IAS 37 Provisions, Contingent Liabilities and Contingent Assets: Recognition and Measurement

Some costs belong to the current year even though the cash goes out later, and some possible costs may never arise. A company that sells appliances with a warranty owes repairs it cannot yet name. A company being sued may lose or may win. International Accounting Standard (IAS) 37 Provisions, Contingent Liabilities and Contingent Assets decides which of these are recorded as liabilities, which are only disclosed, and which are ignored.

This topic covers the definition of a provision, the recognition tests, measurement, the double entries and later changes, the specific cases of onerous contracts, restructuring and decommissioning, and contingent liabilities and assets. The next topic covers events after the reporting period.

The topic is examined directly. In May Diet, 2025, Question 7(a) carried 12 marks for explaining provisions, contingent liabilities and contingent assets, with the recognition and measurement criteria for each. Read satisfying performance obligations, contract costs and specific cases first.

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. A provision differs from other liabilities because of the uncertainty about the timing or amount of the cash needed to settle it.

Accruals, by contrast, are liabilities for goods or services already received but not yet invoiced, where any estimation is much smaller. An obligating event creates a legal or constructive obligation so that the entity has no realistic alternative to settling it.

Some accountants use “provision” for a reduction in an asset, such as a provision for depreciation or for doubtful debts. Those are not covered by this standard, which is only about provisions that are liabilities.

Recognition

A provision is recognised when all three of these apply, and not otherwise:

1. the entity has a present obligation (legal or constructive) as a result of a past event;
2. it is probable that an outflow of economic benefits will be required to settle it; and
3. a reliable estimate of the amount can be made.

Present obligation

A legal obligation arises from a contract or the law. A constructive obligation arises from the entity’s actions: through an established pattern of past practice, published policies or a sufficiently specific statement, it has shown others it will accept certain responsibilities, and so created a valid expectation that it will discharge them.

A retailer that always refunds customers who change their mind, and has made the policy known, has a constructive obligation each time it makes a sale. A company that has published and followed a policy of cleaning up contamination, in a country with no such law, has a constructive obligation to clean up.

In rare cases where it is unclear whether an obligation exists, a past event is taken to give rise to one if it is more likely than not that it does, on all the evidence.

Past event

The event must have happened before the reporting date, and the entity must have no realistic alternative to settling the obligation. No provision is made for costs that depend on future actions of the entity. A company that must fit toughened glass in its buildings within five years under new law could avoid the cost by selling the buildings, so there is no present obligation.

A management decision to reorganise is not an obligation until it has been communicated to those affected so that they have a valid expectation. If a company decided on 13 December to close a factory but told no one before 31 December, there is no provision.

An obligation always involves another party, but the party need not be known. A manufacturer that gives three-year warranties has an obligation from each sale, even though it does not know which customers will claim.

Probable

In IAS 37, probable means more likely than not: more than a 50% chance. A guarantee that is unlikely to be called gives no provision. For a population such as warranties, the test looks at the class as a whole.

Measurement

A provision is the best estimate of the expenditure required to settle the obligation at the reporting date: what the entity would pay to settle it or transfer it to a third party. Management estimates it, using experience of similar transactions and, where needed, independent experts. Events after the reporting date give useful evidence. Risks and uncertainties are taken into account.

• A single obligation: the most likely outcome is normally the best estimate, but if other outcomes are mostly higher or mostly lower, the estimate moves that way.
• A large population. (such as warranty claims): the expected value, which weights every possible outcome by its probability. For example, an entity sells 8,000 units. For each unit, there is a 5% chance of a minor repair costing ₦6,000, a 2% chance of a major repair costing ₦30,000, and otherwise nothing.
  The expected cost per unit is 5% × ₦6,000 + 2% × ₦30,000 = ₦900, so the provision is 8,000 × ₦900 = ₦7,200,000.
• Time value: if material, the provision is the present value of the expected expenditure, discounted at a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability.
• Future events: expected changes, such as new technology that will cut clean-up costs, are taken into account if there is sufficient objective evidence they will occur. Possible new law counts only if it is virtually certain to be enacted as drafted. Gains from the expected disposal of assets are not taken into account.
• Reimbursements: recognised only when receipt is virtually certain, as a separate asset not exceeding the provision. The expense in profit or loss may be shown net of the reimbursement.

Double entry, use and changes

The debit when a provision is first recognised is usually an expense: Dr Profit or loss, Cr Provision. The main exception is a decommissioning provision, which is capitalised in the asset. When the cost is paid, Dr Provision, Cr Cash. A provision may be used only for the expenditure for which it was originally recognised, so a warranty provision cannot absorb a legal settlement.

A shortfall is a further expense, and an excess is released to profit or loss.

Each provision is reviewed at every reporting date, and increases, decreases and derecognition are recognised in profit or loss. A legal claim illustrates this. At the end of Year 1 a provision of ₦800,000 is recognised. At the end of Year 2 the expected settlement is ₦950,000, so an extra ₦150,000 is charged. At the end of Year 3 it falls to ₦700,000, so ₦250,000 is credited to profit or loss.

The claim is then settled for ₦740,000: Dr Provision ₦700,000, Dr Profit or loss ₦40,000, Cr Cash ₦740,000. The total charged over the four years is ₦800,000 + ₦150,000 − ₦250,000 + ₦40,000 = ₦740,000, the final settlement.

A provision stated at present value rises each year as the discount unwinds. The increase is a finance cost in profit or loss.

Specific cases

Onerous contracts

A contract is onerous if the unavoidable costs of meeting it exceed the economic benefits expected from it. A provision is made for the net unavoidable cost: the lower of the cost of fulfilling the contract and any compensation or penalty for failing to fulfil it. The cost of fulfilling includes the incremental costs and an allocation of other costs that relate directly to the contract.

Any impairment of assets dedicated to the contract is recognised first. For example, a company is committed for three more years to buy 12,000 units a year at ₦150, but can now resell them for ₦110. The loss is 12,000 × 3 × ₦40 = ₦1,440,000 (discounted if material). A contract that can be cancelled with notice is provided only for the payments due during the notice period.

Future operating losses

No provision is made for future operating losses. They arise from future events, not a past one, and directors cannot “take the bad news early” by creating them.

Restructuring

A restructuring is the sale or termination of a line of business, the closure or relocation of operations, a change of management structure or a fundamental reorganisation. A provision is recognised only if a present obligation exists.

A constructive obligation arises only when the entity (a) has a detailed formal plan that identifies the business concerned, the main locations affected, the location, function and approximate number of employees to be compensated, the expenditures to be incurred and when the plan will be implemented, and (b) has raised a valid expectation in those affected, by starting to implement the plan or announcing its main features to them.

If the plan starts or is announced after the reporting date but before the statements are issued, it is disclosed under IAS 10. The provision includes only direct expenditure that is necessarily entailed by the restructuring and not associated with ongoing activities. Retraining or relocating continuing staff, marketing and new systems are excluded.

Decommissioning and similar provisions

Where a company must clean up a site at the end of its life (oil and gas, mining, nuclear power), a provision is made if the obligation arises from law or from its actions. IAS 16 makes the initial estimate part of the cost of the asset. The provision is usually a present value. For example, a rig will cost ₦12,000,000 to remove in eight years, and the pre-tax rate is 9%.

The provision at the start is ₦12,000,000 ÷ 1.09⁸ = ₦6,022,395: Dr Asset, Cr Provision. The asset is depreciated over its life. After one year the unwinding of the discount, ₦6,022,395 × 9% = ₦542,016, is expensed (Dr Finance cost, Cr Provision), so the provision is ₦6,564,411.

Contingent liabilities and contingent assets

A contingent liability is either (a) a possible obligation arising from past events, whose existence will be confirmed only by uncertain future events not wholly in the entity’s control, or (b) a present obligation that is not recognised because an outflow is not probable or the amount cannot be measured reliably. It is not recognised.

It is disclosed in the notes, with a description of its nature and an estimate of its financial effect where practicable, unless the possibility of an outflow is remote.

A contingent asset is a possible asset arising from past events, whose existence will be confirmed only by uncertain future events, such as a gain from a legal action against a third party. It is not recognised. It is disclosed only if an inflow is probable. If the inflow is virtually certain, it is no longer contingent and the asset is recognised.

For both, the disclosure gives a brief description of the nature and, where practicable, the estimated financial effect. Contingent liabilities and assets are reassessed each period.

Disclosure for provisions

For each class of provision the notes give the opening and closing balances and the movements in the year (additions, amounts used, unused amounts reversed and the unwinding of the discount), a brief description of the nature of the obligation, the expected timing of any outflow and an indication of the uncertainties about the amount or timing.

The ideas in more depth

Why the thresholds differ

Liabilities are recognised when an outflow is more likely than not, because understating obligations would mislead. Assets are held to a stricter test, virtually certain, because recognising an asset that never arrives would overstate profit. This asymmetry is a prudent bias in the standard.

Why there is no provision for the future

An obligation exists independently of the entity’s future actions only if it follows a past event. Future operating losses, planned repairs and planned reorganisations can all be avoided by what the entity chooses to do, so none is a liability today.

Sources and references

• IAS 37 Provisions, Contingent Liabilities and Contingent Assets: definitions, recognition, measurement, onerous contracts, restructuring, and disclosure.
• IAS 16 Property, Plant and Equipment, for decommissioning costs in the cost of an asset, and IAS 10 Events after the Reporting Period.

These points are stated as at 5 November 2026.

Worked examples

1. (a) Present obligation from a past event, an outflow more likely than not and a reliable estimate: provision of ₦5,000,000.
2. (b) The outflow is not probable: a contingent liability, disclosed in the notes.
3. (c) The inflow is probable but not virtually certain: a contingent asset, disclosed but not recognised.
4. (d) Remote: nothing is recognised or disclosed.

1. Obligation. There is a detailed formal plan, and the announcement before the year end has created a valid expectation, so there is a constructive obligation.
2. Provision. Redundancy costs of ₦30,000,000, a direct cost necessarily entailed by the restructuring.
3. Excluded. The ₦5,000,000 retraining of continuing staff is a cost of ongoing activities and is expensed when incurred.

1. Net unavoidable cost per unit.
   ₦200 − ₦150 = ₦50.
2. Total.
   9,000 × 2 × ₦50 = ₦900,000, discounted if the time value is material.

How to answer in the exam

• Define. Give the three terms in one line each.
• Give the recognition test. Three conditions, all required. Then say what happens if one fails.
• State the measurement rule. Best estimate, expected value for populations, present value at a pre-tax rate.
• Classify. For a scenario, test the three conditions in order, and then state provision, contingent liability, contingent asset or nothing.
• Mention the disclosure. Contingent liability: unless remote; contingent asset: only if probable.

Common mistakes in the exam

• Providing for future operating losses or for a plan that has not been announced.
• Treating a 30% chance of loss as a provision.
• Recognising a probable gain as an asset. It is a contingent asset until virtually certain.
• Using the wrong rate, or a post-tax rate, for discounting.
• Forgetting the unwinding of the discount as a finance cost.
• Using a provision for something other than its original purpose.
• Including retraining or relocating continuing staff in a restructuring provision.

Quick revision

• Provision: present obligation, probable outflow, reliable estimate.
• Measure: best estimate; expected value for populations; present value, pre-tax rate; reimbursement only if virtually certain, separate asset.
• Onerous contract: net unavoidable cost. Restructuring: formal plan and announcement; direct costs only. Decommissioning: add to the asset, unwind to finance cost.
• Contingent liability: disclose unless remote. Contingent asset: disclose if probable; recognise if virtually certain.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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