Accounting for Constructive obligations under IAS 37 & Ind AS 37: Provisions, Contingent Liability and Contingent Assets

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An entity interacts with a lot of stakeholders which are key to its survival and growth. They include its employees, customers and society in general. An entity to manage the expectation of its various stake holders makes promises and conducts its business in a particular manner and takes decisions considering their interest as well.

Some of these promises and decisions are executed even if they are not legally binding or enforceable i.e., they are not mandated by law, or the terms of any contract entered. For example:

• Providing warranty services to a customer even if the sale agreement does not include such provisions.

• Paying additional compensation for child support to employees even though their employment contracts don’t contain such clause, nor does the law mandates it.

• Restoring the land to its original state after uninstalling any plant and equipment or any mining operation, even though the entity might not legally require to do so.

The intricacies of accounting for such decisions and practices which are not mandated by any law or terms of any contract:

IAS 37 & Ind AS 37: Provisions, contingent liabilities and contingent assets, contains the following definitions, which sets the preamble for accounting for such transactions.

A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

A provision is a liability of uncertain timing or amount.

An obligating event is an event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation.

A constructive obligation is an obligation that derives from an entity’s actions where:

1. by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and

2. as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.

A case study:

• An entity has set up a manufacturing unit in a remote village, to make use of the incentives provided by the government on doing so. The labor force majorly consists of the residents of the nearby villages.

• The entity processes the smoke it emits during the manufacturing process, through its pollution control equipment mandated by the government. Also, to alleviate the concerns of the residents of the nearby villages the entity also has promised that the medical bills of anyone suffering from breathing related ailments or illness among them, will be borne by the entity. This particular decision of the entity with regard to reimburse the medical bills is not mandated by any law nor is there a legally binding agreement between the entity and the residents of the villages. 

• The entity had made a public announcement to that effect and has actually come through by reimbursing the medical bills of the residents with such ailments.

• In this scenario, the entity has, through a public announcement of its policy and its actions, has indicated that it will accept the responsibility of reimbursing the medical bills and this has created an expectation from the residents.

• Thus, this becomes a constructive obligation for the entity and IAS 37 & Ind AS 37 mandates the entity to provide for such expenses i.e. in a particular period the entity manufactures goods and emits smoke, it also has to create a provision for reimbursement of medical bills to the residents which may come up in the future due to its operations in this period.

A constructive obligation can arise from an entity’s past practice, published policies or sufficiently current statement that an entity will take on certain responsibility (even though it is not mandated to do so under any law or terms of any contract) and this has created a valid expectation on the part of other parties that it will discharge its responsibilities.

Note to Auditors:

The audit plan should contain a procedure on collating and verifying the list of such constructive obligations form the management. The following aspects should be part of such procedures:

• The completeness of the list of constructive obligations received from the management is to be verified.

• Independently collate all the constructive obligations of entity based on the entity’s past practices, public announcements etc.

• Seek a representation the entity’s legal representative about the constructive obligations of the entity.

• Ensure that adequate provision is created as per the requirement of IAS 37 & Ind AS 37.

This article has been published in the Chartered Accountant Study Circle ("CASC") Bulletin.