Key Points
- A provision requires four conditions: a past event, a present obligation arising from it, a probable outflow, and a reliable estimate of the amount.
- "Probable" under IFRS means more likely than not. Most firms treat that 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 expenditure required to settle.
When provisions become an audit problem
Every audit file has at least one provision that nobody wants to touch. A litigation claim the client's lawyers won't quantify. A restructuring programme with vague cost estimates. A warranty reserve that hasn't moved in three years because someone copied it forward SALY. Provisions under IAS 37 are where management judgment is highest and audit evidence is thinnest.
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 must be probable. The entity must be able to make a reliable estimate of the amount. If any one fails, no provision is recognised.
IAS 37.36 requires the amount recognised to be the best estimate of expenditure required to settle 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 discounting 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 are 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, the liability isn't contested, and 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 runs from EUR 800,000 to EUR 1.1M. Because the distribution is asymmetric (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 .
The provision of EUR 939,300 holds up 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 created a valid expectation in other parties. Without evidence of that pattern or statement in the file, the provision lacks a basis. The file should tell a story that a reviewer can follow cold.
- Discount rates on provisions are frequently omitted when the settlement horizon exceeds 12 months. IAS 37.45 requires discounting when the time value of money effect is material. A three-year restructuring provision measured at undiscounted amounts can overstate the liability by 8% to 12% depending on the rate environment.
- In our experience, the bigger risk isn't getting the measurement wrong. It's missing provisions entirely. Completeness testing on provisions is unglamorous work, but it's where most findings come from.
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 can't be measured reliably |
| Measurement | Best estimate of 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 outflow has become probable, triggering reclassification 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 |
Getting this 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.
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Jurisdiction notes
IAS 37 provisions require significant management judgement across all jurisdictions. In the United Kingdom, the FRC has noted that auditors should challenge whether management's "best estimate" reflects the risks and uncertainties inherent in the obligation, particularly for litigation and restructuring provisions. In the Netherlands, the AFM expects auditors to evaluate the completeness of provisions identified by management and to challenge assumptions underlying decommissioning obligations and onerous contracts. In Australia, ASIC inspections have focused on whether auditors obtain sufficient evidence for provision measurement, including the discount rate applied to long-term obligations under AASB 137.
In the United States, provisions and contingencies follow ASC 450, Contingencies (formerly FAS 5), which differs from IAS 37 in key respects. ASC 450 requires recognition when a loss is "probable" and "reasonably estimable," using a higher recognition threshold than IAS 37 's "more likely than not" criterion. For litigation contingencies, AU-C 501 and PCAOB AS 2505 require auditors to obtain a letter of audit inquiry from the entity's legal counsel regarding pending or threatened litigation. PCAOB inspection findings have cited insufficient evaluation of completeness and accuracy of litigation provision estimates, along with inadequate procedures to corroborate management's assessment of loss contingencies. The SEC also scrutinises contingency disclosures through comment letters, particularly around the adequacy of disclosures for "reasonably possible" losses.
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, expected timing of outflows, uncertainties involved, and any reimbursement rights. The audit file should contain evidence supporting each of those disclosures.
Does IAS 37 apply to onerous contracts?
Yes. IAS 37.66 requires a provision when unavoidable costs of meeting 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 assumptions underlying the original estimate still hold, applying ISA 540.13(b) to evaluate whether changes in circumstances require a revised estimate.