At year end, a company is a defendant in a lawsuit arising from an incident that occurred during the year. Legal counsel advises that it is probable the company will lose and be required to pay damages, and is also able to provide a reliable range from which management determines a best estimate of the amount. Under IAS 37, what should the company recognise?
- A contingent liability disclosed only in the notes, because litigation outcomes are inherently uncertain until a court rules
- Nothing, because a legal obligation only arises once a final, non-appealable judgment is issued
- A provision, measured at the best estimate of the expenditure required to settle the present obligation
- A provision equal to the maximum amount claimed by the plaintiff, in order to be prudent
Why C? And why not the others?
Correct answer: C. A provision, measured at the best estimate of the expenditure required to settle the present obligation
IAS 37 requires a provision to be recognised when all three conditions are met: a present obligation exists as a result of a past event, an outflow of economic benefits to settle it is probable, and a reliable estimate can be made of the amount. The scenario satisfies all three — the incident during the year is the past event giving rise to the obligation, counsel assesses the outflow as probable, and a reliable estimate is available — so a provision must be recognised at the best estimate of the settlement amount. The option limiting this to note disclosure describes the treatment for a contingent liability, which applies when an outflow is not probable or a reliable estimate cannot be made; neither limitation applies here since both conditions are satisfied. The option requiring a final, non-appealable judgment before recognising anything ignores that the obligating event is the underlying incident, not the court's eventual ruling, and that IAS 37 recognises obligations based on probability and estimability rather than waiting for legal finality. The option recognising the maximum amount claimed rather than the best estimate misapplies measurement: IAS 37 calls for the best estimate of the expenditure required to settle the obligation, not the highest figure asserted by the counterparty, and deliberately inflating the amount is not what the standard means by exercising caution.
Source: IAS 37 Provisions, Contingent Liabilities and Contingent Assets, paragraphs 14 and 36 (recognition and measurement of provisions)