IAS 37 Contingent Liabilities, Contingent Assets, Onerous Contracts and Restructuring
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Sai Manikanta Pedamallu
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IAS 37 Contingent Liabilities, Contingent Assets, Onerous Contracts and Restructuring
By Sai Manikanta Pedamallu (ACCA, CMA US, CSCA US, CGMA, ACMA, Dip IFRS, M.Com, MBA, MA)
Lead Instructor, Global Fin X | www.globalfinx.in/manikanta
Post 42 covered the three recognition criteria for provisions and how they are measured. This post covers the four specific areas where IAS 37 application is most often tested and most often misapplied: contingent liabilities and how they differ from provisions, contingent assets and their asymmetric treatment, onerous contracts including the 2020 amendment that changed the cost definition, and restructuring provisions where the timing and scope of costs included are both tightly constrained.
Contingent Liabilities: The Disclosure Zone
A contingent liability is not a provision. It falls short of a provision in one of two ways:
It is a possible obligation whose existence depends on whether an uncertain future event occurs or does not occur, and that event is not wholly within the entity's control. The outcome has not yet resolved into a present obligation.
Or it is a present obligation that does not meet both remaining recognition criteria: either the outflow is not probable, or the amount cannot be reliably estimated.
The practical distinction from a provision: a provision is recognised on the balance sheet. A contingent liability is disclosed in the notes only, not recognised. This distinction drives significant commercial behaviour: companies prefer to characterise obligations as contingent liabilities rather than provisions because contingent liabilities do not reduce profit.
The Three-Zone Framework
The probability spectrum runs from remote to probable, and the appropriate accounting treatment follows directly:
| Probability of Outflow | Treatment |
|---|---|
| Probable (more likely than not, >50%) | Recognise as provision |
| Possible (less than 50% but not remote) | Disclose as contingent liability |
| Remote | No disclosure required |
The line between "possible" and "remote" is not defined numerically in IAS 37. Common practice treats anything below roughly 5-10% probability as remote, but judgment applies. An entity that characterises a significant legal claim with a 15% probability of loss as remote, without documented rationale, will face audit challenge.
What Contingent Liability Disclosure Must Include
For each class of contingent liability not remote enough to be ignored:
A description of the nature of the obligation. An estimate of the financial effect, or a statement that such an estimate cannot be made. An indication of the uncertainties as to the amount or timing. The possibility of reimbursement by a third party.
For Indian companies with large tax disputes and regulatory investigations, the contingent liability note is often the most information-dense part of the annual report. Infosys typically carries contingent liabilities related to tax demands, client indemnification claims, and capital commitments running into thousands of crores. The note distinguishes between items where the company assesses the obligation as probable (provisioned) and those where it is possible but not probable (disclosed).
Guarantees Given to Third Parties
Financial guarantees within IFRS 9's scope are not contingent liabilities under IAS 37; they are financial liabilities measured under IFRS 9. Non-financial guarantees, such as a performance guarantee given to a client or a guarantee of a subsidiary's lease obligations, remain within IAS 37's scope. These are disclosed as contingent liabilities where outflow is possible but not probable, or recognised as provisions where outflow is probable.
Indian parent companies that provide guarantees for subsidiaries' borrowings face this assessment at each reporting date. If the subsidiary is financially healthy, the guarantee is a contingent liability (possible outflow but not probable). If the subsidiary faces financial difficulty, the guarantee may become probable, requiring a provision.
Contingent Assets: The Asymmetric Treatment
Contingent assets are treated conservatively and asymmetrically relative to contingent liabilities. This reflects the accounting prudence principle: recognise losses more readily than gains.
A contingent asset is a possible asset that arises from past events and whose existence will be confirmed only by the occurrence of one or more uncertain future events not wholly within the entity's control.
The Recognition and Disclosure Threshold
Contingent assets are never recognised in the financial statements. They are disclosed in the notes only when an inflow of economic benefits is probable.
When the realisation of income is virtually certain rather than merely probable, the asset is no longer contingent. A genuinely virtually certain inflow is recognised and reported accordingly (as a receivable or accrued income), because it no longer depends on a genuinely uncertain future event.
The probability spectrum for contingent assets:
| Probability of Inflow | Treatment |
|---|---|
| Virtually certain | Recognise (no longer contingent) |
| Probable | Disclose in notes |
| Less than probable | No disclosure |
The asymmetry is deliberate. For provisions, the threshold for recognition is "probable" (>50%). For contingent assets, recognition requires "virtually certain." Mere probability of a gain is insufficient for balance sheet recognition; it is only sufficient for note disclosure.
Indian Context: Insurance Claims and Legal Awards
An Indian manufacturer filing an insurance claim for a factory fire faces this question: the claim is submitted, investigations are ongoing, and the insurer has not yet accepted liability. Is this a contingent asset?
If acceptance of the claim is probable but not yet confirmed: disclosed as a contingent asset in the notes. If the insurer has accepted the claim in principle and the only remaining uncertainty is the quantum of payment: possibly virtually certain, depending on the assessment of whether the quantum will be agreed or disputed. If a court has awarded damages to the company and the judgment is enforceable: virtually certain; the receivable is recognised on the balance sheet.
A supplier pursuing arbitration against a customer for contract breach sits in the "probable" or "possible" zone depending on the strength of the claim. Indian arbitration proceedings are often long-running, creating multi-year contingent asset situations that require annual reassessment.
Onerous Contracts: Recognise the Full Loss Immediately
A contract is onerous when the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. The entity cannot escape the contract without paying a price.
The provision for an onerous contract is measured at the lower of:
The cost of fulfilling the contract, and the cost of terminating it (penalties and compensation for non-fulfilment).
This is the "lower of" principle. The entity will rationally settle the obligation at the minimum cost. If it is cheaper to pay a penalty and exit the contract than to complete it, the provision equals the exit cost. If completing the contract is cheaper than exiting, the provision equals the net loss from completion.
The 2020 Amendment: All Direct Costs in Fulfilment
Before the 2020 amendment, entities used different approaches to calculating the cost of fulfilling a contract. Some included only incremental costs (direct materials, direct labour that would not exist without the contract). Others also included an allocation of fixed overhead attributable to the contract.
The 2020 amendment (effective 1 January 2022) clarified definitively that the cost of fulfilling a contract comprises both:
Incremental costs of fulfilling that contract: costs that would not be incurred if the entity did not have the contract. Direct materials, direct labour paid per unit, subcontractor costs.
An allocation of other costs that relate directly to fulfilling contracts: fixed costs that relate directly to contract fulfilment. Depreciation on a machine used solely for this contract, supervision costs attributable to the contract, allocated factory overhead directly related to production under the contract.
The amendment resolved a diversity in practice. Some contracts that appeared marginal under an incremental-cost-only approach became onerous under the all-direct-costs approach because the full cost allocation revealed the contract was loss-making.
Worked Example: Onerous Supply Contract
A manufacturing company has a two-year fixed-price supply contract to deliver 50,000 units at Rs. 120 per unit. At the end of Year 1, raw material costs have risen sharply. Updated cost projections for Year 2:
Incremental costs (direct materials, direct labour): Rs. 100 per unit
Allocated direct fixed costs (depreciation, supervision): Rs. 35 per unit
Total cost of fulfilment: Rs. 135 per unit
Contract price: Rs. 120 per unit
Net loss per unit: Rs. 15 per unit
The contract is onerous. Cost of fulfilment for remaining 25,000 units: Rs. 15 × 25,000 = Rs. 3,75,000.
Cost of terminating: penalty clause of Rs. 2,50,000.
Provision = Lower of Rs. 3,75,000 (fulfilment) and Rs. 2,50,000 (exit) = Rs. 2,50,000
The entity would rationally pay the penalty and exit rather than fulfil at a larger loss. The provision is the exit cost.
Before Recognising an Onerous Contract Provision
Before recognising a provision for an onerous contract, the entity first recognises any impairment loss on the assets dedicated to fulfilling that contract (under IAS 36). The impairment must be taken first; the onerous contract provision covers the remaining loss that impairment alone does not absorb.
This sequencing prevents double-counting: an asset already impaired to reflect the onerous position need not also be captured in the provision.
Onerous Contracts in Indian Practice
Indian IT services companies face onerous contract risk when fixed-price contracts run into scope changes, technical challenges, or cost overruns. A fixed-price ERP implementation contract signed at Rs. 25 crore where revised cost estimates reach Rs. 35 crore is an onerous contract requiring a provision of Rs. 10 crore (or the exit cost, whichever is lower).
Indian retail companies with long-term leases for stores in declining locations face onerous lease situations. Under IFRS 16, operating leases are now on the balance sheet as lease liabilities, but if the store generates cash flows insufficient to cover all costs including the lease payments, the CGU may be impaired and the lease may be onerous. The interaction between IAS 36 impairment, IFRS 16 lease accounting, and IAS 37 onerous contract provisions requires careful sequencing.
Restructuring Provisions: Two Strict Conditions
A restructuring is a programme that is planned and controlled by management and materially changes the scope of business undertaken or the manner in which that business is conducted. Examples: sale or termination of a line of business, closure of sites, changes in management structure, fundamental reorganisation.
A provision for restructuring is recognised only when the entity has a constructive obligation to restructure. The general IAS 37 recognition criteria apply, but with specific guidance on what creates the constructive obligation.
The Two Conditions for a Constructive Obligation to Restructure
Both must be present:
Condition 1: There is a detailed formal plan identifying: the business or part of the business concerned, the principal locations affected, the location, function, and approximate number of employees to be compensated, the expenditures that will be undertaken, and when the plan will be implemented.
Condition 2: The entity has raised a valid expectation in those affected that it will carry out the restructuring, by either starting to implement the plan or announcing its main features to those affected before the end of the reporting period.
Management's decision to restructure, standing alone, creates no provision. The obligation requires an announcement to affected employees or the commencement of implementation. Until then, the entity could change its mind; no valid expectation has been raised.
What a Restructuring Provision Includes
Only direct expenditures arising from the restructuring, which are:
Necessarily entailed by the restructuring, and not associated with the ongoing activities of the entity.
Included: redundancy payments to employees being made redundant, early lease termination penalties for vacated premises, write-off of assets with no future use, costs of notifying customers and suppliers of the change.
Excluded: retraining or relocating continuing employees, marketing and advertising costs for the restructured business, investment in new systems or distribution networks for the continuing business, future operating losses associated with the restructured business.
The excluded items are ongoing business costs, not costs of the restructuring event. They belong in the income statement as incurred, not in a provision.
The No Future Operating Losses Rule
IAS 37 is explicit: a provision cannot be made for future operating losses. Even if the restructuring is designed to eliminate a loss-making operation, the future losses of that operation cannot be provisioned; only the direct restructuring costs can.
This limitation is tested frequently in Dip IFRS. A scenario describing a management decision to close a loss-making division will typically include both the expected future losses of the division and the direct restructuring costs. Only the direct costs are provisionable; the future losses remain in the income statement as they are incurred.
Indian Restructuring Examples
Tata Motors restructuring its commercial vehicle manufacturing operations in response to shift to electric vehicles involves significant restructuring costs: redundancy payments for displaced assembly workers, closure costs for specific plants, write-off of ICE-specific tooling and equipment. Once Tata Motors announces the restructuring plan to affected employees, a provision is recognised for these direct costs.
The provision does not include: the cost of setting up new EV production lines (capital expenditure for the continuing business), training costs for employees who will work on EV production (ongoing costs), or expected losses from legacy ICE vehicle sales during the transition period (future operating losses).
Indian IT companies that periodically announce workforce restructuring and facility consolidations face the same boundary: redundancy payments and facility exit costs are in the provision; retraining, relocation, and new hire costs for the continuing business are not.
Interaction: Restructuring and Discontinued Operations (IFRS 5)
When a restructuring involves the disposal of a component of the entity that meets the IFRS 5 "discontinued operation" definition, both standards interact. The restructuring provision covers direct costs of the restructuring itself. IFRS 5 governs the classification and measurement of the assets being disposed of, and the income statement presentation of the discontinued operation's results.
The provision cannot include an expected loss on disposal of assets; the assets are remeasured under IFRS 5 (lower of carrying amount and fair value less costs to sell) independently of the restructuring provision. Combining disposal losses with restructuring costs in a single provision overstates the restructuring provision and misclassifies the disposal adjustment.
Disclosure: What the Notes Must Show
For each class of provision, IAS 37 requires a movement table showing:
Opening carrying amount. Additional provisions recognised during the period, including increases to existing provisions. Amounts used (charged against the provision) during the period. Unused amounts reversed during the period. Increase during the period from the passage of time (unwinding of discount) and the effect of any change in discount rate. Closing carrying amount.
Additionally, for each class of provision: a brief description of the nature of the obligation and the expected timing of the resulting outflows. An indication of the uncertainties about the amount or timing. The amount of any expected reimbursement.
For contingent liabilities disclosed in the notes: the same qualitative information plus an estimate of the financial effect.
For contingent assets disclosed in the notes: a brief description and an estimate of the financial effect.
Ind AS 37 vs IAS 37: Key Differences
| Area | IAS 37 | Ind AS 37 |
|---|---|---|
| Contingent liability: disclosure threshold | Possible but not probable | Same |
| Contingent asset: disclosure threshold | Probable | Same |
| Onerous contract provision | Required when unavoidable costs exceed benefits | Same |
| Cost of fulfilling: incremental + allocated direct costs | 2020 amendment, effective 2022 | Ind AS 37 amended correspondingly; effective from same date |
| Restructuring: two conditions for constructive obligation | Same | Same |
| Restructuring: excluded costs | Same | Same |
| Future operating losses: never provisioned | Same | Same |
| Guarantee contracts within IFRS 9 | IFRS 9 governs; not IAS 37 | Ind AS 109 governs; same treatment |
| Climate-related constructive obligations | Covered under current criteria; IASB ED proposes refinement | Same |
What Big 4 Auditors Focus On
Provision vs contingent liability boundary. The most commercially sensitive judgment is whether an obligation is probable (provision) or possible (contingent liability). For significant legal claims and regulatory investigations, auditors obtain independent legal opinions and test whether management's probability assessment is consistent with the legal advisor's view. A company with a pattern of re-categorising probable provisions as contingent liabilities when earnings pressure increases warrants heightened scrutiny.
Onerous contract identification. Auditors test whether management has identified all contracts where fulfilment costs now exceed benefits. For IT services companies with large fixed-price contracts, auditors review project completion reports and margin analyses to identify contracts in loss-making positions. For retailers, they test whether leases for underperforming stores create onerous situations after the IFRS 16 adoption changes how total occupancy costs are allocated.
Restructuring provision scope. Auditors test whether the restructuring provision includes only direct costs and excludes ongoing business costs. Training, marketing, and new system costs are the most commonly misclassified items. They also verify that the constructive obligation conditions are genuinely met: that the announcement was made to affected employees before the reporting date, not just to the board.
Contingent asset thresholds. Auditors challenge whether items disclosed as contingent assets are genuinely only probable rather than virtually certain. Confirmed insurance claims and court judgments in the entity's favour where enforcement is straightforward should be recognised as receivables, not disclosed as contingent assets.
Movement table reconciliation. For all significant provisions, auditors test the movement table against underlying transactions: amounts charged against the provision are traced to actual expenditures, reversals are supported by documented changes in circumstances, and unwinding of discount is verified against the applicable rate.
Dip IFRS Exam Angle
The four topics in this post appear regularly in Dip IFRS exam scenarios, individually and in combination.
Most tested areas:
Contingent liability vs provision: given a probability assessment, determine the correct treatment. Know the three zones: probable (provision), possible (disclose), remote (ignore).
Contingent asset: know the asymmetry. Disclosure requires probable; recognition requires virtually certain. Mere probability of a gain is not enough for balance sheet recognition.
Onerous contract provision: given a contract with updated cost estimates, test whether the contract is onerous, calculate the cost of fulfilment (incremental + allocated direct costs), and compare to the exit cost. Provision is the lower of the two.
Restructuring provision: identify whether both conditions are met (detailed plan + announcement to affected parties). Calculate the provision including only direct restructuring costs, excluding future operating losses, retraining, and new system investment.
Common traps:
Recognising a contingent asset when the inflow is merely probable. Disclosure only until virtually certain.
Measuring the onerous contract provision at the cost of fulfilment alone, without comparing to the exit cost. It is always the lower of the two.
Including future operating losses in a restructuring provision. Never permitted.
Recognising a restructuring provision based on a board decision alone, without announcement to affected employees or commencement of implementation. The constructive obligation requires the announcement.
Including retraining costs and new system investment in a restructuring provision. These are costs of the continuing business, not costs of the restructuring.
FAQ
Can a guarantee given by a parent on behalf of a subsidiary be a contingent liability?
If the guarantee is a financial guarantee contract within IFRS 9's scope, it is a financial liability under IFRS 9, not a contingent liability under IAS 37. If it is a performance guarantee (guaranteeing the subsidiary will deliver goods or services), IAS 37 applies and it is a contingent liability where outflow is possible, or a provision where outflow is probable.
What if an entity discovers an onerous contract during a period-end review, not at the contract inception date?
The provision is recognised in the period the contract becomes onerous, not at the period it was originally entered into. Prior periods are not restated. The full expected loss on the contract from the current date to expiry is provisioned at the point of identification.
Can a restructuring provision be recognised for a specific part of a business before the whole restructuring plan is finalised?
Yes, if the specific part meets both conditions independently: a detailed plan for that specific part exists, and the affected employees have been notified. The recognition can be partial if only part of the restructuring meets the constructive obligation conditions at the reporting date.
Is a contract loss the same as an onerous contract?
Not necessarily. A contract that is currently generating a loss may not be onerous if the entity can exit without penalty. Onerousness requires that the unavoidable costs of continuing exceed the benefits, where "unavoidable" means the entity cannot exit at zero or negligible cost. A loss-making contract with no exit penalty is not onerous; it is simply a bad contract being executed.
When does a contingent liability become a provision mid-year?
When new information changes the probability assessment from possible to probable. The provision is recognised at the date the probability crosses the "more likely than not" threshold, not at the end of the reporting period. The income statement charge falls in the period when the probability changed.
Does IAS 37 require disclosure of contingent liabilities that are individually immaterial?
No. Disclosure is required for contingent liabilities that are individually or collectively material. Immaterial contingencies need not be disclosed. Where a large number of individually immaterial contingent liabilities exist (product warranties, minor legal claims), aggregated disclosure at the class level is appropriate.
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This is Post 43 of the Global Fin X IFRS Series. Previous: IAS 37: Provisions Recognition Criteria, Best Estimate and Discount Rate. Next: Post 44: IAS 37 vs IFRS 9: When a Financial Liability Provision Meets ECL.