When must a company recognize a provision under IAS 37, and how is the provision measured?
I keep mixing up provisions, contingent liabilities, and contingent assets for CFA Level I. A practice question asked whether a company should recognize a provision for a pending lawsuit where the legal team said there was a 60% chance of losing $2 million. I got it wrong because I wasn't sure if 60% meets the 'probable' threshold. Can someone clarify the recognition rules?
IAS 37 draws a clear line between provisions that are recognized on the balance sheet and contingent liabilities that are only disclosed. The three recognition criteria must ALL be met simultaneously.
Recognition Criteria:
A provision is recognized when:
- Present obligation — the entity has a present legal or constructive obligation as a result of a past event
- Probable outflow — it is probable (more likely than not, i.e., >50%) that an outflow of economic benefits will be required to settle the obligation
- Reliable estimate — a reliable estimate of the amount can be made
Your lawsuit example:
Sentinel Corp is defending a product liability claim. Legal counsel estimates a 60% probability of losing and paying $2 million.
- Present obligation? Yes — the alleged defective product was sold (past event).
- Probable outflow? Yes — 60% > 50% threshold under IFRS.
- Reliable estimate? Yes — $2 million is the estimated settlement.
All three criteria met = Recognize a provision of $2,000,000
| Account | Debit | Credit |
|---|---|---|
| Litigation Expense (or Loss) | $2,000,000 | |
| Provision for Litigation | $2,000,000 |
IFRS vs US GAAP threshold:
This is critical for the exam:
| Standard | "Probable" Means | Typical Threshold |
|---|---|---|
| IFRS (IAS 37) | More likely than not | >50% |
| US GAAP (ASC 450) | Likely to occur | ~70-80% |
So a 60% probability triggers a provision under IFRS but likely would NOT under US GAAP — it would only be disclosed as a contingent liability.
Measurement:
- Best estimate of the expenditure required to settle the obligation at the reporting date.
- For a large population of items (e.g., warranty claims), use the expected value (probability-weighted average).
- For a single obligation (like a lawsuit), use the most likely outcome.
- If the time value of money is material, the provision is measured at its present value, with the unwinding of the discount recognized as a finance cost.
Contingent liabilities (disclosed only):
If the probability is possible (not probable) — say 30-40% under IFRS — no provision is recognized. Instead, the company discloses the nature, estimated financial effect, and uncertainties in the footnotes.
Contingent assets:
These are NEVER recognized. If the inflow is probable, it is disclosed. If virtually certain, it is recognized as an asset (but then it is no longer "contingent").
Exam tip: When a question describes a possible future payment, immediately ask: (1) Is there a present obligation from a past event? (2) Is outflow probable? (3) Can I estimate it? If all three are yes, book the provision.
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