Measuring a provision at year end
How IAS 37 measures a provision, how to reflect risk without padding, when discounting matters, and how to book and update the estimate each year.
By Achekam · · 5 min read · For Accountants & audit firms in South Africa, Nigeria, Kenya
Deciding that a client needs a provision is usually the easier half of the job. A solar installer gives customers a warranty on every system. A clothing retailer refunds unhappy customers well beyond what the law requires. A logistics company has promised its landlord to restore the warehouse floor when the lease ends. In each case an obligation exists. The harder question is what number to put on it.
Directors tend to answer that question in one of two ways: with a round figure that "feels safe", or with nothing until the cost is certain. Neither is what IAS 37 asks. This article covers how a provision is measured, how risk and the time value of money enter the figure, and how to book and maintain it.
The amount the entity would rationally pay at year end
IAS 37 defines a provision as a liability of uncertain timing or amount, which may be a legal obligation or a constructive one. A constructive obligation arises from the entity's own actions, through which it has indicated to others that it will accept certain responsibilities and so created an expectation that it will discharge them. The IFRS Foundation's examples include warranty obligations, obligations to clean up contaminated land or restore facilities, and a retailer's policy of making refunds to customers.
A provision is recognised if it is probable that an outflow of cash or other resources will be needed to settle it; if an outflow is not probable, the item is a contingent liability instead. Recognition is covered in provisions and contingent liabilities. This article starts once the decision to recognise has been made.
Under IAS 37, a provision is measured at the amount the 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. This is often called the best estimate. The word "rationally" rules out both extremes: it is not the most the client might conceivably pay, and it is not the least it could hope to get away with.
Risks and uncertainties without padding
IAS 37 states that risks and uncertainties are taken into account in measuring a provision. That is not an invitation to add a cushion. A provision padded to be safe overstates the liability and understates profit as surely as an inadequate one does the reverse, and the excess tends to be released quietly in a later year when results need help.
Different obligations call for different approaches:
- Many similar items, such as warranties or refunds. Use the client's history. What proportion of systems sold needed warranty work, and at what typical cost? What share of sales came back as refunds after year end? Adjust for anything that has changed, such as a new product with a higher fault rate.
- A single obligation, such as one legal claim or one restoration. Consider the range of possible outcomes and the most likely one. A lawyer's assessment of the claim, or a contractor's quotation for the restoration, is far better evidence than the director's estimate.
Write down the approach, the data used and the reasons for any judgement. That record, more than the number itself, is what a reviewer will test.
Discounting long-dated provisions
IAS 37 also states that a provision is discounted to its present value. For a warranty claim likely to be settled in the next few months, the arithmetic barely moves the figure. For an obligation that falls due years ahead, such as restoring the warehouse floor at the end of a long lease, the difference between today's cost of the work and its present value can be large.
Where discounting matters, record the expected timing of the payment, the expected amount at that time and the rate used, with the reason for choosing that rate. Each year, as the settlement date gets closer, the discount unwinds and the provision grows; that growth is a cost to be recognised, separate from any change in the estimate itself.
Updating the estimate each year
Because the measure is what the client would rationally pay at the end of the reporting period, the provision is re-measured at every year end. Last year's figure carried forward unchanged is almost never right. Compare last year's provision with what was actually paid against it during the year: a large gap in either direction says something about the method, and the method should change rather than be defended.
Two limits frame the exercise. A provision cannot be recognised for future operating losses, because at the end of the reporting period there is no obligation to incur them. And an onerous contract does give rise to a provision, which is a separate test with its own rules on which costs count. Events after year end can also supply evidence of the year-end position, as discussed in a court case settled after year end.
Booking, reviewing and reversing provision entries
In Achekam's Studio, staff post provisions and their annual movements as year-end adjusting entries against the client's trial balance. Each movement, whether a new provision, an increase, a release or an amount used, is worth posting separately so the provisions note can show it. If an entry later proves wrong, it is reversed with a record of who did it and why, not deleted.
Before sign-off, staff can run an automated review of the draft, which lists findings for a person to accept, resolve or dismiss. It is advice only and does not block signing. The separate Validation & Math Engine runs fixed, non-AI checks such as double entry and note ties, which helps confirm that the provisions note agrees with the statement of financial position. Neither check judges whether the estimate is reasonable; that remains the preparer's and reviewer's work.
The IFRS Foundation's IAS 37 page summarises how provisions, contingent liabilities and contingent assets are defined and accounted for, and what must be disclosed about them. For each provision in this year's file, write one sentence explaining why the figure is what the client would rationally pay. If that sentence is hard to write, the measurement needs more work.
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
