Most provision files we see are SALY with a methodology shield bolted on top. You’re reviewing a client’s year-end provision schedule and there are four line items. A warranty provision, a legal claim, a restructuring provision, and an onerous contract. The financial controller has measured all four using the most likely outcome. Open IAS 37.39 and you’ll see that’s only correct for one of them. The measurement method depends on whether you’re dealing with a large population of obligations or a single obligation, and most files don’t document the choice.
The recognition framework is well known. IAS 37.14 requires a provision when a present obligation exists from a past event, an outflow of resources is probable, and the amount can be reliably estimated. Where those conditions are not met but the outflow is not remote, the entity discloses a contingent liability under IAS 37.86 .
Key Takeaways
- How to apply the IAS 37.14 recognition test and distinguish between provisions, contingent liabilities, and items that require neither recognition nor disclosure
- How to select the correct measurement method under IAS 37.39 (expected value) versus IAS 37.40 (most likely outcome) and document the rationale
- How to audit restructuring provisions under the specific conditions in IAS 37.72 and IAS 37.80
- Why the contingent liability disclosure requirements in IAS 37.86 are the most frequently missed element, and what your working paper should contain
The IAS 37.14 recognition test and why “probable” trips people up
IAS 37.14 sets out the recognition criteria. Three conditions must hold at the same time: 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 (when the possibility of outflow is remote).
“Probable” under IFRS means more likely than not. That’s a 50%+ threshold.
That sits below the “probable” threshold under US GAAP (which runs 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, or 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. That sounds straightforward until you encounter situations where the past event has occurred but the obligation depends on a future event.
IAS 37.15 clarifies that in rare cases, it is not clear whether a present obligation exists. When that happens, 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. Your client was served a litigation 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 and identify the past event. Cite the evidence supporting your 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, or 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, or a single onerous lease, or 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. The IAS 37 provision calculator computes both methods side by side so you can document the impact of the measurement choice.
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 WP needs to document which method was used and why that method was selected. For most likely outcome cases, also document whether other possible outcomes were considered.
The error you’ll see most often is 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. On the engagements we’ve worked, this is the line item where the WP most often reads “appears reasonable. Waive further pursuit.” without any actual recomputation behind it. This is the finding that generates the most review notes on the provisions section.
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 ). That sits on 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. That 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.
That 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, meaning expenditures that are both necessarily entailed by the restructuring and not associated with the ongoing activities of the entity. Retraining costs for retained employees and relocation costs for staff moving to a new site are excluded. So are marketing costs for a rebranding. The provision covers severance and lease termination penalties only.
Your WP 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 and the dated communication to employees. Cross-reference against 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 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.
That affects manufacturing and construction entities with fixed-price contracts, as well as service companies with similar arrangements. 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 onerous-contract test is the line we’ve seen the most disagreement about during partner review, because the “allocation” question swings the answer.
The audit procedure is a comparison of 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. That 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 cover several routes. 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.
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.
Documentation note: record the warranty claim history used (four-year data set from the client’s defects register), the defect rates and average repair costs by category, the number of units under warranty, and the expected value calculation. Cross-reference to IAS 37.39 for the expected value method and note that this is a large population of similar obligations.
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.
Documentation note: record the legal counsel assessment (source, date, probability estimate), the most likely outcome, the range of possible outcomes, and the conclusion on why the most likely outcome is the best estimate. Attach or cross-reference the legal confirmation letter obtained under ISA 501.9 .
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 .
Documentation note: obtain the board resolution (dated 5 December 2024), the communication to employees (dated 12 December 2024), and the detailed cost breakdown. Verify each cost component against IAS 37.80 . Document the exclusion of retraining costs with the paragraph reference.
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.
Documentation note: record the contract revenue, cost to complete (with breakdown showing both incremental and allocated direct costs per the 2022 IAS 37 amendment), the termination penalty, and the comparison. Cross-reference to IAS 37.66 and the contract documentation.
A reviewer sees four distinct obligations, each with the correct measurement method and specific IAS 37 paragraph references. Every judgment has supporting evidence attached.
Practical checklist
Common mistakes
- Using the most likely outcome method for warranty provisions covering a large population of items. 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%.
Related content
- IAS 37 provisions (glossary). Covers the recognition criteria and measurement methods in a shorter reference format.
- Financial ratio calculator. Useful for assessing whether provisions are material relative to key financial metrics and for testing the sensitivity of profitability ratios to provision adjustments.
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Frequently asked questions
When should the expected value method be used instead of the most likely outcome for measuring provisions?
IAS 37.39 requires the expected value (probability-weighted average) for a large population of similar items such as warranty claims or product returns. IAS 37.40 permits using the individual most likely outcome for a single obligation such as a specific lawsuit. Using the most likely outcome for a warranty population is the most common measurement error on provision working papers.
What conditions must be met before recognising a restructuring provision under IAS 37.72 ?
IAS 37.72 requires two conditions: a detailed formal plan identifying the business affected, locations, employees, expenditures, and timing; and a valid expectation raised in those affected by starting implementation or announcing the main features. A board resolution without communication to affected employees does not create a constructive obligation at the reporting date.
What costs can be included in a restructuring provision under IAS 37.80 ?
IAS 37.80 limits the provision to direct expenditures necessarily entailed by the restructuring and not associated with ongoing activities. This includes severance payments and lease termination penalties, but excludes retraining costs for retained employees, relocation costs, and marketing costs for rebranding.
How do you assess whether a contract is onerous under IAS 37.66 ?
Compare expected total costs to complete (including both incremental costs and allocated direct costs per the 2022 amendment) against expected total benefits under the contract. If costs exceed benefits, the difference is a provision. The unavoidable cost is the lower of fulfilment cost and termination cost. This assessment must be performed at every reporting date.
When must contingent liabilities be disclosed under IAS 37.86 ?
IAS 37.86 requires disclosure whenever the possibility of outflow is not remote. A lawsuit with a 40% probability of loss does not require a provision (below the 50% threshold) but absolutely requires disclosure. Only when the probability of outflow is remote (typically less than 5% to 10%) can disclosure be omitted entirely.
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.