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Provisions and Contingencies

SME Par.IFRS SMEU.S. GAAP
Scope of this section
21.1 This section applies to all provisions (ie liabilities of uncertain timing or amount), contingent liabilities and contingent assets except those provisions covered by other sections of this IFRS. These include provisions relating to:
  1. leases (Section 20 Leases). However, this section deals with operating leases that have become onerous.
  2. construction contracts (Section 23 Revenue).
  3. employee benefit obligations (Section 28 Employee Benefits).
  4. income tax (Section 29 Income Tax).
 Provision in this context generally has the same meaning as what in U.S. GAAP is referred to as a contingent liability that meets the criteria for recognition. However, provision also includes obligations that are not treated as contingencies under U.S. GAAP (e.g., asset retirement obligations), and it excludes certain loss contingencies (see 21.3) that are covered by the same literature as contingent liabilities under U.S. GAAP.

Unlike IFRS, use of the word provision in financial statements is discouraged.
21.2 The requirements in this section do not apply to executory contracts unless they are onerous contracts. Executory contracts are contracts under which neither party has performed any of its obligations or both parties have partially performed their obligations to an equal extent.  
21.3 The word ‘provision’ is sometimes used in the context of such items as depreciation, impairment of assets, and uncollectible receivables. Those are adjustments of the carrying amounts of assets, rather than recognition of liabilities, and therefore are not covered by this section.  
Initial recognition
21.4 An entity shall recognise a provision only when:
  1. the entity has an obligation at the reporting date as a result of a past event;
  2. it is probable (ie more likely than not) that the entity will be required to transfer economic benefits in settlement; and
  3. the amount of the obligation can be estimated reliably.
 The probability threshold for recognition of contingent liabilities is higher than “more-likely-than-not,” and is typically interpreted to mean about 80%.
21.5 The entity shall recognise the provision as a liability in the statement of financial position and shall recognise the amount of the provision as an expense, unless another section of this IFRS requires the cost to be recognised as part of the cost of an asset such as inventories or property, plant and equipment.  
21.6 The condition in paragraph 21.4(a) (obligation at the reporting date as a result of a past event) means that the entity has no realistic alternative to settling the obligation. This can happen when the entity has a legal obligation that can be enforced by law or when the entity has a constructive obligation because the past event (which may be an action of the entity) has created valid expectations in other parties that the entity will discharge the obligation. Obligations that will arise from the entity’s future actions (ie the future conduct of its business) do not satisfy the condition in paragraph 21.4(a), no matter how likely they are to occur and even if they are contractual. To illustrate, because of commercial pressures or legal requirements, an entity may intend or need to carry out expenditure to operate in a particular way in the future (for example, by fitting smoke filters in a particular type of factory). Because the entity can avoid the future expenditure by its future actions, for example by changing its method of operation or selling the factory, it has no present obligation for that future expenditure and no provision is recognised. Same.
Initial measurement
21.7 An entity shall measure a provision at the best estimate of the amount required to settle the obligation at the reporting date. The best estimate is the amount 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.
  1. When the provision involves a large population of items, the estimate of the amount reflects the weighting of all possible outcomes by their associated probabilities. The provision will therefore be different depending on whether the probability of a loss of a given amount is, for example, 60 per cent or 90 per cent. Where there is a continuous range of possible outcomes, and each point in that range is as likely as any other, the mid-point of the range is used.
  2. When the provision arises from a single obligation, the individual most likely outcome may be the best estimate of the amount required to settle the obligation. However, even in such a case, the entity considers other possible outcomes. When other possible outcomes are either mostly higher or mostly lower than the most likely outcome, the best estimate will be a higher or lower amount.
When the effect of the time value of money is material, the amount of a provision shall be the present value of the amount expected to be required to settle the obligation. The discount rate (or rates) shall be a pre-tax rate (or rates) that reflect(s) current market assessments of the time value of money. The risks specific to the liability should be reflected either in the discount rate or in the estimation of the amounts required to settle the obligation, but not both.		 Unlike IFRS SMEs, the amount recognized is a reasonable estimate of the amount to be paid.

Unlike IFRS SMEs, where there is a continuous range of possible outcomes, the minimum amount in the range is used.  This requirement is not limited to large populations.

Unlike IFRS SMEs, an obligation is measured at the single most likely outcome even if other possible outcomes are either mostly higher or mostly lower than that amount.

Liabilities that involve known or estimated amounts of money payable at unknown future dates, for example trade payables or warranty obligations, generally are reported at their net settlement value, which is the nondiscounted amounts of cash, or its equivalent, expected to be paid to liquidate an obligation in the due course of business, including direct costs, if any, necessary to make that payment. Unlike IFRS SMEs, liabilities other than financial liabilities generally are discounted only if the amount and timing of payments is fixed or reliably determinable.  When such liabilities are discounted, unlike IFRS SMEs, the risk-free rate generally is used.

Obligations required to be measured at fair value (e.g., asset retirement obligations) are, like IFRS SMEs, measured at discounted future cash flows.

Environmental remediation liabilities are measured at the entity’s estimate of what it will cost to perform the remediation when it is expected to be performed.
21.8 An entity shall exclude gains from the expected disposal of assets from the measurement of a provision. Same.
21.9 When some or all of the amount required to settle a provision may be reimbursed by another party (eg through an insurance claim), the entity shall recognise the reimbursement as a separate asset only when it is virtually certain that the entity will receive the reimbursement on settlement of the obligation. The amount recognised for the reimbursement shall not exceed the amount of the provision. The reimbursement receivable shall be presented in the statement of financial position as an asset and shall not be offset against the provision. In the statement of comprehensive income, the entity may offset any reimbursement from another party against the expense relating to the provision. Unlike IFRS SMEs, a reimbursement right is recognized as a separate asset when recovery is probable.
Subsequent measurement
21.10 An entity shall charge against a provision only those expenditures for which the provision was originally recognised. Same.
21.11 An entity shall review provisions at each reporting date and adjust them to reflect the current best estimate of the amount that would be required to settle the obligation at that reporting date. Any adjustments to the amounts previously recognised shall be recognised in profit or loss unless the provision was originally recognised as part of the cost of an asset (see paragraph 21.5). When a provision is measured at the present value of the amount expected to be required to settle the obligation, the unwinding of the discount shall be recognised as a finance cost in profit or loss in the period it arises. Like IFRS SMEs, provisions are remeasured at each reporting date.
Contingent liabilities
21.12 A contingent liability is either a possible but uncertain obligation or a present obligation that is not recognised because it fails to meet one or both of the conditions (b) and (c) in paragraph 21.4. An entity shall not recognise a contingent liability as a liability, except for provisions for contingent liabilities of an acquiree in a business combination (see paragraphs 19.20 and 19.21). Disclosure of a contingent liability is required by paragraph 21.15 unless the possibility of an outflow of resources is remote. When an entity is jointly and severally liable for an obligation, the part of the obligation that is expected to be met by other parties is treated as a contingent liability. Contingent liability has the same meaning as what in U.S. GAAP is referred to as a contingent liability that does not meet the criteria for recognition, i.e., that is not both probable and reasonably estimable.

Unlike IFRS SMEs, exposure to loss in excess of the amount of a provision (an accrued best estimate of the loss) is a contingent liability.
Contingent assets
21.13 An entity shall not recognise a contingent asset as an asset. Disclosure of a contingent asset is required by paragraph 21.16 when an inflow of economic benefits is probable. However, when the flow of future economic benefits to the entity is virtually certain, then the related asset is not a contingent asset, and its recognition is appropriate.  
 Prejudicial disclosures
21.17 In extremely rare cases, disclosure of some or all of the information required by paragraphs 21.14–21.16 can be expected to prejudice seriously the position of the entity in a dispute with other parties on the subject matter of the provision, contingent liability or contingent asset. In such cases, an entity need not disclose the information, but shall disclose the general nature of the dispute, together with the fact that, and reason why, the information has not been disclosed. Unlike IFRS SMEs, U.S. GAAP makes no exception for prejudicial disclosures.
 Example 1 Future operating losses
21A.1 An entity determines that it is probable that a segment of its operations will incur future operating losses for several years.

Present obligation as a result of a past obligating event—There is no past event that obliges the entity to pay out resources.

Conclusion—The entity does not recognise a provision for future operating losses. Expected future losses do not meet the definition of a liability. The expectation of future operating losses may be an indicator that one or more assets are impaired—see Section 27 Impairment of Assets.		 Same.
 Example 2 Onerous contracts
21A.2 An onerous contract is one in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. The unavoidable costs under a contract reflect the least net cost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it. For example, an entity may be contractually required under an operating lease to make payments to lease an asset for which it no longer has any use.

Present obligation as a result of a past obligating event—The entity is contractually required to pay out resources for which it will not receive commensurate benefits.

Conclusion—If an entity has a contract that is onerous, the entity recognises and measures the present obligation under the contract as a provision.		 Unlike IFRS SMEs, there is no general requirement to recognize a loss for onerous contracts; such a provision is recognized only when required by a specific standard, e.g, contractual sublease losses, firm purchase commitments for inventory that are impaired, and long-term construction contracts that are expected to result in a loss.

Unlike IFRS SMEs, a liability to make payments under an operating lease without economic benefit is determined based on the remaining lease rentals, reduced by estimated sublease rentals that could be reasonably obtained for the property, even if the entity does not intend to enter into a sublease.
 Example 3 Restructurings
21A.3 A restructuring is a programme that is planned and controlled by management and materially changes either the scope of a business undertaken by an entity or the manner in which that business is conducted.

Present obligation as a result of a past obligating event—A constructive obligation to restructure arises only when an entity:
  1. has a detailed formal plan for the restructuring identifying at least:
    1. the business or part of a business concerned;
    2. the principal locations affected;
    3. the location, function and approximate number of employees who will be compensated for terminating their services;
    4. the expenditures that will be undertaken; and
    5. when the plan will be implemented; and
  2. has raised a valid expectation in those affected that it will carry out the restructuring by starting to implement that plan or announcing its main features to those affected by it.
Conclusion—An entity recognises a provision for restructuring costs only when it has a legal or constructive obligation at the reporting date to carry out the restructuring.		 For costs associated with a restructuring other than employee termination benefits, the recognition guidance in IFRS SMEs is similar to that previously included in EITF Issue 94-3 for exit costs and, in addition, requires public announcement (or implementation) of an exit plan.  Because SFAS 146, which nullified EITF Issue No. 94-3, did not retain the definition or requirements for recognition of exit costs, the timing of recognition of a liability for similar costs under U.S. GAAP and IFRS SMEs will differ.

Under U.S. GAAP, a liability for an exit activity (which includes a restructuring as that term is defined in IFRS SMEs) is recognized when the definition of a liability is met.  Only present obligations to others are liabilities under the definition.

For purposes of measurement, IFRS SMEs refers in par. 21.7 to the best estimate of the amount required to settle the obligation at the balance sheet date, which is similar to fair value (which is the measurement attribute required by SFAS 146).  However, the extent to which initial measurement under U.S. GAAP and IFRS SMEs will be similar will depend on, among other things, how the measurement objective of IFRS SMEs is interpreted and the specific measurement approaches used to achieve that objective under IFRS SMEs.

Under U.S. GAAP, contract termination costs are recognized when the entity terminates the contract in accordance with the contract terms.

Employee termination benefits are covered in section 27, Employee Benefits.
 Example 4 Warranties
21A.4 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 the basis of experience, it is probable (ie more likely than not) that there will be some claims under the warranties.

Present obligation as a result of a past obligating event—The obligating event is the sale of the product with a warranty, which gives rise to a legal obligation.

An outflow of resources embodying economic benefits in settlement—Probable for the warranties as a whole.

Conclusion—The entity recognises a provision for the best estimate of the costs of making good under the warranty products sold before the reporting date.

Illustration of calculations:

In 20X0, goods are sold for CU1,000,000. Experience indicates that 90 per cent of products sold require no warranty repairs; 6 per cent of products sold require minor repairs costing 30 per cent of the sale price; and 4 per cent of products sold require major repairs or replacement costing 70 per cent of sale price. Therefore estimated warranty costs are:

CU 1,000,000 x 90% = CU 0
CU 1,000,000 x 6% x30% = CU 18,000
CU 1,000,000 x 4% x 70% = CU 28,000
Total = CU 46,000

The expenditures for warranty repairs and replacements for products sold in 20X0 are expected to be made 60 per cent in 20X1, 30 per cent in 20X2, and 10 per cent in 20X3, in each case at the end of the period. Because the estimated cash flows already reflect the probabilities of the cash outflows, and assuming there are no other risks or uncertainties that must be reflected, to determine the present value of those cash flows the entity uses a ‘risk-free’ discount rate based on government bonds with the same term as the expected cash outflows (6 per cent for one-year bonds and 7 per cent for two-year and three-year bonds). Calculation of the present value, at the end of 20X0, of the estimated cash flows related to the warranties for products sold in 20X0 is as follows:

Year Expected 
cash 
payments 
(CU)		 Discount 
rate		 Discount 
factor		 Present 
value
(CU)
1:
60% × CU46,000		 27,600 6% 0.9434 
(at 6% for 1 year)		 26,038
2:
30% × CU46,000		 13,800 7% 0.8734 
(at 7% for 2 years)		 12,053
3:
10% × CU46,000		 4,600 7% 0.8163
(at 7% for 3 years)		 3,755
Total 41,846


The entity will recognise a warranty obligation of CU41,846 at the end of 20X0 for products sold in 20X0.		 See par. 21.7 for measurement differences; in particular, the obligation would not be discounted under U.S. GAAP.
 Example 5 Refunds policy
21A.5 A retail store has a policy of refunding purchases by dissatisfied customers, even though it is under no legal obligation to do so. Its policy of making refunds is generally known.

Present obligation as a result of a past obligating event—The obligating event is the sale of the product, which gives rise to a constructive obligation because the conduct of the store has created a valid expectation on the part of its customers that the store will refund purchases.

An outflow of resources embodying economic benefits in settlement—Probable that a proportion of goods will be returned for refund.

Conclusion—The entity recognises a provision for the best estimate of the amount required to settle the refunds.		 The accounting would generally be the same.  However, measurement differences mat arise as described in par. 21.7.
 Example 6 Closure of a division—no implementation before end of reporting period
21A.6 On 12 December 20X0 the board of an entity decided to close down a division. Before the end of the reporting period (31 December 20X0) the decision was not communicated to any of those affected and no other steps were taken to implement the decision.

Present obligation as a result of a past obligating event—There has been no obligating event, and so there is no obligation.

Conclusion—The entity does not recognise a provision.		 Same.
 Example 7 Closure of a division—communication and implementation before end of reporting period
21A.7 On 12 December 20X0 the board of an entity decided to close a division making a particular product. On 20 December 20X0 a detailed plan for closing the division was agreed by the board, letters were sent to customers warning them to seek an alternative source of supply, and redundancy notices were sent to the staff of the division.

Present obligation as a result of a past obligating event—The obligating event is the communication of the decision to the customers and employees, which gives rise to a constructive obligation from that date, because it creates a valid expectation that the division will be closed.

An outflow of resources embodying economic benefits in settlement—Probable.

Conclusion—The entity recognises a provision at 31 December 20X0 for the best estimate of the costs that would be incurred to close the division at the reporting date.		 See par. 21A.3.
 Example 8 Staff retraining as a result of changes in the income tax system
21A.8 The government introduces changes to the income tax system. As a result of those changes, an entity in the financial services sector will need to retrain a large proportion of its administrative and sales workforce in order to ensure continued compliance with tax regulations. At the end of the reporting period, no retraining of staff has taken place.

Present obligation as a result of a past obligating event—The tax law change does not impose an obligation on an entity to do any retraining. An obligating event for recognising a provision (the retraining itself) has not taken place.

Conclusion—The entity does not recognise a provision.		 Same.
 Example 9 A court case
21A.9 A customer has sued Entity X, seeking damages for injury the customer allegedly sustained from using a product sold by Entity X. Entity X disputes liability on grounds that the customer did not follow directions in using the product. Up to the date the board authorised the financial statements for the year to 31 December 20X1 for issue, the entity’s lawyers advise that it is probable that the entity will not be found liable. However, when the entity prepares the financial statements for the year to 31 December 20X2, its lawyers advise that, owing to developments in the case, it is now probable that the entity will be found liable.
  1. At 31 December 20X1

    Present obligation as a result of a past obligating event—On the basis of the evidence available when the financial statements were approved, there is no obligation as a result of past events.

    Conclusion—No provision is recognised. The matter is disclosed as a contingent liability unless the probability of any outflow is regarded as remote.
  2. At 31 December 20X2

    Present obligation as a result of a past obligating event—On the basis of the evidence available, there is a present obligation. The obligating event is the sale of the product to the customer.

    An outflow of resources embodying economic benefits in settlement— Probable.

    Conclusion—A provision is recognised at the best estimate of the amount to settle the obligation at 31 December 20X2, and the expense is recognised in profit or loss. It is not a correction of an error in 20X1 because, on the basis of the evidence available when the 20X1 financial statements were approved, a provision should not have been recognised at that time.
 December 31, 20X1
Same.

December 31, 20X2
The probability threshold for recognition of a liability is higher under U.S. GAAP than more-likely-than-not.

There may be measurement differences between U.S. GAAP and IFRS SMEs as described in par. 21.7.

Unlike IFRS, exposure to loss in excess of the amount accrued is a contingent liability.
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