Accounting for Provisions – IAS 37

International Accounting Standard (IAS) 37, released in July 1999, sets out the criteria and rules for the accounting of provisions, in how they are to be recognised, measured and disclosed in the financial accounts. In today’s article, as part of our accounting tutorial series, we are going to work through the key points of this standard to help you better understand provisions and to account for them in the financial statements.

Definition of Provisions

So what is a provision? It is a liability of uncertain timing and amount. Ok, so what is a liability then?

A liability is a present obligation of an entity arising from past events, the settlement of which is expected to result in an outflow of economic benefits from an entity. The critical point here is the occurrence of a past event or obligating event that gives rise to an obligation.

So if there’s no past event, then there’s no obligation. However provisions can still arise where there are legal or constructive obligations formed between the firm and third parties.

Legal and Constructive Obligations

The first one is a legal obligation that derives from some contract, legislation, or some other operation of law.

The second one is a constructive obligation and they arise from a party’s actions such as established practices or some statement of acceptance of responsibilities.

Under IAS 37 there is no difference between provisions created by legal or constructive obligations, with regard to their respective accounting treatment. However, if you identify the underlying obligation, whether it’s legal or constructive, that may help you to identify when to recognise a provision.

Accounting for Provisions

To bring a provision to account in the financial accounts of an entity all three conditions are required to be met. Firstly, there must be a present obligation, whether legal or constructive, as a result of some past event or obligating event.

Secondly, the outflow of economic benefits required to settle the obligation must be probable. This is the probability of having to pay rather than not having to pay being more than 50%. When probability is less than 50% this is referred to as being possible and in that case the item may come within the disclosers around contingent liabilities.

And thirdly, there must be a reliable estimate of outflow of economic benefits. In other words, how much is it going to cost to settle the obligation. So if a reliable estimate cannot be made a provision cannot be recognised.

Provision v Contingent Liability

To help in deciding between whether a provision should be brought to account or a contingent liability is to be disclosed IAS 37 provides a useful decision tree, which really focuses in on one question. And that is …

“can you avoid the obligation by some future action?”

If the answer is yes, then a provision cannot be brought to account. For example, when a government is introducing new goals and your company must train the employees to stay updated. Your company may decide not to continue in business, or not to train the personnel. Therefore a present obligation is not in place.

If the answer is no, and the other three criteria above can be met (past event, economic benefits and reliable estimate), then a provision should be accounted for. For example a warranty you provide for products you are selling. If we run through the three criteria we used in the section above, you can see how a warranty comes under provision guidance.

Present Obligation

In attaching the warranty to the goods sold, a potential obligation is created at each sale. It is not known which sales will generate warranty claims in the future, but the obligation to deal with one as per the warranty contract is known and created.

Outflow of Economic Benefits

A warranty issued does not involve any flow of economic benefits, but certainly when a warranty claim is made there is that potential. This may mean product replacement, repair or other compensation to the purchaser.

Reliable Estimate of Outflow

Of course when it comes to warranties perhaps the most difficult part is perhaps a reliable estimate of what those costs could be. Certainly when starting out this could be more difficult, although for those businesses in well established industries trade data would be available.

Accounting EntriesContingent Liability

So far we have been through what contingency liabilities and provisions are, and in particular with the latter, when these need to be brought to account. What we’ll do next is look at a couple of examples, one for each type of disclosure, to show the type of work involved. First off, are contingent liabilities.

A good example of a contingent liability disclosure is one we found in Volkswagen’s 2018 account accounts. Reproduced below is the table from their Note 36:

In the note they go onto discuss the types of issues arising, for example in regards to “Other contingent liabilities” they state:

“The other contingent liabilities primarily comprise potential liabilities arising from matters relating to taxes and customs duties, as well as litigation and proceedings relating to suppliers, dealers, customers, employees and investors. The contingent liabilities recognized in connection with the diesel issue totalled €5.4 billion (previous year: €4.3 billion), of which €3.4 billion (previous year: €3.4 billion) was attributable to investor lawsuits.”

The purpose in the disclosures is to provide the reader with as much information as the company can disclose about future obligations that may arise and what the economic outflows might be.

Accounting EntriesProvisions

Because provisions require some debits and credits we will focus on that for this section (however for completeness, IAS paragraphs 84 and 85 set out the provision note disclosure requirements). In the mean time we are going to return to our example company we normally use, ABC Ltd. We will look at three common provisions made in business and often found in accounting exam questions.

Provision for Doubtful Debts

One of the most common form of provisions is that for doubtful debts. Most businesses providing any sort of sale on credit, and therefore having trade debtors on their balance sheet, will experience delays on payment and in some instances none payment by customers. After a period of operation, and/or perhaps using trade industry data, a business can start to make a reliable estimate on the level of doubtful debts it will experience.

Specific and General Allowances

Now there are two types of allowances made for debts, specific and general. The titles are rather self explanatory. Specific allowances relate to specific debts that a provision needs to be made for. Examples would include the debtor is in financial difficulties or there is a legal dispute between the parties (which may also tie into a contingent liability disclosure for legal proceedings and their associated costs).

General allowances of course then relate to the business making an assessment across its debtor books. From trading experience it will have an understanding of what percentage of that balance it will have trouble or fail to collect on.

As the debits and credits are the same for specific and a general allowance we’ll just work through a general allowance allowance.

Set out below is an analysis of ABC’s trade debtors as at July 31. Out of a total of $20,000, $15,000 are within their trade terms and not in arrears. This leaves $5,000 that are now late in payment. These amounts are then split into 30 days tranches, starting with up to 30 days late in payment, all the way up to over 150 days late on payment. Then for each tranche ABC maintains historical on the percentage of the balance it has trouble in collecting. The sum of these two figures provides us with a provision figure we can use for the journal entry.

The journal entry ABC’s accounting team would then prepare is detailed below. With the assumption that ABC already had a provision in place for trade debtors, but this was only for $1,000. So the journal entry reflects the adjustment required:

$1,315 (new provision figure) – $1,000 (old provision figure) = $315

DateAccount NameDebitCredit
July 31Allowance for Doubtful Debts315
Provision for Doubtful Debts315

So the debit to the allowance is an expense and so will be reflected in the profit and loss account. While to the credit to the provision account is a contra asset account and is reflected in the balance sheet. An extract from ABC’s accounts is below as an example.

Provision for Depreciation

The theory behind accounting for depreciation provisions has already been covered in a couple of other tutorials we have prepared and we’ll skip over that here. However, the journal entry is worth going over again. Borrowing from one of our previous tutorials on this topic, ABC has new machinery and is having to account for $140,000 in depreciation at year-end. So the journal entry required to bring this into the books is:

DateAccount NameDebitCredit
March 31Depreciation – Machinery140,000
Provision for Depreciation – Machinery140,000

If you checked out the tutorial we referenced above you would have noticed that in that article we referred to the “provision for depreciation” as “accumulated depreciation”. Don’t be confused … it means the same thing. If you haven’t already noticed in accounting we have different terms to mean the same thing; very confusing at times!

So the debit to depreciation is an expense and is disclosed in the profit and loss statement. While the credit to the provision account, which is a contra asset account, is disclosed in the balance sheet – being netted against the machinery asset account. An extract from the balance sheet is below.

Provision for Warranties

An IAS 37 warranty provision requires the same types of journal entries as we have already covered above, and like doubtful debts an analysis of how much the provision should be for. So let’s look at an example with ABC Ltd and how it goes about making this journal entry.

ABC Ltd has a side line of selling landscaping machinery and tools to the general public. From it’s small shop the line of products covers electric tillers/cultivators. With the brand it sells it provides a two year warranty on these units. Over the years the following data has been collected:

  • sell on average 150 units per year;
  • there is about a 4 per cent warranty claim; and
  • each warranty costs approximately $200 in repairs and/or replacement.

So with this information we can calculate the warranty cost figure:

150 x 4 % x $200 = $1,200

DateAccount NameDebitCredit
April 1Warranties Expense1,200
Provision for Warranties1,200

The debit of the entry raises an expense for the anticipated warranty expense for the electric tillers/cultivators over the year – to be disclosed in the profit and loss statement. While the credit creates the provision (liability) to be disclosed in the balance sheet.

Conclusion

And warranties brings us to the end of our tutorial looking at accounting for provisions under IAS 37. If you have any questions please use the comment section below, the ask a question page or our contact us section.

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