Learning Outcomes
After reading this article, you will be able to explain when a provision or contingent liability should be recognised and how it should be measured under IAS 37. You will distinguish between legal and constructive obligations, understand the recognition and measurement of government grants, and apply these rules to typical ACCA exam scenarios with confidence.
ACCA Strategic Business Reporting (SBR) Syllabus
For ACCA Strategic Business Reporting (SBR), you are required to understand the principles governing the recognition and measurement of provisions, contingent liabilities, contingent assets, and government grants according to IAS 37 and related standards. You should be ready to:
- Explain when a provision, contingent liability, or contingent asset arises
- Distinguish between legal and constructive obligations
- Apply the recognition and measurement rules for provisions and government grants
- Assess the impact of changes in estimates and circumstances on recorded provisions
- Discuss disclosure requirements for provisions, contingencies, and government grants
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Which three criteria must be met for a provision to be recognised under IAS 37?
- True or False? A provision can be made for future operating losses if these are probable and can be measured reliably.
- A business agrees to clean up environmental damage at its site, even though there is no legal obligation. Is a provision required?
- How must a government grant related to the purchase of PPE be presented in the financial statements?
Introduction
IAS 37 Provisions, Contingent Liabilities and Contingent Assets sets out the rules for recognising liabilities where the timing or amount is uncertain. It also covers government grants, which are often relevant in business scenarios where entities receive support in exchange for meeting certain conditions. Correct application of these principles is commonly examined in ACCA SBR.
Provisions ensure financial statements reflect present obligations arising from past events. You must judge whether an obligation exists (and is not just a possibility), whether an outflow is probable, and whether a reliable estimate can be made. For government grants, recognition matches the grant to related costs or assets, with careful attention to both eligibility and presentation.
Key Term: provision
A liability of uncertain timing or amount, recognised when an entity has a present obligation as a result of a past event, and an outflow of resources is probable and measurable.Key Term: contingent liability
A possible obligation depending on uncertain future events, or a present obligation not recognised because an outflow is not probable or cannot be measured reliably.Key Term: government grant
Transfers of resources to an entity by government in return for compliance with specified conditions, excluding normal trade arrangements.
Recognition and Measurement of Provisions
A provision must only be recognised if all of the following are met:
- The entity has a present obligation (legal or constructive) as a result of a past event.
- It is probable that a transfer of economic resources will be required to settle the obligation.
- A reliable estimate can be made of the obligation amount.
Identifying Obligations
Obligations may be:
- Legal, arising from contracts or legislation.
- Constructive, arising from an entity’s established patterns of past practice, published policies, or specific statements, creating a valid expectation in other parties that the entity will settle a responsibility.
If there is doubt whether an obligation exists, or whether an outflow is probable, no provision is recognised. Instead, a contingent liability is disclosed unless the chance of an outflow is remote.
Measurement of Provisions
Provisions are calculated as the best estimate of the cost to settle the obligation at the reporting date. Where the effect of the time value of money is material, discounting to present value is required.
Best estimate considerations:
- If a single obligation: most likely outcome.
- For large populations (e.g., warranties): expected value (probability-weighted amount).
- Future events that may affect the cost (e.g., new legislation) are included only if there is sufficient objective evidence they will occur.
Where reimbursement from a third party (e.g., insurance) is expected, recognise an asset only if receipt is virtually certain.
Worked Example 1.1
A company sells 1,000 units with a one-year warranty. Expected repair rate is 5%, and average repair cost is $100 per unit. Should a provision be made, and for how much?
Answer:
Yes. The warranty creates a present obligation because a past event (sale) has led to a legal obligation to repair. It's probable and measurable. Provision = 1,000 × 5% × $100 = $5,000.
Worked Example 1.2
Zeta Ltd faces a court claim for an accident at its premises. Lawyers advise a 60% chance of losing and paying $200,000 in damages. What is the proper accounting treatment?
Answer:
A provision for $200,000 is recognised. There is a present legal obligation (the accident), a probable outflow, and a reliable estimate. If the likelihood were less than 50%, instead disclose a contingent liability.
Exam Warning
In exam answers, provisions are often wrongly recognised for anticipated future operating losses or for planned restructurings before a detailed plan exists. Remember: provisions must not be made for costs that can be avoided by future actions.
Contingent Liabilities and Assets
A contingent liability is not recognised except where the outflow is virtually certain, in which case it is treated as a provision. Otherwise, disclose the nature and potential financial effect unless the probability of outflow is remote.
Contingent assets (possible inflows from uncertain events) are disclosed only when inflow is probable, and recognised as assets only when the inflow is virtually certain.
Onerous Contracts and Specific Situations
Key Term: onerous contract
A contract in which the unavoidable costs of fulfilling the agreement exceed the expected economic benefits.
For an onerous contract, a provision is made for the lower of the cost to fulfil or to exit the contract. Future operating losses are not recognised as provisions, even if probable and measurable. For future repairs required by law or contract, a provision is made only if an obligation exists as a result of a past event.
Government Grants: Recognition and Presentation
IAS 20 governs the recognition and presentation of government grants:
- Grants are recognised when there is reasonable assurance that the entity will both comply with attached conditions and receive the grant.
- Income-related grants are matched with the related expense, either:
- Shown as other income in profit or loss, or
- Deducted from the related expense.
- Grants for assets (e.g., PPE) are:
- Deducted from the asset’s cost, with reduced depreciation, or
- Recognised as deferred income and amortised to profit or loss over the asset’s useful life.
Worked Example 1.3
Electro Ltd purchases equipment costing $400,000 and receives a $40,000 government grant towards this. The equipment’s useful life is 4 years. What are the acceptable accounting treatments?
Answer:
- Deduct grant: Asset recognised at $360,000; depreciation = $90,000/year.
- Deferred income: Asset at $400,000; depreciation = $100,000/year; $10,000/year ($40,000/4) credited to profit or loss as grant income.
If a grant becomes repayable (e.g., non-compliance), treat the repayment as a revision of estimate:
- For deferred income method: reduce deferred income, excess to profit or loss.
- For asset deduction method: increase the asset’s cost, recalculate and charge additional depreciation to profit or loss immediately.
Disclosures and Updates to Provisions
IAS 37 requires disclosure of:
- Nature and carrying amount of each provision
- Major uncertainties about amount or timing
- Reimbursements
- Movements in each class of provision
Provisions are remeasured at each reporting date to reflect best estimates.
Summary
Provisions should only be recognised for present obligations creating probable resource outflows with reliable estimates. Added care is needed to avoid incorrect recognition for future costs, anticipated operating losses, or general uncertainties. Government grants are recognised only on reasonable assurance and must be matched to related expense or asset, with flexible presentation allowed by IAS 20.
Key Point Checklist
This article has covered the following key knowledge points:
- Conditions for recognising provisions and contingent liabilities under IAS 37
- Measurement and updating of provisions, including discounting
- Distinguishing legal and constructive obligations
- Accounting for onerous contracts and exclusions for future operating losses
- Rules for recognising and presenting government grants under IAS 20
- Required disclosures for provisions, contingencies, and grants
Key Terms and Concepts
- provision
- contingent liability
- government grant
- onerous contract