Provisions and contingent liabilities

A provision is a liability of uncertain timing or amount — a warranty obligation, a lawsuit the entity expects to lose, a legal duty to clean up contamination. Under IAS 37.14 a provision is recognised only when all three conditions are met:

1. A present obligation (legal or constructive) as a result of a past event. A legal obligation comes from a contract or law; a constructive obligation comes from an established pattern of practice or a published policy that has created a valid expectation in others (for example, a store that always refunds unhappy customers). The obligating event must already have happened — the sale of goods under warranty, the contamination caused.
2. A probable outflow of resources — under IAS 37, "probable" means more likely than not (over 50%).
3. A reliable estimate can be made. IAS 37 says this is almost always possible; only in extremely rare cases is a provision left out for this reason.

If the first condition is met but the outflow isn't probable — or there is only a possible obligation whose existence depends on uncertain future events — the item is a contingent liability. Contingent liabilities are not recognised; they are disclosed in the notes unless the possibility of an outflow is remote. Contingent assets (a lawsuit the entity expects to win) are never recognised until the inflow is virtually certain; they're disclosed when an inflow is probable.

Things that are not provisions: future operating losses (no past event), costs the entity can avoid by its own future actions (planned staff training, a decision to refurbish), and general "reserves for contingencies". A restructuring is provided for only when there is a detailed formal plan and those affected have a valid expectation it will happen — a board decision kept inside the boardroom isn't enough.

Measurement (IAS 37.36–40) is the best estimate of the amount to settle the obligation at the reporting date. For a large population of similar items (warranties) use the expected value — each outcome weighted by its probability. For a single obligation (one lawsuit) the most likely outcome is often the best estimate, adjusted if the other outcomes are mostly higher or lower. Where the effect of the time value of money is material, discount the expected cash flows; the provision then unwinds each year, and the increase is a finance cost (IAS 37.60).