When is a provision no longer a provision?

Different accounting rules apply for recognising and measuring ‘provisions’ and ‘financial liabilities’ in your balance sheet - so it is important to distinguish which one you are accounting for.

Provision

A ‘provision’ is a liability of uncertain timing or amount. It is measured at the best estimate of the expenditure required to settle the present obligation at the end of the reporting period, discounted to present value using a pre-tax rate that reflects current market assessment of the time value of money and the risks specific to the liability for which cash flow estimates have not been adjusted.

Financial liabilities

On the other hand, a ‘financial liability’ is a contractual obligation that is measured at amortised cost. The discount rate used to determine amortised cost is not adjusted each reporting period to reflect the current market movements, as is the case for provisions.

When does a provision become a financial liability?

An obligation may start out as a provision because its timing or amount is uncertain, and later be firmed up when the uncertainty has been resolved. For example, at the start of a lease, a lessee may have an obligation to ‘make good’ or restore premises to their original state. While the timing to settle this obligation may be certain (i.e. at the end of the lease), the amount is likely to be uncertain. The lessee therefore recognises a ‘make good’ provision, and not a financial liability. However, at or near the end of the lease, the amount required to settle the ‘make good’ provision is also likely to be known. Here is another example.

Example

XYZ Limited did not follow proper process when it dismissed one of its executives, John Smith. On 1 April 2022, John Smith instituted proceedings against XYZ Limited to claim ‘unfair dismissal’ and sought $500,000 in unpaid redundancy, and compensation for psychological pain and suffering. At 30 June 2022, XYZ Limited was advised by its lawyers that John Smith would accept a negotiated settlement in the region of $300,000, and XYZ Limited recognised a provision for this amount in its 30 June 2022 financial statements.

Negotiations continued backwards and forwards for a while, until John Smith accepted an amount of $400,000 in June 2023, which XYZ Limited paid out in July 2023.

In assessing whether XYZ Limited should reclassify the provision recognised at 30 June 2022 to financial liabilities in its 30 June 2023 financial statements to reflect the change in circumstances, neither IAS 37 nor IFRS 9 provide guidance on this matter.

IAS 37 does not require a provision to be reclassified once its amount and/or timing become certain. However, once both the amount and timing for settlement have been agreed, XYZ Limited has a legal obligation to deliver $400,000 cash to John Smith, which it cannot avoid. This obligation therefore meets the definition of a ‘financial liability’.

In our view, at 30 June 2023, XYZ Limited no longer has a provision, but rather a financial liability. It should therefore disclose in its reconciliation of provision movements, a transfer to financial liabilities to reflect this change.

Reimbursements

An entity is sometimes entitled to a reimbursement from another party when it is required to settle a provision. IAS 37, paragraph 53, requires that reimbursements are only recognised as assets when it is virtually certain that the reimbursement will be received if the entity settles the obligation. Reimbursements are treated as a separate asset and cannot be offset against the provision in the balance sheet. However, any expense and income relating to the provision and reimbursement recognised may be setoff in profit or loss. This treatment would apply, even though the provision may have been transferred to financial liabilities (payables).

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