Provisions – Definition

Key term

Provisions: A provision is a liability of uncertain timing or amount.

(IAS 37 – Provisions, contingent liabilities, contingent assets, para. 10)

 A liability is a present obligation of the entity to transfer an economic resource as a result

Do you remember of past events.
what a liability is?
(Conceptual Framework for Financial Reporting 2018, para. 4.26)

Example 1: Provision for warranty

Edway Vietnam is a automobile manufacturer and in the sale contract signed with customers,
there is a standard 10-year warranty term for all sold cars. This is a kind of assurance-type
warranty to guarantee the committed quality of its cars.
Required:
How should Edway Vietnam treat this kind of warranty in the financial statements?
Solution:
This kind of warranty should be associated in the same performance obligation as of the sold car
because it’s assurance-type warranty, but not service-type warranty. Edway’s contractual obligation
incurred when cars are sold and Edway must make provision for warranty costs.

Edway.edu.vn Financial Accounting (F3) Chapter 11: Provisions and contingencies 5

Provisions – Definition
Key term

Provisions: A provision is a liability of uncertain timing or amount.

(IAS 37 – Provisions, contingent liabilities, contingent assets, para. 10)

 Trade payables are liabilities to pay for goods or services that have been received
How can provisions be or supplied and have been invoiced or formally agreed with the supplier;
distinguished from other
liabilities such as trade  Accruals are liabilities to pay for goods or services that have been received or
payables and accruals? supplied but have not been paid, invoiced or formally agreed with the supplier,
including amounts due to employees (for example, amounts relating to accrued
vacation pay). Although it is sometimes necessary to estimate the amount or
timing of accruals, the uncertainty is generally much less than for provisions.

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 Provisions – Recognition
Legal obligation – An obligation derives from:
 a contract (through its explicit or implicit terms);
 legislation; or
 other operation of law;
 An entity has a present obligation For examples: Warranty; Site restoration; etc.
(legal or constructive) as a result of
a past event
Constructive obligation – The entity’s actions where:
 by an established pattern of past practice,
published policies or a sufficiently specific
current statement, the entity has indicated that it
 It is probable that an outflow of will accept certain responsibilities.
3 CRITERIA for
resources embodying economic
recognition of
benefits will be required to settle
provisions
the obligation; and

“Probable”
means that the
likelihood is
more than 50%
 A reliable estimate can be made
of the amount of the obligation.

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Provisions – Measurement
BEST ESTIMATE

How to measure The amount recognized as a provision shall be the best estimate of the expenditure required to settle
provision the present obligation at the end of the reporting period.
amount? (IAS 37 – Provisions, contingent liabilities, contingent assets, para. 36)

For single obligations For large population of items

(one-off events)
For example: Site restoration; Obligation For example: Assurance-type warranty in
incurred from a lawsuit; Restructuring sale contract; customers refunds.

The provision is measured at the The provision is measured at the

most likely outcome. ‘Expected value’
(by weighting all possible outcomes by
their associated probabilities.)

The amount of a provision shall be the present value of the estimate

which is discounted by using pre-tax discounted rates.

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Provisions – Measurement
Example 2: Estimate the provision amount for single obligations (one-off events)

An employee was injured at work in 20X2 due to faulty equipment and is suing Rey Co. Rey Co’s lawyers have advised that it
is probable that the entity will be found liable. Rey Co would have to provide for the best estimate of any damages payable to
the employee.

Rey Co has received legal advice that the most likely outcome of the court case from the employee is that they will lose the
case and have to pay $10m. The legal team think there is an 80% chance of this. They believe there is a 10% chance of
having to pay $12m, and a 10% chance of paying nothing.

Required:

(a) Did Rey Co have any obligation for this event? If yes, which year did this obligation belong to?
(b) How much should the provision amount be in this case?

Solution:

(a) Yes, Rey Co will be found liable and the event arose in 20X2 and it had an obligation in 20X2.
(b) In this case, Rey Co would provide $10m, being the most likely outcome.

Edway.edu.vn Financial Accounting (F3) Chapter 11: Provisions and contingencies 9

Provisions – Measurement
Example 3: Estimate the provision amount for large population items

Rey Co gives a year’s warranty with all goods sold during the year. Past experience shows that Rey Co needs to do no
repairs on 85% of the goods. On average, 10% need minor repairs, and 5% need major repairs. Rey Co’s manufacturing
manager has calculated that if minor repairs were needed on all goods, it would cost $100,000 and major repairs on all goods
would cost $1m.

Required:

How much should the provision amount be in this case?

Solution:

Events (warranty) Warranty costs for all goods Probabilities Outcome

$ % $
No repair needed - 85% -
Minor repairs 100,000 10% 10,000
Major repairs 1,000,000 5% 50,000

Total expected value 60,000

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Provisions – Accounting treatment
Accounting
Narrative of Journal Entries Detailed Journal Entries (JE)
period

 To make initial provision with the best Dr Warranty expense (SoPL) $10,000
Period 1 estimate of the obligations (Let’s say JE1
Cr Provision - Liabilities (SoFP) $10,000
$10,000).

 To record the actual expenses incurred to Dr Warranty expense (SoPL) $1,000

settle the obligations (a part of obligations) JE2
Cr Cash/ Trade payables/ … (SoFP) $1,000
in P/L (Let’s say $1,000).

 To review the  To increase a Dr Warranty expense (SoPL) $200

Period 2 provision for the provision (Let’s JE3
say new provision Cr Provision - Liabilities (SoFP) $200
outstanding
obligations at the of $10,200):
end of the period 2
and compare with  To decrease a Dr Provision - Liabilities (SoFP) $1,400
existing balance of provision (Let’s JE4
the provision account say new provision Cr Warranty expense (SoPL) $1,400
($10,000): of $8,600):

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Provisions – Accounting treatment

Example 4: Accounting treatment for provisions

Grass Co is reviewing its warranty obligations. Based on sales during 20X7, it has established that if all lawnmowers sold
required minor repairs, this would cost $1 million whereas if major repairs were required, this would cost $6 million.
Grass Co expects that 75% of lawnmowers will have no faults, 20% will need minor repairs and 5% major repairs.
Required:
(a) What provision should be made in 20X7 and what accounting entry is needed to record it?
(b) What entry should be made in 20X8 assuming the provision required then is $0.75m?
(c) What entry should be made in 20X9 assuming the provision required then is $0.3m?

Solution:

(a) Expected value of warranty costs = $1m x 20% + $6m x 5% = $0.5m

Journal entry at the end of 20X7:

Dr Warranty expense (SoPL) $0.5m

Cr Provisions (SoFP) $0.5m

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Provisions – Accounting treatment
Example 4: Accounting treatment for provisions

Grass Co is reviewing its warranty obligations. Based on sales during 20X7, it has established that if all lawnmowers sold
required minor repairs, this would cost $1 million whereas if major repairs were required, this would cost $6 million.
Grass Co expects that 75% of lawnmowers will have no faults, 20% will need minor repairs and 5% major repairs.
Required:
(a) What provision should be made in 20X7 and what accounting entry is needed to record it?
(b) What entry should be made in 20X8 assuming the provision required then is $0.75m?
(c) What entry should be made in 20X9 assuming the provision required then is $0.3m?

Solution:

(b) At the end of 20X8, the provision needs to increase by $0.25m ($0.75m - $0.5m)

Journal entry at the end of 20X8:

Dr Warranty expense (SoPL) $0.25m

Cr Provisions (SoFP) $0.25m

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Provisions – Accounting treatment

Example 4: Accounting treatment for provisions

Grass Co is reviewing its warranty obligations. Based on sales during 20X7, it has established that if all lawnmowers sold
required minor repairs, this would cost $1 million whereas if major repairs were required, this would cost $6 million.
Grass Co expects that 75% of lawnmowers will have no faults, 20% will need minor repairs and 5% major repairs.
Required:
(a) What provision should be made in 20X7 and what accounting entry is needed to record it?
(b) What entry should be made in 20X8 assuming the provision required then is $0.75m?
(c) What entry should be made in 20X9 assuming the provision required then is $0.3m?

Solution:

(c) At the end of 20X9, the provision needs to decrease by $0.45m ($0.75m - $0.3m)

Journal entry at the end of 20X8:

Dr Provisions (SoFP) $0.45m

Cr Warranty expense (SoPL) $0.45m

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Provisions – Accounting treatment
Example 5: Discounting the provision

Cambridge Co is preparing its financial statements for the year ended 31 December 20X4. Cambridge Co was informed on 31
December 20X4 that, due to a change in environmental legislation, it will be required to pay environmental clean-up costs of
$5 million on 31 December 20X9.
The relevant discount rate in this case is 10%.
The discounted values of $1 are as follows: $1 in five years = $0.621

Required:

1. Calculate the provision required for the year ended 31 December 20X4.
2. Calculate the provision required for the year ended 31 December 20X5.

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Provisions – Accounting treatment

Example 5: Discounting the provision

Solution:
1. The provision required for the year ended 31 December 20X4.
 The provision for environmental damage should be initially measured at the present value of the $5m payable
in five-years' time.

$
$5m x 0.621 3,104,607

2. At 31 December 20X5, the provision will be unwound as follows:

 The provision for environmental damage should be initially measured at the present value of the $5m payable
in five-years' time.

$
Carrying amount of provision at 1 January 20X5 3,104,607
Unwinding of the discount at 10% 310,460
Carrying amount of the provision at 31 December 20X5 3,415,067

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 Provisions – Disclosure
What do the financial
statements need to 01 Disclosure of details of a change in carrying amount of a provision from the
disclose about beginning to the end of the year, including:
Provisions?
 Additional provisions made;
 Amounts used;
 Other movements

02 For each class of provision, disclosure of the background to the making of the
provision and the uncertainties affecting its outcome, including:
 A brief description of the nature of the obligation and the expected timing of any
resulting outflows of economic benefits;

 An indication of the uncertainties about the amount or timing of those outflows.

Where necessary to provide adequate information, an entity shall disclose the
Let’s see an example on the major assumptions made concerning future events;
financial
statements of a listed company.  The amount of any expected reimbursement, stating the amount of any asset that
has been recognized for that expected reimbursement.

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Contingent liabilities – Definition

A contingent liability

Or

A possible obligation A present obligation

and

 Arises from past events but NOT recognized

 Arises from past  Its existence will
because:
events be confirmed only
by the
Or
occurrence or
non-occurrence
of one or more  It is not probable  The amount of the
uncertain future that a transfer of obligation cannot
events not wholly economic be measured with
within the control benefits will be sufficient
of the entity. required to settle reliability.
the obligation.
(Likelihood < 50%)

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 Contingent liabilities – Definition
Key term

Contingent A contingent liability is:

liability:
a. A possible obligation that arises from past events and whose existence will be confirmed
only by the occurrence or non-occurrence of one or more uncertain future events not wholly
within the control of the entity; or

b. A present obligation that arises from past events but is not recognized because:
i. it is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; or
ii. the amount of the obligation cannot be measured with sufficient reliability.

(IAS 37 – Provisions, contingent liabilities, contingent assets, para. 10)

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Contingent liabilities – Accounting treatment and disclosure

• An entity shall not recognize a contingent liability (in the financial statement).
What’s the accounting
treatment for
contingent liabilities?
• A contingent liability is disclosed unless the possibility of an outflow of resources embodying
economic benefits is remote. The required disclosures are:
 A brief description of the nature of the contingent liability;
 An estimate of its financial effect;
 An indication of the uncertainties relating to the amount or timing of any outflow; and
 The possibility of any reimbursement.

Example 5: Contingent liability

Company A has entered into an agreement to act as guarantor on a bank loan taken out by Mr. Smith. Mr Smith is a financially
secure individual, and the directors are of the opinion that the chances of him defaulting on the loan are slim.

Required: How should Company A account for this guarantee?

Solution: Company A has a present obligation (it is legally obliged to honor the guarantee).
However, as the likelihood of Company A having to pay out under the guarantee is not probable then no provision
for the liability should be made. Instead, the guarantee should be disclosed in the notes as a contingent liability
(unless considered remote, in which case it should be ignored altogether).

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 Contingent liability or provision?

What’s the decision Start

tree to determine
provision or contingent
liability?
Present obligation as a result of an
No Possible obligation? No
ongoing obligating event?

Yes Yes

Is possibility of an
Probable outflow? No Yes
outflow remote?
< 50% < 10%
Yes > 50% No > 10%

Reliable estimate? No (Rare)

Yes

Disclose contingent Do
Provide
liability nothing

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Contingent liability or provision?

Example 6: Contingent liability or provision?

After a wedding in 20X0 ten people became seriously ill, possibly as a result of food poisoning from products sold by
Callow Co. Legal proceedings are started seeking damages from Callow but it disputes liability. Up to the date of
approval of the financial statements for the year to 31 December 20X0, Callow's lawyers advise that it is probable that
it will not be found liable. However, when Callow prepares the financial statements for the year to 31 December 20X1
its lawyers advise that, owing to developments in the case, it is probable that it will be found liable.

Required:
What is the required accounting treatment:
(a) At 31 December 20X0?
(b) At 31 December 20X1?

Solution:
(a) At 31 December 20X0
On the basis of the evidence available when the financial statements were approved, there is no obligation as a
result of past events. No provision is recognized. The matter is disclosed as a contingent liability unless the
probability of any transfer is regarded as remote.
(b) At 31 December 20X1
On the basis of the evidence available, there is a present obligation. A transfer of economic benefits in settlement
is probable.
A provision is recognized for the best estimate of the amount needed to settle the present obligation.

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Contingent liability or provision?
Example 7: Contingent liability or provision?

An oil company causes environmental contamination in the course of its operations, but cleans up only when required
to do so under the laws of the country in which it is operating. One country in which it has been operating for several
years has up to now had no legislation requiring cleaning up. However, there is now an environmental lobby in this
country. At the date of the company's year end, it is virtually certain that a draft law requiring clean-up of contaminated
land will be enacted very shortly. The oil company will then be obliged to deal with the contamination it has caused over
the past several years.

Required:

What accounting treatment is required at the year end?

Solution:

At the year end there is a present obligation as a result of a past obligating event. Because it is 'virtually certain' that the
law will be enacted, the past contamination becomes an obligating event. It is highly probable that an outflow of
economic resources will be required to settle this. A provision should therefore be made of the best estimate of the
costs involved.

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Contingent assets – Definition

Key term

Contingent A contingent asset is a possible asset that arises from past events and whose existence will be
asset: confirmed only by the occurrence or non-occurrence of one or more uncertain future events not
wholly within the control of the entity.
(IAS 37 – Provisions, contingent liabilities, contingent assets, para. 10)

A contingent asset

and

 A possible asset arising from past events  Its existence will be confirmed only by the
occurrence or non-occurrence of one or more
uncertain future events not wholly within the
control of the entity.

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 Contingent assets – Accounting treatment and disclosure
What’s the accounting • An entity shall not recognize a contingent asset (in the financial statement).
treatment for
contingent assets?
• A contingent asset is disclosed where an inflow of economic benefits is probable. The
required disclosures are:
 A brief description of the nature of the contingent assets;
 An estimate of its financial effect;

Example 8: Contingent asset

On 1 January 20X2, Edway Vietnam Co., Ltd. entered a 2-year insurance contract to secure some of its high-valued
inventories. During December 20X2, there was a fire in the warehouse, which led to the entire damages of some inventories
valued at $2 million on book. In the same month, Edway’s lawyer evaluated that some of the damaged inventories valued at
$1.5 million would be probably covered by the insurance with the compensation amounting to $1.3 million. For the remaining
damaged inventories, the possibility of claiming successfully is quite remote.

Required: How should Edway account for this case?

Solution:
- For the compensation amounting to $1.3 million evaluated by the lawyer as probable, Edway should treat it as contingent
asset and disclose the nature and financial effect.
- For the remaining damaged inventories, the possibility of claiming successfully is quite remote, Edway should do nothing.

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Likelihood and summary of accounting treatments

Outflow of resources Inflow of resources
Likelihood (P)
(The entity has to pay out) (The entity may receive income)

Remote Do nothing Do nothing

(P ≤ 10%)

Possible Contingent liability Do nothing

(10% < P ≤ 50%) (No recognition – Just disclose)

Probable Provision Contingent asset

(50% < P ≤ 95%) (Recognized if reliably estimated) (No recognition – Just disclose)

Virtually certain Liability Asset

(P > 95%)

No numerical probability of terms of likelihood is mentioned in IFRSs.

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