IAS 37 provisions: when your business owes something it can't quite measure

IAS 37 provisions deal with one of the most uncomfortable corners of accounting: the bills you know are coming but can't yet put an exact number on. A warranty claim that hasn't arrived. A lawsuit that hasn't settled. A lease on premises you no longer use. Your business owes something — you just don't know precisely how much, or exactly when you'll pay it.

Most small business owners handle these in one of two wrong ways: they ignore the obligation until the invoice lands, which understates what the business owes, or they book a vague "just in case" reserve, which overstates it and quietly smooths profits. IAS 37 exists to draw the line between those two mistakes.

IAS 37 provisions: the three recognition tests

Under IAS 37, you recognise a provision — a real liability on your balance sheet — only when all three conditions are met at the same time:

1. A present obligation from a past event. Something has already happened that leaves you with no realistic alternative but to pay. The obligation can be legal, like a contract or a law, or constructive: you have created a valid expectation through past practice, published policies, or a specific statement — a shop that has always honoured warranty repairs has a constructive obligation even before any customer complains.

2. A probable outflow of resources. "Probable" in IAS 37 means more likely than not — better than a 50% chance that money will leave the business. If the outflow is only possible, not probable, you don't have a provision.

3. A reliable estimate can be made. You don't need the exact figure — a defensible one will do. If no reliable estimate is possible, which is rare, you disclose rather than recognise.

Miss any one of these three, and there is no provision. That discipline is the whole point: provisions are not a general cushion against bad luck. A business may not provide for future operating losses, future repairs, or a downturn it merely fears. Until a past event creates a present obligation, there is nothing to recognise.

IAS 37 provisions: how big should the number be?

A provision is measured at the best estimate of the amount needed to settle the obligation at the reporting date:

• A single obligation, like one lawsuit, is measured at the most likely outcome, adjusted if other outcomes are much higher or lower.
• A large population, like hundreds of warranty claims, is measured using expected value: weight each possible outcome by its probability. If 5% of products sold typically need a $40 repair, the provision is roughly 5% of units sold times $40.
• Long-dated obligations are discounted to present value when the time value of money is material. A decommissioning cost payable in ten years is carried at present value, using a pre-tax discount rate reflecting market assessments and the liability's specific risks; the discount unwinds over time as a finance cost.

Provisions are reviewed at every reporting date and adjusted to the current best estimate. If the obligation will not materialise, the provision is reversed.

If a third party will reimburse some of the cost — an insurer, for example — recognise that reimbursement as a separate asset only when it is virtually certain. Never net it off against the provision.

IAS 37 provisions vs contingent liabilities

The most common IAS 37 mistake is confusing a provision with a contingent liability — the difference decides whether anything appears on your balance sheet.

A contingent liability is a possible obligation that depends on an uncertain future event, or a present obligation where the outflow is not probable or the amount cannot be reliably estimated. You do not recognise it. You disclose it in the notes, describing its nature and, where practicable, an estimate of its financial effect. A lawsuit you expect to win is usually a contingent liability: possible, not probable — disclosed, not booked.

The mirror image is a contingent asset: a possible inflow from a past event. Contingent assets are never recognised until the inflow is virtually certain, and disclosed only when an inflow is probable. This asymmetry is deliberate: accounting is cautious about gains before they are certain, and stricter about obligations.

Three everyday examples for a small business

Warranties. You sell appliances with a one-year warranty. Past experience says 4% come back, at an average repair cost of $60. Each sale creates a present obligation with a probable outflow and a reliable estimate from your own history. Book the provision at sale, not when the customer complains.

An onerous contract. You lease a shop for $2,000 a month but closed the branch. The lease still has a year to run, and subletting would fetch only $800 a month. The unavoidable costs exceed the benefits — an onerous contract under IAS 37, so you recognise a provision for the lower of the cost of fulfilling the contract and the penalties for exiting it. You cannot, however, provide for the future rent of a shop you still plan to use: that is a future operating cost, not a present obligation.

A restructuring. You have decided to close a division. You can only provide for the direct costs of that restructuring — and only once you have a detailed formal plan and have raised a valid expectation in those affected, for example by announcing it. Retraining staff, marketing the relaunched business, and investment in new systems are future costs, not restructuring provisions.

Why this matters even if nobody audits you

You may never prepare full IFRS financial statements. But the thinking behind IAS 37 provisions is useful in any business: face obligations when they arise, estimate them honestly, and disclose what is uncertain instead of hiding it.

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