According to IAS 37 accounting for provision, contingent liability and contingent assets, provision is the liability of uncertain timing or amount.
A liability is defined in the conceptual framework (para 4.4 (b)) as the 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.
A provision must meet the above definition. The expected in the definition of liability clearly allows for uncertainty. The timing and/or amount of the outflow of economic benefits may be uncertain. Hence, an estimate of these must be made when recording a provision in the books.
IAS 37 sets out strict guidelines regarding when provision should be recognized. This should be read both ways. The standard is equally strict in implying when provision must not be recognized. In the past, there was a tendency of the preparer of financial statements to abuse the prudence concept by over recognizing provisions based on the probability of outflow of economic benefits rather than the obligation to incur such outflow. This would have created a buffer of provisions that could be reversed by crediting profit and loss when profit boot was deemed desirable.
There are three conditions laid down by IAS 37, all of which must be met if the provision is to be recognized.
- A provision should be recognized when and only when:
- It is probable (that is more likely than not) that an outflow of resources embodying economic benefits will be required to settle the obligation; and
- A reliable estimate can be made of the amount of obligation. The standard notes that it is in extremely rare cases that a reliable estimate will not be possible.
- An entity has the present obligation (legal or constructive) as a result of a past event;