NFRA Auditor-Audit Committee Series 5 | Key insights

1. Introduction

The National Financial Reporting Authority (NFRA), through its enforcement, review, and monitoring activities, has consistently observed the critical importance of effective communication between statutory auditors and those charged with governance (TCWG), particularly Audit Committees. In this context, NFRA has initiated a series of Auditor–Audit Committee interaction papers to reinforce communication practices, drawing upon the requirements of the Companies Act, 2013, relevant Standards on Auditing (notably SA 260 (Revised) and SA 265), and the Standard on Quality Control (SQC 1). This initiative is aligned with NFRA’s broader objective of enhancing audit quality, promoting adherence to accounting and auditing standards, and safeguarding public and investor interests.

In the extant “Interaction Series 5”, NFRA focuses on provisions, contingent liabilities, and contingent assets under Ind AS 37, highlighting areas where significant management judgment is involved and where auditors are expected to engage more deeply with Audit Committees.The key aspects of this edition of the interaction series are discussed below:

2. Significance of Accounting Estimates and Judgements

Financial reporting inherently requires management to make estimates and judgments, particularly in areas such as impairment of assets, expected credit losses, litigation provisions, and deferred tax assets. These estimates often involve uncertainty and complexity, necessitating heightened scrutiny by preparers, auditors, and Audit Committees. NFRA emphasises that provisions and contingencies are especially sensitive areas due to their reliance on assumptions regarding future events and obligations.

3. Core Principles of Ind AS 37

Ind AS 37 establishes a robust framework for recognition, measurement, and disclosure of provisions, contingent liabilities, and contingent assets. Its primary objective is to ensure that financial statements present a true and fair view of obligations and risks by applying appropriate recognition criteria and measurement bases, and by providing adequate disclosures.

Ind AS 37 defines provision asa defined liability of uncertain timing or amount arising from a past event, which is recognised only when a present obligation exists, an outflow of resources is probable, and a reliable estimate can be made. Notably, obligations may be legal, contractual, or constructive in nature, thereby expanding the scope beyond strictly enforceable liabilities.

The standard distinguishes provisions from contingent liabilities, which are not recognised but disclosed unless the possibility of outflow is remote. Similarly, contingent assets are not recognised and are disclosed only when an inflow of economic benefits is probable.

4. Key Points Discussed About the Provision Under Ind AS 37

The standard emphasises the use of judgment, incorporation of uncertainties, and continuous reassessment, thereby enhancing reliability while also introducing areas requiring careful evaluation. It also provides specific guidance for complex scenarios such as large populations and onerous contracts.

4.1 Best Estimate Concept

The measurement of provisions under Ind AS 37 is based on the “best estimate” of the expenditure required to settle a present obligation. This estimate is not a mere approximation but a reasoned assessment considering all available evidence, including past experience, expert opinions, and prevailing circumstances. The inclusion of risks and uncertainties ensures that the provision reflects a prudent and realistic liability rather than an optimistic or understated figure.

4.2 Use of Expected Value Method

Where obligations involve a large number of similar items, such as warranties or customer claims, the standard requires the use of probability-weighted outcomes. The expected value method considers various possible scenarios and assigns probabilities to each, resulting in a more accurate and representative provision. This approach avoids reliance on a single most likely outcome and instead captures the overall risk profile of the obligation.

4.3 Discounting of Provisions

In situations where the time value of money is material, provisions must be discounted to their present value. The discount rate used should be a pre-tax rate that reflects current market assessments of the time value of money and risks specific to the liability. This ensures that long-term obligations are not overstated and are presented in line with their present economic burden.

4.4 Periodic Reassessment and Management Judgement

Ind AS 37 requires provisions to be reviewed at the end of each reporting period and adjusted to reflect the latest estimates. This continuous reassessment introduces a dynamic element, ensuring that provisions remain relevant and accurate over time. However, it also creates scope for management bias, making it essential for auditors to critically evaluate assumptions, methodologies, and changes in estimates.

4.5 Onerous Contracts

For onerous contracts, the provision is measured at the least net cost of exiting the contract, which is the lower of the cost of fulfilling the contract and the compensation or penalties arising from non-fulfilment. Only direct costs that are necessary to fulfil the contract are considered. A contract is classified as onerous when the unavoidable costs of meeting obligations exceed the expected economic benefits, thereby necessitating recognition of a provision.

4.6 Recognition of Changes in Provisions

Any revision in the amount of provision, arising from reassessment or change in estimates, must be recognised in the statement of profit and loss. Such changes are either recorded as an additional expense or as a reduction in the previously recognised provision.

5. Auditor’s Responsibilities under Standards on Auditing

The Standards on Auditing, particularly SA 540, place significant responsibility on auditors in evaluating accounting estimates related to provisions and contingencies. Auditors are required to assess whether such estimates are reasonable, supported by sufficient audit evidence, and appropriately disclosed in accordance with the applicable financial reporting framework.

Further, auditors must evaluate estimation uncertainty, identify potential management bias, and obtain written representations from management regarding key assumptions. Standards such as SA 501 and SA 505 also require auditors to obtain external evidence, including legal confirmations, especially in cases involving litigation or disputes.

Auditors are additionally required to consider subsequent events that may impact the recognition or disclosure of provisions and contingencies, ensuring that financial statements reflect all relevant developments up to the date of issuance.