Accounting For Provisions, Contingent Liabilities and Assets

Definition of Provisions

A provision is an amount that you set aside in your book of accounts to cover a future liability. The liability created in the balance sheet is matched to an appropriate expense in the income statement. For instance if you create a liability  for legal fees then you need to match it with a posting to the legal fees expense account. This is true under International Financial reporting standards (IFRS) but not so for  US GAAP where provisions are treated as expenses and not liabilities.

Troubled History of Provisions

In the past there were no rules as regards the treatment of provisions. This lead to accountants to abuse provisions in what is known as creative accounting. Creative accounting is when accountants exploit loopholes in accounting rules in order to present figures in a misleadingly favourable lights. For instance accountants could create provisions for the purposes of smoothing out the profits. Thus in years when profits are low the accountants could use provisions to increase the profits.

These were the days of big bath accounting where accounts used provisions to "bathe" the accounts to meet their expectations or to smooth out some unfavourable figures. Thus accounts would create provisions in good years which would be adjusted to smooth out the profits in difficult years.

IAS 37 Provisions, Contingent Liabilities and Contingent Assets was created to prevent this type of "wild west" accounting. It came into force in July 1999.  Therefore under International Finance Reporting Standards rules for provisions are covered in IAS 37.

Conditions For Recognising Provisions

There is a mnemonic for the criteria that need to be met for a provision to be recognised. That mnemonic that helped me quite a lot as a student is ROT.  When and only when all three conditions are met is a provision to be recognised. The three are:

1. (R) Reasonably reliable estimate

There needs to be a reasonably reliable estimate available for the amount of the obligation.

2. (O) Obligation

There must be a present legal or constructive obligation at the year end as a result of a past event.

(T) Transfer

Cash or another form of payment must be expected to transfer out in the future. Or as the standard puts it, "it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation.

An obligation is something that cannot be avoided. In the case of this standard that obligation can be in the form of a constructive obligation or a legal obligation.

A legal obligation arises from a contract or from laws and legislation.

Whereas a constructive obligation arises from an entity's established pattern of past practice, published policies or a sufficiently specific current statement, that indicate to other parties that it will accept certain responsibilities and, as a result , the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.

A example of a constructive obligation would be a statement on the companies website stating for instance that they will provide restoration works at the end of a mining activities.

An outflow of economic benefits should only be regarded as probable is there is more than 50% chance that it is more likely than not to occur. It is rare to have a situation where it is impossible to have a reliable estimate of the obligation amount.

Double Entry For A Provision

The double entry for a provision would be :

Dr  Relevant expense account (Statement of Comprehensive Income or as some call it profit and loss )

Cr Provision (Statement of Financial Position)

Measurement

To come with the figure or the amount for the provision, IAS 37 provides the following guidance:

It should be the best estimate of the expenditure to be required to settle the obligation that existed at the reporting date. IAS 37 states that the best estimate of a provision is:

• In the case of a single obligation i.e. once outcome e.g. one litigation then you pick the most likely amount payable for that single outcome.
• Expected value for a large population of items (various different outcomes). An example would be a case of where you offer to repair for free in the first year of use to all people who buy fridges from you.  Based on your experience you can say that there would be 10% of customers who may require you to repair their fridge at an average cost of $10 per fridge.

IAS 37 also says that an entity should use its own judgement in determining the best estimate based on their past experience and advice of experts eg. lawyers, quantity surveyors etc. You also need to factor in future events that may affect the amount required to settle the obligation as long as there is sufficient evidence that that they will occur.

• You may also need to discount to present value if the value of money causes the figures to be materially different. In determining this the discount rate used should be pre-tax and risk-specific.

Subsequent Treatment.

The standard requires preparers of financial statements to:

1. Review the provision annually and adjusted to show the best current estimate.

2. Only use the provision for expense originally created.

3. In the case where a provision has been discounted to present value, then the discount must be unwound and presented in finance costs in the profit and loss statement or as it is called nowadays statement of profit or loss. The treatment in the books for this as follows:

Dr Finance costs (Statement of Profit and Loss)

Cr. Provisions (Statement of Finance Position or Balance Sheet)

This is done every year until the end of the period of the provision.

Derecognition

As indicated previously the provision should only be used for expenditure that it was originally created for.

If at the reporting date, it is found that it is no longer probable that an outflow of economic benefits will occur then the provision needs to be reversed. To do this:

Dr Provision

Cr PL 

Specific Issues

The standard also provides guidance on a few specific issues:

Future Operating losses

IAS 37 forbids the creation of provision for anticipated losses as there is no obligation for this. The company has options to either close the business or avoid these costs. Besides this this does not meet the definition of a liability as there is no past events here.

However this could also be a sign of an impairment of your assets therefore an impairment review  needs to be conducted and  recognise impairment loss under IAS 36.

Onerous Contracts:

An onerous contract is where  the cost of fulfilling the contract exceeds the benefits received from the contract. An example is a non cancellable operating lease.

In such as case the provision is recognised at the lower of:

Present value of continuing under the contract, and

Present value of exiting the contract.

In other words determine the lower of net cost of fulfilling (i.e. income less costs) and the penalty and use that as the provision amount.

This is also another case where you may need to conduct an impairment review.

Restructuring

A restructuring occurs in the following cases:

• Sale or closure of a line of business
• Ceasing activities in a geographical location.
• Relocating activities
• Re-organisation (management or focus of operations)

In the case of a restructuring a provision is recognise if there is a detailed plan and that plan has been announced. The provision will only include costs which are necessarily to be incurred and not associated with continuing activities.

To test your understanding here are a few questions on provisions:

John is a seller of fridges. On 31st December 2018 he decides to start selling these fridges with a warranty. Under the warranty John offers to repair without charge any fridge that breaks down during the period of the warranty. His estimation based on past experience is that 10% of the fridges sold will require repair within the warranty period at an average cost of $20 per fridge.

On 31st  December 2018 he has sold 100 fridges. 

Note: Time value of money should be ignored.

Requirement: Calculate the warranty provision required.

Answer: Since the best estimate possible is 10% of the sold machines would require repairs at a cost of $20 then the provision should be :  100 fridges sold x 10% x $20 = $200

Dr. P/L $200

Cr. Provision $200

A contingent liability is:

• a possible obligation that arises from past events whose existence will be confirmed by the outcome of one or more uncertain future events not wholly within the control of the entity.

• a present obligation that arises from past events, but does not meet the criteria for recognition as a provision. This is either because an outflow of economic benefits is not probable or (more rarely) because it is not possible to make a reliable estimate of the obligation.

Contingent Assets

A contingent asset is a possible asset that arises from past events and whose existence will be confirmed only by outcome of one or more uncertain future events, not wholly within the control of the entity.

Treatment of Contingent Assets and Liabilities.

Both contingent liabilities and contingent assets should not be recognised in the financial statement but should be disclosed. In the case of a contingent liability it should be disclosed unless the possibility of a future outflow of economic benefits is remote.

However contingent assets should be disclosed if the future inflow of economic benefits is probable i.e more than 50% probability. If the future inflow is virtually certain then it ceases to be a contingent asset and should be recognised as a normal asset.

Below is a table to help in determining on whether to provide or disclose or not for Provisions, contingent Liabilities and contingent assets.

Outcome	Liability (outflow)	Asset (Inflow)
Probable (>50%)	Provide	Disclose
Possible (<50%)	Disclose	ignore
Remote	Ignore	ignore