Once an obligation clears the three-part recognition test covered in Part 1, IAS 37 still has to answer a harder question: how much should actually be recognized? This is Part 2 of a three-part series on IAS 37. It covers how the best estimate of a provision is arrived at, when that estimate must be discounted to present value, how reimbursements and future events factor in, and the two most common special cases entities run into in practice — onerous contracts and restructuring provisions. Part 3 offers a free calculator that applies the expected-value method and discounting to build a provision estimate from scenario inputs.

Measurement: The Best Estimate

The amount recognized as a provision is the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. The best estimate is the amount an entity would rationally pay to settle the obligation at that date, or to transfer it to a third party. Estimates are determined by the judgment of management, supplemented by experience of similar transactions and, in some cases, reports from independent experts, and take into account any additional evidence provided by events after the reporting period.

Expected Value and Most Likely Outcome

Where the provision being measured involves a large population of items, the obligation is estimated by weighting all possible outcomes by their associated probabilities — the expected-value method. Where a single obligation is being measured, the individual most likely outcome may be the best estimate; but even in this case, the entity considers other possible outcomes, since where these are predominantly higher or lower than the most likely outcome, the best estimate will be a higher or lower amount.

Risks and Uncertainties, and Discounting

The risks and uncertainties that inevitably surround many events and circumstances are taken into account in reaching the best estimate of a provision. Risk describes variability of outcome, and a risk adjustment may increase the amount at which a liability is measured — but uncertainty does not justify the creation of excessive provisions or the deliberate overstatement of liabilities.

Where the effect of the time value of money is material, the amount of a provision is discounted to its present value, using a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the liability. The discount rate does not reflect risks for which future cash flow estimates have already been adjusted, to avoid double-counting.

Future Events, Asset Disposals, and Reimbursements

Future events that may affect the amount required to settle an obligation are reflected in the amount of a provision where there is sufficient objective evidence that they will occur — for example, expected changes in the legal environment, or in technology, to the extent this is expected to reduce the cost of settlement. Gains from the expected disposal of assets are not taken into account in measuring a provision, even where the expected disposal is closely linked to the event giving rise to the provision; gains are instead recognized separately, at the time specified by the standard governing the relevant assets.

Where some or all of the expenditure required to settle a provision is expected to be reimbursed by another party — for example, through an insurance contract — the reimbursement is recognized as a separate asset, and only when it is virtually certain that the reimbursement will be received if the entity settles the obligation. The amount recognized for the reimbursement does not exceed the amount of the provision itself, and in the statement of profit or loss, the expense relating to the provision may be presented net of the reimbursement.

Reviewing and Using Provisions

Provisions are reviewed at the end of each reporting period and adjusted to reflect the current best estimate. If it is no longer probable that an outflow of resources will be required to settle the obligation, the provision is reversed. A provision is used only for the expenditures for which it was originally recognized — charging unrelated expenditures against a provision would obscure the impact of two different events.

Onerous Contracts

An onerous contract is a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. If an entity has an onerous contract, the present obligation under the contract is recognized and measured as a provision. The unavoidable costs under a contract reflect the least net cost of exiting from it — the lower of the cost of fulfilling the contract, and any compensation or penalties arising from failure to fulfill it.

Restructuring Provisions

A restructuring is a programme that is planned and controlled by management, and materially changes either the scope of a business undertaken by the entity, or the manner in which that business is conducted — examples include the sale or termination of a line of business, the closure of business locations, or a fundamental reorganization that has a material effect on the nature and focus of operations.

A constructive obligation to restructure arises only when an entity has a detailed formal plan for the restructuring — identifying, at minimum, the business or part of a business concerned, the principal locations affected, the location, function, and approximate number of employees to be compensated for terminating their services, the expenditures that will be undertaken, and when the plan will be implemented — and has raised a valid expectation in those affected that it will carry out the restructuring, either by starting to implement the plan or by announcing its main features to those affected by it.

A restructuring provision includes only the direct expenditures arising from the restructuring — those that are both necessarily entailed by the restructuring and not associated with the ongoing activities of the entity. It specifically excludes costs such as retraining or relocating continuing staff, marketing, and investment in new systems and distribution networks, since these relate to the future conduct of the business rather than to the restructuring itself.