Measurement of Provision – Ind AS 37
- The amount of the provision should be measured at the best estimate of the expenditures required to satisfy the obligation at the end of the reporting period
- As you can see, here’s some judgment and estimates involved. Management should really incorporate all available information in their estimates, and they must not forget about:
- Risks and uncertainties (like inflation)
- Time value of money (discounting when the settlement is expected in the long-term future)
- Some probable future events, etc
- There are 2 basic methods of measuring a provision
- Expected value method: You would use this method when you have a range of possible outcomes or you measure the provision for large amount of items. In this case, you need to weight each outcome by its probability (for example, warranty repair costs for 10,000 products).
- The most likely outcome: This method is suitable in the case of a single obligation or just 1 item (for example, provision for loss in the court case).
Example: Expected value method
An entity is a retail chain distributing shoes. It faces 200 legal claims filed by its distributors. Each with a 30 per cent likelihood of success with no cost and a 70 per cent likelihood of failure with the cost of each claim to be Rs. 20,000.
Using expected value method, the best estimate of the provision should be measured using the following formula:
70% × 200 claims × Rs. 20,000 per claim = Rs 28,00,000.
Example: Most likely outcome method
An entity has a legal claim for damages filed by its customer of Rs. 2.50 million. There is a 40% chance that the entity will win the case and no cost will be involved. However, there is a 60% chance that decision will not be in the favor of the entity and it will have to pay for the damages.
In this case the outcome will either be zero cost or a cost of Rs. 2.5 million. As per paragraph 40 of Ind AS 37 “where a single obligation is being measured, the individual most likely outcome may be the best estimate of the liability.”
In this example, the provision should be measured at the most likely outcome which is Rs. 2.5 million.
When the provision relates to a single event, or a small number of events, expected value is not a valid Technique
- The amount recognized as a provision shall be the best estimate of the expenditure required to settle the present obligation at the end of the reporting period.
- The best estimate of the expenditure required to settle the present obligation is 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.
- The estimates of outcome and financial effect are determined by the judgment of the management of the entity, supplemented by experience of similar transactions and, in some cases, reports from independent experts.
- Uncertainties surrounding the amount to be recognized as a provision are dealt with by various means according to the circumstances.
- Where the provision being measured involves a large population of items, the obligation is estimated by weighting all possible outcomes by their associated probabilities.
- The name for this statistical method of estimation is ‘expected value’. The provision will therefore be different depending on whether the probability of a loss of a given amount is, for example, 60 per cent or 90 per cent.
- Where there is a continuous range of possible outcomes, and each point in that range is as likely as any other, the mid-point of the range is used.
- The provision is measured before tax, as the tax consequences of the provision, and changes in it, are dealt with under Ind AS 12.
An entity sells goods with a warranty under which customers are covered for the cost of repairs of any manufacturing defects that become apparent within the first six months after purchase.
If minor defects were detected in all products sold, repair costs of Rs 1 million would result. If major defects were detected in all products sold, repair costs of Rs 4 million would result.
The entity’s past experience and future expectations indicate that, for the coming year, 75 per cent of the goods sold will have no defects, 20 per cent of the goods sold will have minor defects and 5 per cent of the goods sold will have major defects.
In accordance with paragraph 24, an entity assesses the probability of an outflow for the warranty obligations as a whole.
The expected value of the cost of repairs is:
(75% of nil) + (20% of 1m) + (5% of 4m) = Rs 400,000
Where a single obligation is being measured, the individual most likely outcome may be the best estimate of the liability. However, even in such a case, the entity considers other possible outcomes. Where other possible outcomes are either mostly higher or mostly lower than the most likely outcome, the best estimate will be a higher or lower amount.
If an entity has to rectify a serious fault in a major plant that it has constructed for a customer, the individual most likely outcome may be for the repair to succeed at the first attempt at a cost of Rs 1,000, but a provision for a larger amount is made if there is a significant chance that further attempts will be necessary.
Risks and Uncertainties
- The risks and uncertainties that inevitably surround many events and circumstances are taken into account in reaching the best estimate of a provision
- Risk describes variability of outcome. A risk adjustment may increase the amount at which a liability is measured
- Caution is needed in making judgments under conditions of uncertainty, so that income or assets are not overstated, and expenses or liabilities are not understated
- However, uncertainty does not justify the creation of excessive provisions or a deliberate overstatement of liabilities
- 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
- The time value of money is the greater benefit of receiving money now rather than an identical sum later
- For example, Rs. 100 invested for one year, earning 5% interest, will be worth Rs. 105 after one year; therefore, Rs. 100 paid now and Rs. 105 paid exactly one year later both have the same value to a recipient who expects 5% interest assuming that inflation would be zero percent
- That is, Rs. 100 invested for one year at 5% interest has a future value of Rs. 105 under the assumption that inflation would be zero percent
- Because of the time value of money, provisions relating to cash outflows that arise soon after the reporting period are more onerous than those where cash outflows of the same amount arise later. Provisions are therefore discounted, where the effect is material
- The discount rate (or rates) shall be a
- pre-tax rate (or rates)
- that reflect(s) current market assessments of the time value of money and
- the risks specific to the liability
- The discount rate(s) shall not reflect risks for which future cash flow estimates have been adjusted
- Let’s understand the requirement of discounting by using an example-
There is a court case which is currently ongoing and as per the letter received from legal counsel it is estimated that an amount of INR 10,000,000 (ten million Indian rupees) will required to be paid after two years. Discounting will be done using Pre tax-risk-free government bond rate i.e. 5% (assumed). [Make sure One takes bonds with the similar maturity as the liability settlement time (e.g. when one expects to settle the liability in 2 years, then one should take bonds with maturity in 2 years).]
At the initial recognition it will be recognized based on its present value as per the table below-
Notes and guidance summary
Below are some of the notes and guidance summary for the concept mentioned above –
- Provisions are being made based on constructive and legal liability as defined by Ind AS 37.
- Provisions are those in which amount and timing of cash outflow is not certain and hence it is being calculated based on estimation as prescribed within the standard. Since there is no contractual obligation exists hence this will not be a financial liability because these provisions are being made based on constructive obligations only and that is the reason these provisions are being specifically scoped out from the financial instrument’s standard,
- Now, relevant Para requires recognizing those provisions at its present value where the time value of money is material. It will certainly be a judgmental area where the management can define a threshold limits based on assets size of its recent financial or profits and accordingly the process can be embedded into the system itself to calculate all eligible provisions for discounting,
- Present value will be calculated using a risk- free pre-tax rate of government bond (yield rate and not coupon rate) for that period and recognize the present value in the financial statements. Then each year a borrowing cost will be calculated which will be debited to the profit and loss account and corresponding credit amount will add into the initially recognize liability by which that liability will reach to its face value at the end of year of payment (refer example above),
- In the example, what essentially requires by the standard is to recognize 10M INR at its discounted value i.e INR 9.07M and then each year this amount will keep on increasing and corresponding amount will be part of borrowing cost (debited to PL) and if it will be added together by using all such borrowing costs and initially recognized present value of the provision, then it will end up getting full value of provision i.e. 10 M (initial value),
When a provision has a long-term nature (beyond 12 months), then there’s some discounting involved as you need to present it in its present value. In each reporting period, your account for an interest on the opening balance of the provision and this is called “unwinding the discount“.
You should recognize the interest in profit or loss and it also increases the amount of a provision
- 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
- Expected future events may be particularly important in measuring provisions
An entity may believe that the cost of cleaning up a site at the end of its life will be reduced by future changes in technology.
- The amount recognized reflects a reasonable expectation of technically qualified, objective observers, taking account of all available evidence as to the technology that will be available at the time of the clean-up.
- Thus, it is appropriate to include, for example, expected cost reductions associated with increased experience in applying existing technology or the expected cost of applying existing technology to a larger or more complex clean-up operation than has previously been carried out.
The effect of possible new legislation is taken into consideration in measuring an existing obligation when sufficient objective evidence exists that the legislation is virtually certain to be enacted.
Evidence is required both of what legislation will demand and of whether it is virtually certain to be enacted and implemented in due course. In many cases sufficient objective evidence will not exist until the new legislation is enacted.
Expected disposal of assets
- Gains from the expected disposal of assets shall not be taken into account in measuring a provision
- Gains on the expected disposal of assets are not taken into account in measuring a provision, even if the expected disposal is closely linked to the event giving rise to the provision. Instead, an entity recognizes gains on expected disposals of assets at the time specified by the Standard dealing with the assets concerned
At the end of 2020, an entity is demonstrably committed to the closure of some facilities, having drawn up a detailed plan and made appropriate announcements. The expected impact of the plan is as follows:
The provision required at the end of 2020 is CU 100 Million (ignoring discounting.) The expected gain on sale of the property is dealt with separately under the derecognition criteria in Ind AS 16 Property plant and equipment.
- Where some or all of the expenditure required to settle a provision is expected to be reimbursed by another party, the reimbursement shall be recognized when, and only when, it is virtually certain that reimbursement will be received if the entity settles the obligation
- The reimbursement shall be treated as a separate asset
- The amount recognized for the reimbursement shall not exceed the amount of the provision
- In the statement of profit and loss, the expense relating to a provision may be presented net of the amount recognized for a reimbursement
- Sometimes, entities have right to reimbursement of related expenditures by the third party (e.g. from an insurance company)
- In this case, a right to reimbursement is recognized as a separate asset (no netting off with the provision itself), but you can net off the expenses for provision with the income from reimbursement in the profit or loss
- In most cases the entity will remain liable for the whole of the amount in question so that the entity would have to settle the full amount if the third party failed to pay for any reason. In this situation, a provision is recognized for the full amount of the liability, and a separate asset for the expected reimbursement is recognized when it is virtually certain that reimbursement will be received if the entity settles the liability
Assume that after a natural disaster, Entity A recognizes a CU1 million provision for its obligation for environmental rehabilitation, which it will undertake itself. Entity A’s insurance policy covers the cost of hiring an external contractor to perform the environmental rehabilitation. Before the end of the reporting period, the insurer has confirmed it will pay Entity A up to CU1.5 million as the environmental rehabilitation is performed. Entity A would recognize a CU1 million provision for environmental rehabilitation costs and a corresponding virtually certain insurance reimbursement asset that is limited to CU1m. Any increase in the estimate of the rehabilitation costs to be incurred up to CU1.5 million would result in a corresponding increase in the amount recognized for the reimbursement asset.