When teaching accounting standards to students for the first time, the concept of judgment can be a tricky one to convey initially. Often students can come in with a black-and-white approach to things, learning the rules and then applying them in an exam. Initially the application of IFRS Accounting Standards can feel like a very simple compliance exercise where you simply do what the rules say.
Then we hit IAS 37, Provisions, Contingent Liabilities and Contingent Assets, and it all gets a little more interesting. Most people who have worked in audit have war stories about the endless discussions and arguments about whether to recognise a provision and how much. Even then, students still often see it as people trying to find loopholes to get out of things rather than seeing the difficulties in really assessing situations.
An exposure draft on IAS 37 could now lead to some notable changes
With the increasing focus on sustainability disclosures, IAS 37 remains in focus, particularly in the light of potential commitments made by companies, as discussed previously in AB in the context of ‘net zero’ commitments made by entities.
IAS 37 has remained relevant to many entities, and there have been relatively few changes to it in recent years. An exposure draft (comment deadline 12 March 2025) recently issued by the International Accounting Standards Board could now lead to some notable changes.
Definition changes
In 2018, the revised Conceptual Framework altered the definition of a liability. Previously this was defined as ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’. This has been replaced by the new definition, which is ‘a present obligation of the entity to transfer an economic resource as a result of past events’.
Initially, IAS 37 was left unchanged, but now the definition of a liability has been updated to match that in the Conceptual Framework.
The exposure draft outlines three conditions (or tests) to determine whether a present obligation exists
While the change in liability definition resulted in a removal of the need for an expected outflow to have a liability, IAS 37 continues to maintain the probability factor in whether to recognise a provision. The IASB stated that the probability factor remains a recognition issue, even if it has been removed from the definition of a liability.
Recognition criteria
A key pillar for a provision to be recognised under IAS 37 has been that it requires three criteria to be satisfied:
- It has a present obligation from a past event
- It has a probable outflow of economic resources
- The amount can be estimated reliably.
These criteria are unchanged in the ED, other than criterion 2 being reworded to match the updated liability definition. While these are unchanged, the IASB has noted that the most difficult issue in establishing whether a provision is required deals with criterion 1 and establishing whether a present obligation exists.
With that in mind, the ED outlines three conditions (or tests) to determine whether a present obligation exists: an obligation condition, a transfer condition and a past-event condition.
The ED then goes into some detail on when these conditions may or may not be met. One change is linked to the obligation condition. Previously this used to consider whether an entity could avoid the transfer of economic resources. Now the draft reframes this as ‘the practical ability to avoid the obligation under law’.
The information on obligations and costs should result in some provisions being higher
One consequence of this could be linked to levies, such as a levy on emissions. Currently IFRIC 21, Levies, is applied, but this will now be removed and brought into the principles of IAS 37. Instead of providing for the levy when the emissions level is breached, provisions will be recorded based on the current activity if the current activity is such that it appears the threshold will be breached within the given time period. This may mean that in threshold-based scenarios, provisions will be based earlier and progressively as activities are undertaken, rather than at the point the threshold is breached.
Other proposals
In addition to the above, the ED also seeks to clarify guidance on costs and discount rates. The draft proposes that all direct costs are to be included in provisions. This could mean that provisions become larger, including allocations of internal legal team costs in addition to amounts paid to external lawyers and claimants. Finally, the ED is aiming to remove choice on which discount rates to use, requiring the use of a risk-free rate.
On the face of it, it seems like this is an attempt to provide more clarity rather than changing the standard dramatically. Despite that, the information on obligations and costs should result in some provisions being recognised earlier, and some provisions being higher with the inclusion of all direct costs.
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