Key Points
- A provision requires all three recognition criteria: present obligation, probable outflow, and reliable estimate.
- "Probable" under IFRS means more likely than not, which most firms interpret as a threshold above 50%.
- If the obligation is possible but not probable, the entity discloses a contingent liability instead of recognising a provision.
- Provisions must be remeasured at every reporting date and adjusted to reflect the current best estimate of the expenditure required to settle.
What is a Provision (IAS 37)?
IAS 37.14 sets out three cumulative recognition criteria. The entity must have a present obligation (legal or constructive) arising from a past event. An outflow of resources embodying economic benefits must be probable. And the entity must be able to make a reliable estimate of the amount. All three must be met; if any one fails, the entity does not recognise a provision.
The measurement rule at IAS 37.36 requires the amount recognised to be the best estimate of the expenditure required to settle the present obligation at the reporting date. For a large population of items (warranty claims, for instance), the expected value method weights all possible outcomes by their probabilities. For a single obligation (a lawsuit), the most likely outcome is often the best estimate, though the entity must consider other possible outcomes if the range is wide. When the time value of money is material, IAS 37.45 requires the provision to be discounted to present value using a pre-tax rate reflecting current market assessments.
The auditor's role under ISA 540.13(a) is to evaluate whether the entity's estimation method is appropriate and whether the inputs (probability assessments, cash flow projections, discount rates) are supported. Provisions sit squarely within the domain of accounting estimates, and the best estimate of expenditure is where judgment concentrates.
Worked example: Fernandez Distribucion S.L.
Client: Spanish wholesale distribution company, FY2025, revenue EUR 34M, IFRS reporter. In September 2025, a fire at one of Fernandez's warehouses damages inventory belonging to a customer. The customer files a claim for EUR 1.2M. Fernandez's legal counsel advises that the company is liable and expects the settlement to fall between EUR 800,000 and EUR 1.1M, with EUR 950,000 being the most likely outcome. No insurance recovery is expected. Settlement is anticipated in late 2026.
Step 1 — Identify the present obligation
The fire occurred in September 2025 (past event). Fernandez's liability arises from the damage to customer property, confirmed by legal counsel's assessment. The obligation is legal in nature.
Step 2 — Assess probability of outflow
Legal counsel confirms that an outflow is probable (the claim is well-founded and the liability is not contested). The "more likely than not" threshold is met.
Step 3 — Measure the provision
This is a single obligation. IAS 37.40 indicates the most likely outcome may be the best estimate, but the entity should also consider other possible outcomes. The most likely outcome is EUR 950,000. The range is EUR 800,000 to EUR 1.1M. Because the distribution of outcomes is not symmetrical (the upper end extends further from the most likely amount than the lower end does), management adjusts the estimate upward to EUR 975,000. Settlement is expected in approximately 12 months. Discounting at a pre-tax rate of 3.8% produces a present value of EUR 939,300.
Step 4 — Recognise and present
Fernandez recognises a provision of EUR 939,300 in the statement of financial position. The unwinding of the discount (EUR 35,700 over the following year) will be recognised as a finance cost, not an operating expense, under IAS 37.60.
Conclusion: the provision of EUR 939,300 is defensible because the probability assessment rests on an external legal opinion, the measurement considers the full range of outcomes (not just the midpoint), and the discount rate is traceable to a market benchmark.
Why it matters in practice
- Teams often recognise provisions without documenting why a constructive obligation exists. IAS 37.10 defines a constructive obligation as one arising from the entity's established pattern of past practice, published policies, or a specific statement that has created a valid expectation in other parties. Without documented evidence of that pattern or statement, the provision lacks a basis.
- Discount rates on provisions are frequently omitted when the settlement horizon exceeds 12 months. IAS 37.45 requires discounting when the effect of the time value of money is material. A three-year restructuring provision measured at undiscounted amounts can overstate the liability by 8% to 12% depending on the rate environment.
Provision vs. contingent liability
| Dimension | Provision (IAS 37) | Contingent liability (IAS 37) |
|---|---|---|
| Recognition | Recognised in the statement of financial position when all three criteria are met (IAS 37.14) | Not recognised; disclosed in the notes only (IAS 37.27) |
| Probability threshold | Outflow is probable (more likely than not) | Outflow is possible but not probable, or the amount cannot be measured reliably |
| Measurement | Best estimate of the expenditure required to settle (IAS 37.36) | No measurement required; disclose nature, estimated financial effect, and uncertainties (IAS 37.86) |
| Reassessment | Reviewed and adjusted at each reporting date (IAS 37.59) | Reassessed at each reporting date to determine whether an outflow has become probable, at which point the entity reclassifies to a provision |
| Audit focus | Estimation method, probability inputs, discount rate, completeness of population | Completeness of disclosure, risk that a contingent liability should have been reclassified as a provision |
The distinction matters because getting it wrong in either direction has consequences. Recognising a provision when the outflow is only possible overstates liabilities. Disclosing a contingent liability when the outflow is actually probable understates them. The probability assessment is the hinge, and the auditor needs to see the evidence behind it, not just management's assertion.
Related terms
Frequently asked questions
How do I document a provision in the audit file?
Record the obligating event, the probability assessment (with supporting evidence such as legal opinions or historical claim data), the measurement method, and the inputs used to arrive at the best estimate. IAS 37.84 requires the entity to disclose the nature of the obligation, the expected timing of outflows, and the uncertainties involved. The audit file should contain the evidence that supports each of those disclosures.
Does IAS 37 apply to onerous contracts?
Yes. IAS 37.66 requires the entity to recognise a provision when the unavoidable costs of meeting the obligations under a contract exceed the economic benefits expected. Since the 2022 amendment, unavoidable costs include both incremental costs and an allocation of other costs that relate directly to fulfilling the contract. The onerous contract provision is measured as the lower of the cost of fulfilling and the cost of exiting the contract.
When should I reassess a provision?
IAS 37.59 requires provisions to be reviewed at each reporting date and adjusted to reflect the current best estimate. If an outflow is no longer probable, the provision is reversed entirely. The auditor should verify at every period-end that the assumptions underlying the original estimate still hold, applying ISA 540.13(b) to evaluate whether changes in circumstances require a revised estimate.