IAS 37 Provision Valuation: Why Discounting & Probabilities Matter
Introduction to Certified IAS 37 Provision Valuation Training
IAS 37 is one of the conceptually most demanding of the standards in IFRS because it applies to obligations that lie in the area of uncertainty, judgement and estimation over a long period of time. Provisions are fundamentally different from routine payables because they are related to payments whereby the timing and quantity to be learnt cannot be known in a precise manner.
They may be of legal origin, as part of contracts, for environmental purposes, as part of restructuring plans, as an employee benefit or as an asset retirement obligation. Each of these situations requires management to look not only at the current existence of an obligation, but also at the anticipated future cash flows for an obligation and the potentials associated with alternative outcomes. IAS 37 therefore draws on financial modelling, probability theory, risk assessment, engineering or legal analysis and discounting principles to produce an approach to measurement which is based on the underlying economic reality of uncertain obligations.
The dictum that the provisions are based on the “best estimate” of expenditure at the date of reporting is key to the role played by IAS 37. This best estimate is not an arbitrary measurement, but the amount socially that a rational third party would expect to have in order to accept the obligation. It is the best estimate along with probability-weighted estimates of potential scenarios.
In other words, IAS 37 provision valuation using probability-weighted cash flow models requires provision valuation to act economically as if it is a hypothetical transfer of liability between market participants. This way, provisions are not overstated with too conservative assumptions or understated with overoptimistic assumptions. Because provisions are often of long-term and high-impact cash outflows nature, under IAS 37, provisions must be ensured to be based on rigorous analyses for every element, such as probabilities, discounting, inflation assumptions, risk adjustments, legal interpretations, cost estimations, etc.
IAS 37 is also aligned very well to modern fair value thinking, although it does not necessarily expressly call out IFRS 13 measurement. Both standards have a philosophical basis in common; liabilities should reflect current market conditions and risk adjusted expectations and prevailing discount rate environment.
The use of present value techniques and probability-weighted modelling brings the measurement of provisions in line with the rest of the IFRS playing field, to ensure consistency between impairment testing, the accounting of leases, financial instrument valuation, and asset retirement obligations. As business environments become more complex, and regulatory requirements become more stringent, the principles of transparency, realistic valuation and disciplined estimation of IAS 37 become even more critical to reflect in financial reporting accurately.
Asset Retirement Obligations and Decommissioning Liabilities in Focus
Among some of the major provisions of IAS 37 are asset retirement obligations and decommissioning liabilities. These obligations are common in industries like mining, oil and gas, manufacturing, energy production, telecommunications, etc. Obtaining compliance under two Acts-EPA acts-belies the EPA’s requirement of responsible entities to dismantle installations, restore the affected land, plug wells, decommission plants, remediate contaminated sites or to achieve the return of leased premises to their original condition. Because these obligations often run 10, 20 or even 50 years into the future, the measurement of these obligations is uniquely prone to uncertainty.
Valuing these obligations requires the mixture of groundbreaking engineering assessments and financial estimation. Engineering consultants may offer estimates of the physical work covered but it is up to the accounting teams to convert these estimates into financial models that take into account inflation, discounting and probability weighting. For example, the cost for shutting down an offshore technology platform may be influenced by future regulatory regimes, environmental safety requirements, technological evolutions in dismantling technologies and labour cost escalation.
These variables form scenarios with varying assignments to probabilities, and all of these scenarios need to be implemented in the expected cash flow model. IAS 37 provides for all reasonably foreseeable outcomes – not just base case – to be reflected in the valuation. This avoids the risk of understating long term environmental or restoration obligations which historically has been a source of significant corporate risk.
As time goes on, new regulations, court decisions, inflation of costs and technological changes can substantially change decommissioning obligations. IAS 37 requires provisions to be measured in accordance with these changes so that updated information is placed in the liability. This dynamic measurement represents the changing economic reality for decommissioning responsibilities, and protects parties who are concerned from old outdated estimates.
Unavoidable Costs and the Economics of Onerous Contracts
Onerous contracts occur when performing a contract obligation costs more than what is economically expected to be gained from performing the obligation. Examples include supply contracts with cost escalations larger than fixed sales prices, unused leased spaces that cannot be sublet and long-term service agreements with revenue guarantees that do not cover increasing operating costs. IAS 37 requires you to recognise a provision when the unavoidable cost of completing the contract is greater than the benefits of the same.
Unavoidable costs refers to the lower of the cost of performing the contract and compensation or penalty resulting from leaving the contract. This involves doing quantitative assessment of several financial dimensions such as alternatives for subcontracting, inflation in the cost of labour, volatility of price of materials and penalties for settlement. An entity may be faced with multiple possible ways of fulfilling or exiting the contract that may produce different financial results.
As there is a good chance that costs may change significantly with time, probability weighting becomes critical. For example, there may be several cost escalation paths provided for a contract depending on the inflation of a commodity, the exchange rate, or supply disruption from a supply chain. IAS 37 helps ensure that the resulting provision is that which has expected value of these scenarios and not just one deterministic estimate.
Onerous contract provisions It is the economic logic of IAS 37 that provisions must reflect actual economic burdens arising from contractual commitment provisions. Recognising these losses early promotes transparency and prevents entities from reporting false numbers in terms of profits by deferring inevitable losses.
Probabilities as the Core of Expected Value Measurement
Provision valuation under IAS 37 is based on a technique of probability modelling. Each scenario has a different potential outcome, as well as its likelihood for occurring. IAS 37 requires probability-weighted cash flows; in other words, the expected value approach familiar from the world of actuarial and financial modelling.
This type of requirement is particularly important in litigation provisions, environmental contamination matters, product warranties, restructuring requirements and regulatory penalties. For example, one case of a suit may have a 20% probability of being thrown out, a 50% probability of settling for a specific number of dollars, and a 30% probability of settling for more dollars. Using the most likely outcome would lead to the distortion of the economic reality. Instead, IAS 37 requires the calculation of expected cash flows in which the outcomes are weighted with regard to the probability of occurrence.
The probability-based approach can also be applied where the timing is not certain. To take a couple of examples, in winding up liabilities the settlement year may be spread over a period of 10 years based on regulatory approvals or operation timelines. Each of the scenarios in terms of timing has a different impact on the present value of the obligation. Probability modelling is used to ensure that such risk of timing is built into the provision.
IAS 37 has also provided that ongoing reassessment of probabilities should take place with the advent of new information. As the regulatory or legal conditions evolve the probability distribution of the resultant outcomes may change and updated provisions may result. This dynamic modelling approach enables such that the financial statements are representations of current risk profiles and not of outdated assumptions.
Risk Adjustments and the Integration of Uncertainty
Risk adjustments are key to measurement of provisions as uncertainties may be substantial, especially if risk obligations are long term. Risk adjustments can be made in terms of adjusting the cash flows or discount rate. However, IAS 37 has a very strict prohibition of double counting risk – if risk is included in the cash flows, the discount rate must not include the risk, and vice versa.
Risk adjustments make allowances for such uncertainties as cost variability, technological change, legal interpretations, complexity of operation, environmental exposure, and inflation uncertainty. For instance, the cost of environmental remediation may vary based on the spread of contamination, enforcement under regulations or weather conditions that impact clean-up logistical conditions. These risks have to be included in the expected cash flow model so that the required provision is not underestimated.
Risk-adjusted modelling brings IAS 37 into line with modern financial theory where the valuation of uncertain liabilities has to embody both the expected consequences and the expected uncertainty of those consequences. It ensures that provision is taken in the code, to capture not only the central scenario, but certain variable and unpredictable aspects of obligations in the real world.
Discount Rates and the Time Value of Future Obligations
Discounting is indispensable in IAS 37 since many of the provisions require the use of cash flows which are in the distant future. IAS 37 requires discounting expected cash flows on a discount rate reflecting current market assessments related to the time value of money and to the risks peculiar to the liability. Determining the correct discount rate requires taking into account government bond yields, inflationary expectations, corporate bond debt spreads and long-term risk-free curve structures.
Longer term obligations are very sensitive to the discount rate assumptions. A minor variation in discount rate can cause major changes in the present value of a liability extending 30 years into the future. This sensitivity is the reason why you have to be rigorous, transparent, and based on something that you can actually see in the markets when you select the discount rate. The discount rate will need to be reviewed at every report date in order to reflect the current financial situation. This dynamic up-dating ensures the present value of provisions change along with the market interest rates and change in economic expectations.
Discounting makes provision measurement consistent with other IFRS standards such as IAS 19 employee benefits, IAS 36 impairment and IFRS 13 fair value standards reinforcing the consistency of the use of the present value techniques in financial reporting.
A Comprehensive Process for Valuing Provisions Under IAS 37
Provision valuation starts with the identification of a present obligation (legal or constructive), an obligation resulting from past occurrences. After establishing the obligation, the entity forecasts future cash flows which are necessary for settling the same. These estimates include anticipated operation costs, penalties, contractor fees, legal settlements, restoration work as well as other pertinent expenditures. The entity then creates several scenarios and assigns probabilities to each of them according to the current knowledge, historical data and the judgement of experts.
Expected cash flows are built from the use of probability weighted down modelling, which incorporates both central and tail risk. The entity discounts these expected cash flows with a market-based risk-adjusted discount rate to get to present value. As provisions essentially run across decades, the entity must reassume provisions either on a yearly basis, or whenever new information can be obtained. Finally, entities must give transparent disclosures of assumptions, uncertainties, discount rates, methods and sensitivity because the user needs to make assessments on the reasonableness of the provision.
This is a comprehensive process that ensures integrity of valuation, internal consistency and economic realism in recognising uncertainty of obligations.
Conclusion
IAS 37 provides an analytical and disciplined approach to the valuation of uncertain liabilities to ensure that they are representative of risk, timing and probability-weighted expectations. By forcing the use of probability modelling and discounting, the standard is to try and force entities to consider the whole distribution of outcomes rather than simplistic or too conservative estimates. Whether dealing with asset retirement obligations, remediation liabilities, onerous contracts, litigation exposures or warranty provisions, IAS 37 makes sure that provisions reflect economic reality as opposed to the managerial optimistic beliefs or regulatory pressure.
The focus on discounting has the effect of matching the valuation of provisions to modern financial principles and injecting long-term obligations at their true present value. As the complexity of regulatory environments rises, the risks of environmental factors escalates and litigation uncertainties are on the rise globally, requirement of rigorous estimation, constant reassessment and transparent disclosing as defined by How to apply discounting techniques for long-term decommissioning liabilities under IAS 37 is indispensable. The bringing together of probabilities and discounting introduces financial statements as a faithful, risk-active position on what has to be solved in the future – cementing the role of IAS 37 to high quality, accountable IAS financial reporting.