Key takeaways
- A provision is a liability of uncertain timing or amount. It is recognised only when there is a present obligation from a past event, an outflow is probable and a reliable estimate can be made.
- Obligations can be legal or constructive — created by an established pattern of practice or published policy.
- Provisions are measured at the best estimate: expected value for large populations, most likely outcome for single obligations, discounted where material.
- Contingent liabilities are disclosed, not recognised; contingent assets are disclosed only when an inflow is probable.
Every year-end, finance teams face questions such as: should we provide for this legal case? For warranty claims on goods sold? For the restructuring the board discussed? For the loss-making contract we cannot exit? IAS 37 Provisions, Contingent Liabilities and Contingent Assets answers them with a short set of principles. Applied properly, they prevent both hidden liabilities and the “cookie-jar” provisions that smooth profit between years.
1. When to recognise a provision
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IAS 37 decision path: when to recognise a provision
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| Question | If yes | If no |
|---|---|---|
| Is there a present obligation (legal or constructive) as a result of a past event? | Continue | No provision. Disclose a contingent liability unless remote |
| Is an outflow of resources probable (more likely than not)? | Continue | No provision. Disclose a contingent liability unless remote |
| Can a reliable estimate be made? | Continue | No provision (rare). Disclose a contingent liability |
| All conditions met | Recognise a provision at the best estimate |
The past event must create an obligation that the entity has no realistic alternative to settling. A constructive obligation arises when, by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated that it will accept certain responsibilities and has created a valid expectation in others that it will discharge them — for example, a long-standing practice of refunding dissatisfied customers beyond legal requirements.
Future operating costs or losses never qualify, because they do not result from a past event; the entity can avoid them by changing its future actions. That is why a provision cannot be made for future repairs or for next year’s expected operating losses.
2. Measurement: the best estimate
The amount recognised is the best estimate of the expenditure required to settle the obligation at the reporting date — the amount the entity would rationally pay to settle it or transfer it to a third party.
- For a large population of items (warranties, product returns), use the expected value, weighting outcomes by their probabilities.
- For a single obligation (one legal case), the individual most likely outcome may be the best estimate, adjusted if other outcomes are mostly higher or lower.
- Where the time value of money is material, discount using a pre-tax rate reflecting current market assessments and liability-specific risks; the unwinding of the discount is a finance cost.
- Expected reimbursements (for example, insurance) are recognised as a separate asset only when virtually certain.
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Warranty provision by expected value: 10,000 units sold (illustrative, BDT)
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| Item | Value |
|---|---|
| Minor repairs (10% × 500) | 0.5m |
| Major repairs (5% × 3,000) | 1.5m |
| Outcome | Probability | Cost per unit (BDT) | Units affected | Expected cost (BDT) |
|---|---|---|---|---|
| No defect | 85% | 0 | 8,500 | 0 |
| Minor repair | 10% | 500 | 1,000 | 500,000 |
| Major repair | 5% | 3,000 | 500 | 1,500,000 |
| Total | 100% | 10,000 | 2,000,000 |
Probabilities and costs are illustrative and should be based on the entity’s own claims history, adjusted for known changes in product quality or terms.
3. Specific situations
| Situation | IAS 37 treatment |
|---|---|
| Onerous contract | Provide for the unavoidable costs of meeting the obligations that exceed the expected benefits. Since 2022, the costs of fulfilling include both incremental costs and an allocation of other costs directly related to the contract. Test related assets for impairment first. |
| Restructuring | Provide only when there is a detailed formal plan and the entity has raised a valid expectation in those affected (by starting implementation or announcing main features). Include only direct expenditures — not retraining, relocating continuing staff or new systems. |
| Legal claims | Provide if an outflow is probable and can be estimated (taking legal advice); otherwise disclose as a contingent liability unless remote. |
| Restoration / decommissioning | Provide for the present value of the obligation when the damage occurs (often on installation), added to the cost of the asset under IAS 16. |
| Future operating losses | No provision. |
| Levies (IFRIC 21) | Recognise when the activity that triggers payment, as identified by the legislation, occurs. |
4. Contingent liabilities and contingent assets
A contingent liability is either a possible obligation whose existence will be confirmed only by uncertain future events not wholly within the entity’s control, or a present obligation that is not recognised because an outflow is not probable or cannot be measured reliably. It is not recognised but is disclosed — nature, estimate of financial effect, uncertainties and possibility of reimbursement — unless the possibility of outflow is remote.
A contingent asset — such as a claim against an insurer or a lawsuit the entity expects to win — is not recognised. It is disclosed when an inflow is probable. When realisation becomes virtually certain, the asset is no longer contingent and is recognised.
| Likelihood of outflow | Present obligation exists | Possible obligation only |
|---|---|---|
| Probable (more likely than not) | Recognise provision + disclose | Disclose contingent liability |
| Possible but not probable | Disclose contingent liability | Disclose contingent liability |
| Remote | No disclosure required | No disclosure required |
5. Review, use and reversal
Provisions are reviewed at each reporting date and adjusted to reflect the current best estimate. If an outflow is no longer probable, the provision is reversed. A provision may be used only for the expenditures for which it was originally recognised — setting provisions against unrelated costs hides the true performance of both periods. A provisions roll-forward (opening balance, additions, amounts used, unused amounts reversed, discount unwinding, closing balance) is a required disclosure for each class.
6. Practical controls
- Maintain a provisions register with the obligating event, basis of estimate, owner and supporting evidence.
- Obtain legal confirmation of open cases at each year-end and half-year.
- Back-test warranty and returns provisions against actual claims.
- Challenge any “general” or round-number provisions without a specific obligation.
- Coordinate with tax: many provisions are deductible only when paid, creating deferred tax assets under IAS 12.
A forthcoming IASB amendment to IAS 37 (proposed in 2024) would refine the present-obligation criterion and the discount rate requirements. Check the status of any changes, and their adoption in your jurisdiction, before applying them.
Standards referenced in this article
IAS and IFRS are one body of standards — IFRS Accounting Standards, issued by the IASB. Standards issued before 2001 keep their IAS numbers and remain fully in force unless replaced. See the full IFRS & IAS standards list for every number and replacement.
| Standard | Title | Status | IFRS # & IAS # link |
|---|---|---|---|
| IAS 12 | Income Taxes | In force | No IFRS number — IAS 12 is the IFRS standard |
| IAS 16 | Property, Plant and Equipment | In force | No IFRS number — IAS 16 is the IFRS standard |
| IAS 37 | Provisions, Contingent Liabilities and Contingent Assets | In force | No IFRS number — IAS 37 is the IFRS standard |
| IFRIC 21 | Levies | In force (Interpretation) | — |
Frequently asked questions
What is the difference between a provision and a contingent liability?
A provision is a recognised liability of uncertain timing or amount, recorded when a present obligation exists, an outflow is probable and the amount can be estimated reliably. A contingent liability is not recognised; it is disclosed in the notes unless an outflow is remote.
What is a constructive obligation?
An obligation arising from an entity's actions — an established pattern of past practice, published policies or a sufficiently specific current statement — that has created a valid expectation in other parties that the entity will discharge certain responsibilities.
Can a company make a provision for future operating losses?
No. Future operating losses do not arise from a past event and do not meet the definition of a liability. However, if a contract is onerous, a provision is made for the unavoidable net cost of that contract.
Conclusion
IAS 37 comes down to three questions — present obligation, probable outflow, reliable estimate — and a best-estimate measurement. Applied consistently with a documented register, legal confirmations and back-testing, it keeps liabilities complete without allowing provisions to become a tool for smoothing results.
Written by Liakat Hossain
Finance and accounts professional with experience in FP&A, SAP FICO, Power BI, internal control, reporting, audit, tax, VAT and export-oriented business operations.
This article is original educational content based on professional finance practice. Real-project examples are anonymized, and scenario figures are identified as model outputs rather than guaranteed results.