How to Audit Provisions, Contingent Liabilities and Contingent Assets Under IAS 37

The IAS 37.14 recognition test and why “probable” trips people up

IAS 37.14 sets out the recognition criteria. Three conditions must hold simultaneously: a present obligation exists as a result of a past event, it is probable that an outflow of economic benefits will be required to settle the obligation, and the amount can be reliably estimated. If any one fails, you’re either in contingent liability territory (disclose) or you do nothing (if the possibility of outflow is remote).

“Probable” under IFRS means more likely than not. That’s a 50%+ threshold.

This is lower than the “probable” threshold under US GAAP (which sits closer to 75% to 80% in practice), and the difference matters when auditing entities with dual reporting obligations or when using US-originated templates. If your client’s legal counsel says “the claim is more likely than not to result in a payment,” IAS 37.14 is satisfied. You don’t need near-certainty.

The “reliable estimate” condition in IAS 37.14(c) rarely fails in practice. IAS 37.25 states that except in extremely rare cases, an entity will be able to determine a range of possible outcomes and therefore make a sufficiently reliable estimate. If the client argues that the amount “cannot be estimated,” push back. The standard’s expectation is that measurement uncertainty alone almost never justifies non-recognition. Measurement uncertainty goes into the estimate (a wider range of outcomes, a different probability weighting), not into the recognition decision.

Present obligation versus possible obligation: where the line falls

The first condition in IAS 37.14 requires a present obligation from a past event. This sounds straightforward until you encounter situations where the past event has occurred but the obligation depends on a future event.

IAS 37.15 clarifies: in rare cases, it is not clear whether a present obligation exists. In those cases, a past event is deemed to give rise to a present obligation if, taking account of all available evidence, it is more probable than not that a present obligation exists at the reporting date. If that threshold isn’t met, the entity discloses a contingent liability (unless the possibility of outflow is remote).

Consider the classic example: litigation. Your client was served a claim in October. The entity’s lawyers say the claim has legal merit but they believe the defence is strong. Does a present obligation exist?

The past event (the incident giving rise to the claim) has occurred. Whether the entity has a present obligation depends on whether the claim will succeed. If legal counsel says the probability of the entity losing is 55%, a present obligation exists under IAS 37.15 and you’re into the measurement phase. If the probability is 45%, no provision is recognised, but the entity discloses a contingent liability under IAS 37.86.

Constructive obligations add complexity. IAS 37.10 defines a constructive obligation as one that derives from an entity’s actions where the entity has indicated to other parties that it will accept certain responsibilities, and as a result has created a valid expectation that it will discharge those responsibilities. A company that has consistently honoured product warranties beyond the contractual period has created a constructive obligation. What matters here is the pattern of behaviour, not the individual sale.

Your working paper should explicitly state whether each provision is based on a legal or constructive obligation, identify the past event, and cite the evidence supporting the conclusion that a present obligation exists at the reporting date.

Measurement: expected value versus most likely outcome

IAS 37.36 requires the amount recognised as a provision to be the best estimate of the expenditure required to settle the present obligation at the reporting date. But “best estimate” is not a single method.

IAS 37.39 and IAS 37.40 give you two measurement approaches, and the choice depends on the nature of the obligation.

For a large population of similar items (warranty claims, product returns, volume rebate disputes), IAS 37.39 requires the expected value method: a probability-weighted average across the range of possible outcomes. If 5% of items sold will need a €200 repair and 2% will need a €500 replacement, the expected value per unit is (5% × €200) + (2% × €500) = €20. Multiply by the number of units under warranty.

For a single obligation (a specific piece of litigation, a single onerous lease, a decommissioning obligation for one site), IAS 37.40 permits using the individual most likely outcome. A lawsuit with a 60% chance of resulting in a €1M payment and a 20% chance of a €5M payment has a most likely outcome of €1M and an expected value of €1.6M.

Same inputs. 60% difference.

IAS 37.40 adds an important caveat: even when using the most likely outcome for a single obligation, the entity considers other possible outcomes. If those other outcomes are mostly higher than the most likely outcome (as in the lawsuit example above), the most likely outcome alone may understate the provision, and the entity should consider whether a higher amount is more appropriate. Your working paper needs to document which method was used, why that method was selected, and (for most likely outcome) whether other possible outcomes were considered.

The error you’ll see most often: applying the most likely outcome to a warranty population. A portfolio of 10,000 warranty claims is not a single obligation. Expected value applies. Conversely, applying expected value to a single lawsuit with only two possible outcomes (win or lose) usually produces a number that doesn’t represent any realistic settlement scenario.

Discounting under IAS 37.45 and when it actually matters

IAS 37.45 requires the provision to be discounted when the effect of the time value of money is material. The discount rate is a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability (IAS 37.47). The rate does not reflect risks for which future cash flow estimates have already been adjusted.

In practice, discounting matters for provisions with settlement dates more than two years out. A decommissioning obligation payable in fifteen years is significantly overstated if recognised at the undiscounted amount. A warranty provision expected to settle within twelve months doesn’t need discounting.

The audit question is whether the client has considered discounting for long-dated provisions. Many mid-tier entities don’t discount any provisions because all their obligations are short-term. That’s fine if it’s true. But a restructuring provision with redundancy payments phased over eighteen months, or a legal claim expected to take four years to resolve, may cross the materiality threshold for discounting.

When discounting applies, the unwinding of the discount is recognised as a finance cost in profit or loss (IAS 37.60). This is a separate line from the charge for the provision itself. If the client has a discounted provision but isn’t recognising the unwinding charge, the interest expense line is understated.

Document whether discounting was considered. If the conclusion is that discounting is immaterial, state the expected settlement timeframe and the discount rate that would apply if it were material. This protects you if a reviewer challenges the conclusion.

Restructuring provisions and the IAS 37.72 conditions

IAS 37.72 sets conditions that are more restrictive than the general IAS 37.14 recognition test. An entity recognises a restructuring provision only when it has a detailed formal plan identifying at minimum the business or part of the business concerned, the principal locations affected, the approximate number of employees who will be compensated for terminating their services, the expenditures that will be undertaken, and when the plan will be implemented.

The plan alone isn’t enough. IAS 37.72(b) requires the entity to have raised a valid expectation in those affected that it will carry out the restructuring, by starting to implement the plan or by announcing its main features to those affected. A board resolution to restructure, without any communication to affected employees or implementation activity, does not create a constructive obligation. The provision cannot be recognised.

This catches entities that want to recognise a restructuring provision at year-end based on a board decision made in December, where the announcement to staff happens in February. At 31 December, no valid expectation exists. No provision.

IAS 37.80 limits what the entity can include in a restructuring provision. Only direct expenditures arising from the restructuring qualify: these are expenditures that are both necessarily entailed by the restructuring and not associated with the ongoing activities of the entity. Retraining costs for retained employees, relocation costs for staff moving to a new site, and marketing costs for a rebranding are excluded. The provision covers severance, lease termination penalties, and similar exit costs only.

Your working paper should list each component of the restructuring provision, verify it meets the IAS 37.80 criteria, and confirm that the IAS 37.72 conditions (formal plan plus valid expectation) were met before the reporting date. Obtain the board resolution, the communication to employees (dated), and the detailed cost estimate.

Onerous contracts under IAS 37.66

IAS 37.66 defines an onerous contract as one in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. The unavoidable costs are the lower of the cost of fulfilling the contract and any compensation or penalties arising from failure to fulfil it.

A key change that took effect from 1 January 2022 (via amendments to IAS 37): the cost of fulfilling a contract now includes both costs that relate directly to the contract (incremental costs) and an allocation of other costs that relate directly to fulfilling contracts (such as depreciation of equipment used to perform the contract). Before the amendment, there was debate about whether “cost of fulfilling” meant only incremental costs or included allocated direct costs. The IASB settled it: allocated direct costs are in.

This affects manufacturing, construction, and service entities with fixed-price contracts. If your client has a fixed-price construction contract where the expected cost (including allocated depreciation of equipment on site and allocated project management salaries) exceeds the contract revenue, IAS 37.66 requires a provision for the onerous portion.

The audit procedure is a comparison: expected total costs to complete versus expected total benefits under the contract. If costs exceed benefits, the difference is a provision.

Many entities perform this assessment only at contract inception. IAS 37 requires it at every reporting date, because cost estimates change as contracts progress.

For entities with IFRS 15 revenue recognition, the onerous contract assessment under IAS 37 sits alongside the revenue recognition analysis but serves a different purpose. IFRS 15 determines how much revenue to recognise. IAS 37.66 determines whether an additional loss provision is needed beyond what IFRS 15 already captures.

Contingent liabilities: the disclosure most files miss

IAS 37.86 requires disclosure of contingent liabilities unless the possibility of outflow is remote. This covers situations where a possible obligation exists but confirmation depends on future events, and situations where a present obligation exists but either the outflow is not probable or the amount cannot be reliably estimated.

The disclosure must include a brief description of the nature of the contingent liability, an estimate of its financial effect where practicable, an indication of the uncertainties relating to the amount or timing of outflow, and the possibility of any reimbursement (IAS 37.86).

This is the area that generates the most inspection findings. Entities recognise provisions when the conditions are met but fail to disclose contingent liabilities when they aren’t. A lawsuit where the entity’s lawyers say the probability of losing is 40% doesn’t require a provision under IAS 37.14 (probability is below 50%), but it absolutely requires disclosure under IAS 37.86 unless the outflow is remote. “Remote” typically means less than 5% to 10% likelihood, though the standard doesn’t specify a threshold.

Your audit procedure for completeness of contingent liabilities should include: inquiry of management about pending claims and disputes, review of legal invoices and correspondence, confirmation from the entity’s external legal counsel (ISA 501.9 directs this procedure for litigation and claims), review of board minutes for references to disputes or regulatory actions, and review of post-balance-sheet events for litigation developments. If you find a claim that management hasn’t assessed, the default position is disclosure until management demonstrates the outflow is remote.

IAS 37.92 provides a narrow exemption: if disclosure of some or all of the information required by IAS 37.86 can be expected to prejudice seriously the entity’s position in a dispute, the entity need not disclose that specific information but must disclose the general nature of the dispute and the reason the information has not been disclosed. Clients sometimes try to use IAS 37.92 to avoid all contingent liability disclosure. The exemption applies to specific information that would prejudice the dispute, not to the existence of the contingent liability itself.

Worked example: Brinkman Bouw B.V.

Brinkman Bouw B.V. is a Dutch construction company with €62M revenue. At 31 December 2024, Brinkman has four items requiring IAS 37 assessment: (1) a warranty provision for defects on completed projects, covering approximately 200 completed units with a two-year warranty period; (2) a legal claim from a subcontractor alleging €380,000 in unpaid variation orders, where Brinkman’s lawyers assess a 65% probability of the entity having to pay between €200,000 and €380,000; (3) a restructuring of the residential division, with a board-approved plan communicated to affected staff on 12 December 2024; and (4) a fixed-price office fit-out contract where costs to complete now exceed the remaining contract revenue by €95,000.

Step 1: Warranty provision (large population, expected value method under IAS 37.39)

Brinkman’s warranty data from the past four years shows that 8% of completed units require minor defect repairs averaging €4,200 per unit, and 2% require major remediation averaging €18,000 per unit. With 200 units under warranty at year-end, the expected value is: (200 × 8% × €4,200) + (200 × 2% × €18,000) = €67,200 + €72,000 = €139,200.

Settlement is expected within 12 months. No discounting required.

Step 2: Legal claim (single obligation, most likely outcome under IAS 37.40)

The subcontractor’s claim of €380,000 is a single obligation. Legal counsel’s 65% probability assessment means the outflow is probable (above 50%). Recognition is required under IAS 37.14. Under IAS 37.40, the most likely outcome is the best estimate for a single obligation. Brinkman’s lawyers estimate the most likely settlement at €280,000, based on the strength of the subcontractor’s documentation for some but not all variation orders.

However, IAS 37.40 also requires consideration of other possible outcomes. The range runs from €200,000 (if the court accepts only the well-documented claims) to €380,000 (if the court accepts all claims). Because the outcomes skew higher than the most likely amount, the engagement team concludes that €280,000 remains appropriate but notes the range in the working paper.

Step 3: Restructuring provision (IAS 37.72 conditions)

The board approved the restructuring plan on 5 December 2024. The plan identifies the residential division, lists 18 affected employees across two sites (Rotterdam and Leiden), estimates €410,000 in severance costs and €35,000 in lease termination penalties, and sets implementation for Q1 2025. Management communicated the plan to affected staff on 12 December 2024. Both IAS 37.72 conditions are met before year-end.

The provision includes only severance (€410,000) and lease termination (€35,000) = €445,000. Retraining costs for the eight employees being redeployed to the commercial division (€28,000) are excluded under IAS 37.80.

Step 4: Onerous contract (IAS 37.66)

The fixed-price fit-out contract has remaining revenue of €520,000 and estimated costs to complete of €615,000 (including allocated depreciation of equipment on site and allocated project supervision costs). The loss on completion is €95,000. A penalty for termination would be €140,000. The unavoidable cost is the lower of fulfilment (€615,000) and termination (remaining revenue forgone plus €140,000 penalty = €660,000). Fulfilment is lower, so Brinkman will complete the contract. The provision is €95,000.

A reviewer sees four distinct obligations, each with the correct measurement method, specific IAS 37 paragraph references, and supporting evidence for every judgment.

Practical checklist

1. For each provision on the balance sheet, confirm the IAS 37.14 recognition criteria are met: present obligation from a past event, probable outflow, and reliable estimate. Document which criterion each provision satisfies and what evidence supports it.
2. Verify the measurement method matches the obligation type: expected value (IAS 37.39) for large populations, most likely outcome (IAS 37.40) for single obligations. If most likely outcome is used, confirm other possible outcomes were considered.
3. For restructuring provisions, obtain the formal plan and the dated communication to affected parties. If the communication postdates the reporting date, the provision cannot be recognised at year-end (IAS 37.72).
4. For onerous contracts, confirm the cost to complete includes allocated direct costs (not just incremental costs) per the 2022 IAS 37 amendment, and verify the assessment is performed at the reporting date rather than only at contract inception.
5. Run the contingent liability completeness procedures: legal counsel confirmation (ISA 501.9), board minute review, legal invoice review, and post-balance-sheet event review. Every claim where outflow is possible but not probable or not reliably estimable must be disclosed unless remote.
6. Check IAS 37.86 disclosures against your list of identified contingent liabilities. If any are missing, the disclosure note is incomplete.

Common mistakes

• Using the most likely outcome for warranty populations: IAS 37.39 requires expected value when there is a large population of similar obligations. The AFM’s inspection findings have noted that measurement method documentation is frequently absent from provision working papers, with auditors accepting the client’s number without verifying which method was applied.
• Failing to assess contingent liability disclosure completeness: Provisions get attention because they hit the balance sheet. Contingent liabilities get missed because they’re disclosure-only. The FRC’s 2022/23 inspection cycle identified incomplete contingent liability disclosures as a recurring finding, particularly for litigation and regulatory matters where the entity’s lawyers assessed the probability of outflow below 50%.

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Further reading and source references

• IAS 37, Provisions, Contingent Liabilities and Contingent Assets: the source standard governing recognition, measurement, and disclosure of provisions and contingent items.
• ISA 501, Audit Evidence – Specific Considerations for Selected Items: directs the legal confirmation procedure for litigation and claims.
• IFRS 15, Revenue from Contracts with Customers: the onerous contract assessment under IAS 37.66 sits alongside IFRS 15 revenue recognition for contract-based entities.
• IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors: applies when changes to provision estimates are made in subsequent periods.