IAS 37 Provisions and Contingencies: A Practical Guide

IAS 37 Provisions, Contingent Liabilities and Contingent Assets answers a deceptively tricky question: when does an uncertain future cost belong on the balance sheet, and when is it just something to mention in the notes? Get it wrong and you either overstate liabilities or hide them. This guide explains what a provision is, the three tests for recognising one, how provisions are measured, and how contingent liabilities and assets are treated. For structured learning, see our financial reporting CPD.

What is a provision?

A provision is a liability of uncertain timing or amount. That uncertainty is what sets it apart from a normal payable or accrual, where the amount and timing are reasonably certain. Typical examples include warranty obligations, restructuring costs, legal claims, onerous contracts and decommissioning costs. The whole point of IAS 37 is to make sure these genuine obligations are recognised when they should be — and not used to smooth profits when they shouldn't.

The three recognition criteria

A provision is recognised only when all three of the following are met:

• A present obligation (legal or constructive) exists as a result of a past event.
• It is probable that an outflow of economic benefits will be required to settle it.
• A reliable estimate can be made of the amount.

If any one of these isn't met, you don't recognise a provision — though you may still need to disclose a contingent liability (see below).

Legal vs constructive obligations

The "present obligation" can be legal or constructive. A legal obligation arises from a contract, legislation or other operation of law. A constructive obligation is subtler: it arises from the entity's own actions — an established pattern of past practice or a specific announcement — that creates a valid expectation in others that it will accept and discharge certain responsibilities. Importantly, an obligation only exists once the triggering event has occurred; simply having a policy or intention isn't enough.

How provisions are measured

A provision is measured at the best estimate of the expenditure required to settle the present obligation at the reporting date. Where the effect of the time value of money is material, the provision is discounted to present value. Because circumstances change, provisions are reviewed at each reporting date and adjusted to reflect the current best estimate — so a provision isn't a "set and forget" figure.

A common example: warranty provisions

Warranties are a textbook illustration of the criteria working together. When a company sells a product with a warranty, the sale (the past event) creates a present obligation to repair or replace faulty goods; across the population of sales an outflow is probable; and the cost can be reliably estimated from past claims experience. So a provision is recognised at the point of sale, not when individual claims later arrive — which is why provisions are often recognised earlier than people expect, and why the estimate is revisited as actual claims experience emerges.

Contingent liabilities

A contingent liability is either a possible obligation that depends on uncertain future events, or a present obligation that isn't recognised because an outflow isn't probable or the amount can't be measured reliably. Crucially, a contingent liability is not recognised on the balance sheet. Instead, it's disclosed in the notes — unless the possibility of an outflow is remote, in which case no disclosure is needed. This is the bridge between "recognise a provision" and "say nothing".

Contingent assets

A contingent asset is a possible asset arising from past events whose existence will be confirmed by uncertain future events. Reflecting accounting prudence, the treatment is deliberately asymmetric: a contingent asset is not recognised, but is disclosed where an inflow of benefits is probable. Only when realisation becomes virtually certain is the asset recognised — at which point it's no longer contingent at all.

Why IAS 37 is challenging

The difficulty is judgement. Deciding whether an outflow is "probable", whether a constructive obligation truly exists, and what a "best estimate" should be all involve assessment rather than a formula. Areas like litigation, restructuring, warranties, onerous contracts and decommissioning provisions are common flashpoints, and because the standard sits at the boundary between recognising and merely disclosing, it's a frequent focus for auditors and a key area of disclosure quality.

Frequently asked questions

When should a provision be recognised?

Only when there's a present obligation (legal or constructive) from a past event, an outflow of resources is probable, and the amount can be reliably estimated. All three must be met.

What's the difference between a provision and a contingent liability?

A provision meets all three recognition criteria and goes on the balance sheet. A contingent liability does not — it's only disclosed in the notes, unless an outflow is remote.

How are provisions measured?

At the best estimate of the cost to settle the obligation at the reporting date, discounted to present value where the time value of money is material, and reviewed each period.

Can you recognise a contingent asset?

Not while it's contingent. It's disclosed if an inflow is probable, and only recognised once realisation is virtually certain.

Sharpen your reporting judgement with Learnsignal

IAS 37 is all about applying judgement consistently and defensibly. Learnsignal's financial reporting CPD helps finance professionals build that judgement across provisions, contingencies and the wider standards, with flexible, expert-led learning.