HKAS 37 - Provisions, Contingent Liabilities

HKAS 37 - Provisions, Contingent Liabilities and Contingent Assets

1. OBJECTIVE AND SCOPE

Objective

The objective of HKAS 37 is to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets, and that sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount.

Scope (Paragraphs 1-9)

HKAS 37 shall be applied by all entities in accounting for provisions, contingent liabilities and contingent assets, except:

Specific Standards that address certain provisions:

Important Note: The term "provision" is also used for depreciation, impairment of assets, and doubtful debts. These are adjustments to carrying amounts of assets and are NOT addressed in HKAS 37.

2. DEFINITIONS (Paragraph 10)

Key Definitions

Provision

A liability of uncertain timing or amount.

Liability

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.

Obligating Event

An event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation.

Legal Obligation

An obligation that derives from:

- (a) a contract (through its explicit or implicit terms);

- (b) legislation; or

- (c) other operation of law.

Constructive Obligation

An obligation that derives from an entity's actions where:

- (a) by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and

- (b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.

Contingent Liability

- (a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or

- (b) a present obligation that arises from past events but is not recognised because:

- (i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or

- (ii) the amount of the obligation cannot be measured with sufficient reliability.

Contingent Asset

A possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.

Onerous Contract

A contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.

Restructuring

A programme that is planned and controlled by management, and materially changes either:

- (a) the scope of a business undertaken by an entity; or

- (b) the manner in which that business is conducted.

Provisions vs Other Liabilities (Paragraph 11)

Accruals are often reported as part of trade and other payables, whereas provisions are reported separately.

Relationship between Provisions and Contingent Liabilities (Paragraphs 12-13)

All provisions are contingent in timing or amount, but the term "contingent" in this Standard is used for liabilities and assets that are not recognised.

3. RECOGNITION

Provisions - Three Recognition Criteria (Paragraph 14)

A provision shall be recognised when:

- (a) an entity has a present obligation (legal or constructive) as a result of a past event;

- (b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and

- (c) a reliable estimate can be made of the amount of the obligation.

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If these conditions are not met, no provision shall be recognised.

Present Obligation (Paragraphs 15-16)

In rare cases where it is not clear whether a present obligation exists:

A past event is deemed to give rise to a present obligation if, taking account of all available evidence, it is more likely than not that a present obligation exists at the end of the reporting period.

Decision Framework:

Past Event - Obligating Event (Paragraphs 17-22)

A past event that leads to a present obligation is called an obligating event. For an event to be an obligating event, it is necessary that the entity has no realistic alternative to settling the obligation created by the event.

Two ways an entity has no realistic alternative:

Key Principles:

Examples of Obligating Events:

Probable Outflow (Paragraphs 23-24)

For the purpose of this Standard, an outflow of resources or other event is regarded as probable if the event is more likely than not to occur, i.e., the probability that the event will occur is greater than the probability that it will not.

For similar obligations (e.g., warranties):

Reliable Estimate (Paragraphs 25-26)

Except in extremely rare cases, an entity will be able to determine a range of possible outcomes and can therefore make an estimate of the obligation that is sufficiently reliable to use in recognising a provision.

In the extremely rare case where no reliable estimate can be made, the liability is disclosed as a contingent liability.

Contingent Liabilities (Paragraphs 27-30)

An entity shall not recognise a contingent liability.

Treatment:

Contingent Assets (Paragraphs 31-35)

An entity shall not recognise a contingent asset.

Treatment:

4. MEASUREMENT

Best Estimate (Paragraphs 36-41)

The amount recognised as a provision shall be the best estimate of the expenditure required to settle the present obligation at the end of the reporting period.

Best Estimate Definition:

The amount that an entity would rationally pay to settle the obligation at the end of the reporting period or to transfer it to a third party at that time.

Measurement Approaches:

Example - Expected Value (Warranties):

An entity sells goods with a warranty. If minor defects were detected in all products sold, repair costs of $1 million would result. If major defects were detected in all products sold, repair costs of $4 million would result. Past experience indicates: 75% no defects, 20% minor defects, 5% major defects.

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Expected value = (75% × $0) + (20% × $1m) + (5% × $4m) = $400,000

Key Points:

Risks and Uncertainties (Paragraphs 42-44)

The risks and uncertainties that inevitably surround many events and circumstances shall be taken into account in reaching the best estimate of a provision.

Guidance:

Present Value (Paragraphs 45-47)

Where the effect of the time value of money is material, the amount of a provision shall be the present value of the expenditures expected to be required to settle the obligation.

Discount Rate Requirements:

Future Events (Paragraphs 48-50)

Future events that may affect the amount required to settle an obligation shall be reflected in the amount of a provision where there is sufficient objective evidence that they will occur.

Examples:

New Legislation:

Expected Disposal of Assets (Paragraphs 51-52)

Gains from the expected disposal of assets shall not be taken into account in measuring a provision.

This applies even if the expected disposal is closely linked to the event giving rise to the provision.

5. REIMBURSEMENTS (Paragraphs 53-58)

Where some or all of the expenditure required to settle a provision is expected to be reimbursed by another party, the reimbursement shall be recognised when, and only when, it is virtually certain that reimbursement will be received if the entity settles the obligation.

Key Requirements:

Three Scenarios:

6. CHANGES IN PROVISIONS (Paragraphs 59-60)

Provisions shall be reviewed at the end of each reporting period and adjusted to reflect the current best estimate. If it is no longer probable that an outflow of resources embodying economic benefits will be required to settle the obligation, the provision shall be reversed.

Discounting Effect:

7. USE OF PROVISIONS (Paragraphs 61-62)

A provision shall be used only for expenditures for which the provision was originally recognised.

Only expenditures that relate to the original provision are set against it. Setting expenditures against a provision that was originally recognised for another purpose would conceal the impact of two different events.

8. APPLICATION OF RECOGNITION AND MEASUREMENT RULES

Future Operating Losses (Paragraphs 63-65)

Provisions shall not be recognised for future operating losses.

Reasons:

Alternative Treatment:

Onerous Contracts (Paragraphs 66-69)

If an entity has a contract that is onerous, the present obligation under the contract shall be recognised and measured as a provision.

Definition:

An onerous contract is a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.

Unavoidable Costs:

The unavoidable costs under a contract reflect the least net cost of exiting from the contract, which is the lower of:

- (a) the cost of fulfilling it; and

- (b) any compensation or penalties arising from failure to fulfil it.

Cost of Fulfilling a Contract (Paragraph 68A):

The cost of fulfilling a contract comprises the costs that relate directly to the contract. Costs that relate directly to a contract consist of both:

- (a) the incremental costs of fulfilling that contract—for example, direct labour and materials; and

- (b) an allocation of other costs that relate directly to fulfilling contracts—for example, an allocation of the depreciation charge for an item of property, plant and equipment used in fulfilling that contract among others.

Before Recognising Onerous Contract Provision:

Before a separate provision for an onerous contract is established, an entity recognises any impairment loss that has occurred on assets used in fulfilling the contract (see HKAS 36).

Restructuring (Paragraphs 70-83)

Examples of Restructuring:

Recognition Criteria:

A provision for restructuring costs is recognised only when the general recognition criteria for provisions set out in paragraph 14 are met.

Constructive Obligation to Restructure (Paragraph 72):

A constructive obligation to restructure arises only when an entity:

- (a) has a detailed formal plan for the restructuring identifying at least:

- (i) the business or part of a business concerned;

- (ii) the principal locations affected;

- (iii) the location, function, and approximate number of employees who will be compensated for terminating their services;

- (iv) the expenditures that will be undertaken; and

- (v) when the plan will be implemented; and

- (b) has raised a valid expectation in those affected that it will carry out the restructuring by starting to implement that plan or announcing its main features to those affected by it.

Timing of Obligation:

What a Restructuring Provision Includes:

A restructuring provision shall include only the direct expenditures arising from the restructuring, which are those that are both:

- (a) necessarily entailed by the restructuring; and

- (b) not associated with the ongoing activities of the entity.

What a Restructuring Provision EXCLUDES:

9. DISCLOSURE

Provisions - Movement Schedule (Paragraph 84)

For each class of provision, disclose:

Comparative information is NOT required.

Provisions - Narrative Disclosures (Paragraph 85)

For each class of provision, disclose:

Contingent Liabilities (Paragraph 86)

Unless the possibility of outflow is remote, disclose for each class:

Contingent Assets (Paragraphs 89-90)

Where inflow of economic benefits is probable, disclose:

Disclosures for contingent assets should avoid giving misleading indications of the likelihood of income arising.

Aggregation of Classes (Paragraph 87)

Consider whether items are sufficiently similar for a single statement. For example:

Disclosure Exemption (Paragraph 92)

In extremely rare cases, disclosure of some or all of the information required by paragraphs 84-89 can be expected to prejudice seriously the position of the entity in a dispute with other parties on the subject matter of the provision, contingent liability or contingent asset. In such cases, an entity need not disclose the information, but shall disclose the general nature of the dispute, together with the fact that, and reason why, the information has not been disclosed.

10. DECISION TREE AND IMPLEMENTATION GUIDANCE

Recognition Decision Tree

The Standard includes a decision tree (Implementation Guidance B) summarising the main recognition requirements:

Summary Tables (Implementation Guidance A)

Provisions and Contingent Liabilities:

Contingent Assets:

Reimbursements:

11. TRANSITIONAL PROVISIONS AND EFFECTIVE DATE

Onerous Contracts Amendments (Paragraphs 94A, 105)

The amendments "Onerous Contracts—Cost of Fulfilling a Contract" (issued June 2020):

Effective Date (Paragraph 95)

This Standard becomes operative for annual financial statements covering periods beginning on or after 1 January 2005. Earlier application is encouraged.

KEY TAKEAWAYS SUMMARY TABLE

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