IAS 37 Provisions, Contingent Liabilities and Contingent Assets exists to stop entities from either hiding real obligations off the balance sheet or, in the other direction, padding profits down with vague, unsubstantiated reserves. It sets a precise three-part test for when an uncertain liability must be recognized as a provision, and separate disclosure rules for the possible obligations and possible assets that fall short of that test. This is Part 1 of a three-part series on IAS 37. It covers the standard’s scope, the key definitions, the three recognition criteria for a provision, and how provisions are distinguished from contingent liabilities and contingent assets. Part 2 covers measurement, discounting, onerous contracts and restructuring provisions, and Part 3 offers a free calculator that applies the expected-value method and discounting to a provision estimate.

Objective and Scope of IAS 37

IAS 37 exists to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities, and contingent assets, and that sufficient information is disclosed for financial statement users to understand their nature, timing, and amount. The standard is, in effect, a gatekeeper: it stops entities from smoothing profits with vague general reserves that don’t meet the definition of a liability, while still requiring genuine uncertain obligations to be recognized.

IAS 37 does not apply to provisions and contingencies covered by their own specific standard — for example, obligations under construction and other customer contracts (IFRS 15), income taxes (IAS 12), leases (IFRS 16), employee benefits (IAS 19), insurance contracts (IFRS 17), and financial instruments measured at fair value. It also does not apply to executory contracts — contracts under which neither party has performed any of its obligations, or both parties have partially performed to an equal extent — unless the contract is onerous, in which case IAS 37 does apply.

Key Definitions

A provision is a liability of uncertain timing or amount. A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow of resources embodying economic benefits. An obligating event is an event that creates a legal or constructive obligation and leaves the entity no realistic alternative to settling it.

Obligations come in two forms. A legal obligation derives from a contract, legislation, or other operation of law. A constructive obligation derives from an entity’s own actions — an established pattern of past practice, published policies, or a sufficiently specific current statement — that has created a valid expectation among other parties that the entity will discharge certain responsibilities.

A contingent liability is either a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of uncertain future events not wholly within the entity’s control, or a present obligation that is not recognized because it is not probable that an outflow of resources will be required, or the amount cannot be measured with sufficient reliability. A contingent asset is a possible asset arising from past events whose existence will be confirmed only by the occurrence or non-occurrence of uncertain future events not wholly within the entity’s control.

The Three Recognition Criteria for a Provision

A provision is recognized if, and only if, all three of the following conditions are met:

• the entity has a present obligation, legal or constructive, as a result of a past event;
• it is probable — meaning more likely than not — that an outflow of resources embodying economic benefits will be required to settle the obligation; and
• a reliable estimate can be made of the amount of the obligation.

If any one of these three conditions is not met, no provision is recognized. Where there is a possible obligation, or a present obligation that fails the probability or reliable-estimate test, the entity instead considers whether the matter needs to be disclosed as a contingent liability.

Present Obligation: Judging Legal and Constructive Obligations

In the great majority of cases it will be clear whether a past event has given rise to a present obligation. In rare cases — for example, in a dispute over whether certain events have occurred, or over whether those events result in a present obligation — an entity determines whether a present obligation exists at the end of the reporting period by taking account of all available evidence, including the opinion of experts, and any additional evidence provided by events after the reporting period. Where it is more likely than not that a present obligation exists, the entity recognizes a provision, if the other two criteria are also met; where it is more likely that no present obligation exists, the entity discloses a contingent liability, unless the possibility of an outflow is remote.

Contingent Liabilities: Recognition and Disclosure

An entity does not recognize a contingent liability. Instead, unless the possibility of an outflow of resources is remote, the entity discloses a brief description of the nature of the contingent liability, an estimate of its financial effect where practicable, an indication of the uncertainties relating to the amount or timing of any outflow, and the possibility of any reimbursement. Contingent liabilities are continually assessed to determine whether an outflow of resources has become probable — if it has, a provision is recognized in the period the change in probability occurs (except in the rare case where a reliable estimate still cannot be made).

Contingent Assets

An entity does not recognize a contingent asset, since this could result in the recognition of income that may never be realized. However, where an inflow of economic benefits is probable, the entity discloses a brief description of the nature of the contingent assets at the end of the reporting period, and, where practicable, an estimate of their financial effect. Contingent assets are assessed continually, and if it has become virtually certain that an inflow of economic benefits will arise, the asset and the related income are recognized in the financial statements of the period in which the change occurs — at which point, by definition, it is no longer a contingent asset at all.