constructive obligation arises. It is a matter of judgement whether and when a constructive
obligation exists. In many unenforceable contracts, a signed contract would not, in itself,
be sufficient to create a constructive obligation. Hence, in the absence of other facts and
circumstances that would create a constructive obligation, the donor would recognise the
expenditure when the cash or other assets are transferred.
By contrast, an exchange transaction is a reciprocal transfer in which each party
receives and sacrifices approximately equal value. Assets and liabilities are not
recognised until each party performs their obligations under the arrangement.
Applying these principles to the options listed in Example 27.23 above:
• In Option 1, the contract is unenforceable, there is no announcement or conditions
preceding payment and there is no exchange of benefits. Accordingly, an expense
would be recognised only when the entity transfers cash to the university.
• For Option 2, it may be appropriate for the entity to conclude that the entity’s
announcement of the donation to be paid by instalments indicates that there is a
constructive obligation because the entity has a created a valid expectation that it
will make all of the payments promised. Alternatively, it could determine that once
the first instalment is paid, the entity has created a valid expectation that it will
make the remaining payments. This is a matter of judgement. In this case the entity
would recognise an expense and a liability, measured at the net present value of
the 5 instalments of €200,000, at the point when it is determined that a
constructive obligation exists.
• Option 3 involves an enforceable contract with no exchange of benefits. Therefore
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 384
