What it means
A provision is recognised only when three conditions are met. The company has a present obligation as a result of a past event, it is probable that money or resources will have to leave the business to settle it, and a reliable estimate of the amount can be made.
Probable here means more likely than not. If the first two conditions are met but no reliable estimate is possible, which is rare, the item is disclosed in the notes instead.
If the outflow is only possible rather than probable, the item is a contingent liability, which is described in the notes without a balance sheet entry. Contingent assets are not recorded at all unless the inflow is virtually certain.
The amount recognised is the best estimate of the cost to settle the obligation at the end of the reporting period. For a single obligation, such as one lawsuit, the most likely outcome is normally used.
For a large group of similar items, such as thousands of products under warranty, the expected value is calculated by weighting each possible outcome by its probability. Where the effect of timing is significant, the provision is discounted to present value.
The unwinding of that discount in later years is shown as a finance cost. Provisions are reviewed at each reporting date and adjusted, and any that are no longer needed are released back to profit.
Restructuring provisions have special rules. A company can only record one when it has a detailed formal plan and has raised a valid expectation in those affected, for example by starting to implement the plan or announcing its main features.
A board decision on its own is not enough. The standard is often tested in practice because it involves judgement.
Managers have an incentive to understate provisions to protect profit, while auditors press for fuller recognition, so documentation of the reasoning is as important as the number itself.
In practice
Real-world examples
Example 1
A software company is sued by a former supplier for $2,000,000 and its lawyers believe it is more likely than not that it will lose, with a best estimate of $1,200,000. It records a provision of $1,200,000 and explains the dispute in the notes.
Example 2
A mining business has an obligation to restore a site at the end of the licence period. It records a provision for the present value of the cleanup cost, and each year adds the unwinding of the discount as a finance cost.
Example 3
A retailer faces a claim that its lawyers regard as unlikely to succeed. No provision is made, but the company discloses the claim as a contingent liability because the possibility of loss is not remote.
Think of it
Imagine setting aside money in a jar for your car's upcoming annual service and potential repairs. You know you will need to pay something soon, even if the exact mechanic bill is still a guess.
Formula
Calculation
Provision for a large population = number of units x sum of (probability of each outcome x cost of that outcome)
Suppose a company sold 20,000 appliances with a warranty. Based on experience, 85% will need no repair, 10% will need a minor repair costing $40, and 5% will need a major repair costing $200. Expected cost per unit = 0.85 x 0 + 0.10 x 40 + 0.05 x 200 = 0 + 4 + 10 = $14. The warranty provision is 20,000 x 14 = $280,000.Case study
Seen in the real world
Ashbourne Electric is an illustrative, fictional manufacturer that discovered a fault in a batch of chargers. At the year end, it had not yet announced a recall, but regulators had contacted the company and a recall looked very likely.
The finance director estimated that 50,000 units would be returned at an average cost of $12 per unit for replacement and handling. She recorded a provision of 50,000 x 12 = $600,000 because there was a present obligation from the sale, an outflow was probable and the estimate was reliable.
The auditor agreed after seeing the regulator correspondence. The illustrative lesson is that IAS 37 requires recognition when an outflow is likely, not when it is formally announced, which brings the cost into the year in which the problem arose.
Watch out
Common mistakes
- Creating a general reserve for unspecified future problems, when IAS 37 requires a present obligation from a past event.
- Booking a restructuring provision on the basis of a board decision alone, without a detailed plan and a valid expectation in those affected.
- Recognising a contingent asset because a gain looks likely, when the standard allows it only when the inflow is virtually certain.
Questions
People also ask
What is the difference between a provision and a contingent liability?
A provision is recognised on the balance sheet because the outflow is probable and measurable, while a contingent liability is only disclosed because the outflow is possible or cannot be reliably measured.
Do provisions need to be discounted?
Yes, where the time value of money has a material effect, the provision is shown at present value.
Can a provision be used for any expense?
No, it may only be used for the purpose for which it was created, and any unused amount is released to profit.