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Audit of Provisions and Contingencies (ISA 37)

Richard Clarke

Audit of Provisions and Contingencies (ISA 37): A Simple Explanation

What is Auditing Provisions and Contingencies?

Auditing provisions and contingencies, per IAS 37, ensures financial statements reflect obligations (provisions) and potential liabilities (contingencies) accurately. In the ACCA AAA exam, you’ll assess recognition, measurement, and disclosure, applying professional scepticism to management estimates.

Let’s audit a warranty provision for a retailer.

Key Components of Auditing Provisions

  1. Recognition: Is there a present obligation (legal/constructive) with probable outflow?
  2. Measurement: Is the estimate reliable (best estimate of expenditure)?
  3. Disclosure: Are contingencies (possible obligations) adequately reported?

Audit Procedures

  • Test Recognition: Verify evidence of obligation (e.g., contracts, past practice).
  • Test Measurement: Recalculate estimates; compare to industry norms.
  • Assess Disclosure: Check notes for clarity on uncertainties.

Numeric Example

A retailer sells appliances with a 1-year warranty:

  • Sales (2025): $10,000,000
  • Historical Warranty Claims: 2% of sales ($200,000 annually)
  • Management Estimate: $250,000 provision (claims rising due to quality issues)
  • Audit Evidence: 10% sample of claims ($20,000) shows $25,000 actual cost.

Step 1: Test Recognition

  • Evidence: Warranty terms in sales contracts; prior claims paid.
  • Conclusion: Present obligation exists (constructive due to past practice).

Step 2: Test Measurement

  • Historical: 2% × $10M = $200,000
  • Management: $250,000 (25% increase, citing defect spike)
  • Sample: 10% claims = $20,000 expected; $25,000 actual (25% understatement)
  • Recalculation: Extrapolate sample: $25,000 ÷ 10% = $250,000
  • Conclusion: $250,000 is reasonable; aligns with evidence.

Step 3: Assess Disclosure

  • Notes: “Warranty provision: $250,000; based on 2.5% of sales, reflecting recent trends.”
  • Contingency: Legal claim ($50,000 possible, not probable) disclosed.
  • Conclusion: Disclosures are adequate under IAS 37.

What Does This Mean?

  • Recognition: Warranty obligation is valid.
  • Measurement ($250,000): Supported by sample and trend, not overstated.
  • Disclosure: Transparent, reducing misstatement risk.

The auditor might challenge: Is the 25% rise justified? Are contingencies understated?

Why It Matters for ACCA AAA

Auditing provisions tests your ability to:

  • Apply ISA 37 and professional scepticism to estimates.
  • Design procedures for complex judgments (e.g., sampling, extrapolation).
  • Ensure compliance and fair presentation.

Practice with litigation or environmental provisions to pass in AAA!