Understanding IAS 37: A CFO's Guide to Litigation Provisions

For CFOs, litigation exposure represents one of the most challenging areas of financial reporting. Unlike operating expenses or capital investments, legal contingencies combine uncertainty about both outcome and timing with the need for judgment-based probability assessments. IAS 37 provides the framework, but applying it to real litigation requires careful interpretation.

This guide explains what IAS 37 requires for litigation contingencies, how to apply the probability bands correctly, and how to document your methodology for auditors.

What IAS 37 Requires

IAS 37 (Provisions, Contingent Liabilities and Contingent Assets) establishes the accounting treatment for provisions and contingent liabilities. For litigation specifically, the standard requires companies to:

1. Assess the probability of an outflow of economic resources
2. Measure the obligation reliably where possible
3. Provision, disclose, or monitor based on the probability assessment

The key challenge is the word “probable.” IAS 37 uses probability thresholds that require judgment to apply, and auditors will scrutinize your methodology.

The Three Probability Bands

IAS 37 establishes three probability classifications for contingent liabilities:

Probable (>50% Likelihood)

When an outflow is probable, you must recognise a provision on the balance sheet. In practice, “probable” means more likely than not — a probability greater than 50%.

For litigation, this typically means:

• An adverse judgment is expected
• Settlement negotiations suggest the company will pay
• Legal counsel advises that defending successfully is unlikely

Accounting treatment: Recognise a provision for the best estimate of the obligation. This appears on the balance sheet as a liability.

Reasonably Possible (Neither Remote nor Probable)

When an outflow is reasonably possible but not probable, you must disclose the contingent liability in the notes but do not recognise a provision.

This middle band captures cases where:

• The outcome is genuinely uncertain
• Legal counsel cannot advise either way with confidence
• Early-stage litigation with unclear merits

Accounting treatment: Disclose in notes to the financial statements. Include the nature of the contingency and an estimate of the financial effect where practicable.

Remote (<~10% Likelihood)

When an outflow is remote, no provision or disclosure is required. The threshold for “remote” isn’t precisely defined in IAS 37, but practice suggests it means a very low probability — typically less than 10%.

Accounting treatment: No action required, though many companies maintain internal tracking.

Measuring the Provision

Once you’ve determined a provision is required, you must measure it at the best estimate of the expenditure required to settle the obligation.

For litigation, this typically means:

Best estimate approach:

• Single most likely outcome if one outcome is clearly more likely
• Expected value (probability-weighted) if outcomes vary

Defence costs:

• Include legal fees expected to defend the matter
• These are often more certain than judgment outcomes

Discounting:

• IAS 37 requires discounting if the effect is material
• Use a pre-tax rate that reflects current market assessments

Practical Examples

Example 1: Employment Dispute (Probable)

A former employee has filed a wrongful dismissal claim for €200,000. Legal counsel advises that the company’s documentation was inadequate and settlement is likely.

Assessment:

• Probability: Probable (legal counsel advises high likelihood of loss)
• Best estimate: €150,000 (expected settlement range €120,000-€180,000)
• Defence costs: €35,000 (largely incurred regardless of outcome)

Accounting: Provision of €185,000 (settlement + remaining defence costs)

Example 2: IP Infringement Claim (Reasonably Possible)

A competitor alleges patent infringement with a claim of €2 million. The case is at an early stage and legal counsel advises the merits are uncertain.

Assessment:

• Probability: Reasonably possible (outcome genuinely uncertain)
• Range of outcomes: €0 to €2.5 million (including costs)

Accounting: Disclose in notes with description of uncertainty and potential financial effect.

Example 3: Frivolous Claim (Remote)

A former supplier has filed a contract claim that legal counsel considers without merit. Similar claims have been dismissed in the past.

Assessment:

• Probability: Remote (legal counsel confident in defence)

Accounting: No provision or disclosure required. Maintain internal tracking.

Documentation for Auditors

Auditors will scrutinize your litigation provisions carefully. They’ll want to see:

For each matter:

• Nature of the claim and current status
• Probability assessment with supporting rationale
• How you arrived at the best estimate
• Legal counsel’s written assessment (where available)
• Change history from prior periods

For the methodology:

• How you apply the probability bands consistently
• Who makes the assessments and when they’re updated
• How you handle uncertainty in estimates
• Treatment of defence costs

Key audit questions:

1. What is the basis for your probability assessment?
2. How did you determine the best estimate?
3. What changed since last period?
4. Have you consulted legal counsel?
5. Are there any matters not disclosed due to privilege concerns?

Common Pitfalls

1. Inconsistent Probability Assessments

Different matters assessed by different people without a consistent framework. Solution: Establish clear criteria for each probability band and document the rationale.

2. Outdated Assessments

Provisions that don’t reflect current case status. Solution: Review all matters quarterly, with ad-hoc updates for significant developments.

3. Missing Defence Costs

Focusing on judgment exposure but ignoring legal fees. Solution: Include defence costs to completion in every estimate.

4. Poor Documentation

Assessments exist only in emails or spreadsheets. Solution: Maintain a structured record with assessment history.

5. Optimism Bias

Consistently classifying matters as less likely than they are. Solution: Track actual outcomes against predictions to calibrate assessments.

Building a Defensible Process

A robust litigation exposure management process should include:

1. Structured matter tracking — Not spreadsheets, but a proper system that captures all required fields

2. Clear probability criteria — Written definitions of what constitutes probable, reasonably possible, and remote in your context

3. Regular reviews — At least quarterly assessment updates, with triggers for ad-hoc reviews

4. Legal input — Documented assessment from legal counsel, refreshed periodically

5. Audit trail — Every change recorded with timestamp and rationale

6. Variance analysis — Comparison to prior periods with explanations for changes

Conclusion

IAS 37 provides a sound framework for litigation provisions, but the challenge lies in consistent, well-documented application. The key is establishing a repeatable process that captures structured data, applies probability bands consistently, and maintains the documentation auditors require.

For CFOs managing portfolios of litigation matters, manual processes quickly become unmanageable. Purpose-built tools like Contingent can automate the calculations, maintain the audit trail, and generate the reports auditors expect.

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