This is from the “Accounting Makes Cents” podcast episode #48 released on Monday, 11 September 2023.
In today’s episode, we are going to unravel the complexities of IAS 37, the International Financial Reporting Standard governing provisions, contingent liabilities, and contingent assets. In our everyday lives, we often encounter situations that mirror the principles of IAS 37, whether we’re budgeting for household expenses or preparing for unexpected emergencies. We’ll explore how provisions are budgeted for and managed, and how contingent liabilities require us to be prepared.
Jump to show notes.
So what we’ll be doing is to address what we might all be wondering about, which is: “What’s IAS 37, and how does it relate to my everyday life?” Jokes aside. What I wanted to do today is to see how we can make this financial standard come to life through a relatable example, something like homeownership, and then we’ll explore how it applies in a business setting.
Provisions in a home setting
So let’s start with the basics: provisions. Think of these as the regular, expected expenses in your life, much like managing a household budget. When you own a home, there are bills you know you’ll have to pay, like your mortgage or rent, utility bills, groceries, and insurance premiums.
Imagine you’re the homeowner, and your household budget is your financial statement. Just like businesses, you allocate a portion of your income to cover these known costs, ensuring that you have enough money set aside when they come due.
So as an aside, here’s a practical tip if you’re a homeowner: it’s always good practice to create a monthly budget spreadsheet. List all your expected expenses, allocate funds accordingly, and track your spending to ensure you’re on target.
Contingent liability in a home setting
Now, let’s talk about contingent liabilities – the surprises that life throws our way. As a homeowner, you know there’s always a chance of the unexpected: you know your roof starts leaking during a heavy rainstorm, or your car could break down and you need to have it fixed.
Just like in accounting, you acknowledge the possibility of these surprises and set aside some emergency funds to deal with these when they occur. It’s like having a financial safety net.
Again as an aside, another practical tip if you’re a homeowner: build an emergency fund. Aim to save at least three to six months’ worth of living expenses. These funds should act as your contingent liability reserve, providing you with peace of mind and financial security when the unexpected happens.
Segue – home to business setting
So, now we’re going to try to match it up and relate it back to IAS 37. IAS 37 is like the accounting rulebook that businesses follow to manage their financial obligations and uncertainties. It’s the professional framework that ensures companies are as well-prepared like a diligent homeowner.
IAS 37 is the financial compass, guiding businesses in setting aside funds for known expenses, such as provisions, and then they also acknowledge the possibility of unexpected financial hurdles, like contingent liabilities. Just as homeowners budget and build an emergency fund, businesses use IAS 37 to plan and safeguard their financial health.
Provisions in a business setting
In a business context, provisions are like the expected costs that a company anticipates, such as paying employee salaries, repaying back debt, or covering ongoing operational expenses. These are recorded as liabilities in the company’s balance sheet and are crucial for accurate financial reporting. You have to report it. If you haven’t paid it by the reporting date, you have to record these as accrued.
Contingent liability in a business setting
On the other side of things, we also have contingent liabilities in business. These are like the unexpected events, as mentioned, that can impact a company’s financial health. For instance, if your business is in manufacturing and you manufacture a product. There’s always a contingent liability associated with product if we have to recall them or there’s some issues with them and get into a legal dispute. While you can’t predict when these events would happen, because you never know what could happen with your products, you’re not really sure if it’s going to break down or anything, or if it’s going to be faulty or anything, you must always be prepared.
If you ever come into a scenario where a customer sues your company for a product-related injury, and you didn’t anticipate this, it’s now going to be a potential financial obligation. So under IAS 37, you would disclose this contingent liability in your financial statements, even if the outcome is uncertain. This provides transparency to your investors and creditors.
Technical definition of IAS 37
Now, I want to just be serious for a moment and discuss the technicality of this accounting standard, the rules and conditions surrounding its use.
IAS 37 provides a comprehensive framework for recognising, measuring, and disclosing provisions, contingent liabilities, and contingent assets in the financial statements. This standard ensures uniformity and consistency in how entities account for and disclose obligations, uncertainties, and potential assets.
One of the primary areas addressed by IAS 37 is provisions. Provisions, in the context of this standard, are liabilities with uncertain timing or amount. So you’re not really quite sure when it’s gonna happen. You know it’s gonna happen but just not exactly when. Or maybe perhaps, you don’t have the exact numbers, but you can reliably estimate it. Provisions are recognized when:
1. There is a present obligation, either legal or constructive, as a result of past events.
2. There is an outflow of resources embodying economic benefits and it is probable that it’s gonna happen
3. The amount of the obligation can be reliably estimated. It doesn’t say 100% exact numbers but you can reliably estimate it.
Provisions are recorded in the financial statements as liabilities, and the amount reflects the best estimate of the expenditure required to settle the obligation. Provisions are reviewed at each reporting date, and adjustments are made to reflect the best estimate at that time.
Now where does contingent liability come in? IAS 37 also addresses contingent liabilities. Now these are potential obligations that may arise from past events. So they’re actually very similar to provisions, except that for contingent liability…one of the things that is big difference between provisions and contingent liability is that contingent liability is not an entry that you record in the books. It’s a note that you disclose in the financial statements where you actually speak about the possibility that an outflow could happen depending on the outcome. Contingent liabilities are assessed based on whether it is probable or remote that an outflow of resources will be required to settle the obligation. So they may relate to legal disputes, warranty claims, or other uncertainties.
On the flip side, there is also contingent assets, which could arise from past events. They are not recognised in the financial statements but are disclosed if the realisation is probable. These are potential future economic benefits that may flow into the entity.
IAS 37 places significant emphasis on disclosure requirements. Companies are required to provide extensive information in the financial statements about the nature and amount of provisions, the timing of expected outflows, and the uncertainties surrounding the obligations. Disclosure of contingent liabilities and, in certain cases, contingent assets are also mandatory to provide a comprehensive view of a company’s financial position and potential risks.
IAS 37, although technically intricate, it does play a pivotal role in financial reporting, both in everyday life of people and the business world. Its principles of provisions, contingent liabilities, and contingent assets ensure that financial statements present a true and fair view of an entity’s financial position.
Conclusion
And there you have it, that’s a glimpse into the world of IAS 37, provisions, and contingent liabilities, both in our everyday lives and in the business world. Remember, whether you’re budgeting for your home or you’re assessing a company’s financial health, the principles of IAS 37 are all around us.
Show notes simplified
In this episode, MJ the tutor explores how everyday situations can mirror the principles of IAS 37, the accounting standard governing provisions and contingent liabilities and contingent assets.
Credits:
“Ding Ding Small Bell” (https://freesound.org/s/173932/) by JohnsonBrandEditing (https://www.youtube.com/channel/UC1RImxnsbfngagfXd_GWCDQ) licensed under CC0 Licence.
MJ THE TUTOR 