F3-25 IAS 37 Provisions, Contingent Liabilities and Contingent Assets

Session 25
IAS 37 Provisions,
Contingent Liabilities
and Contingent Assets
FOCUS
This session covers the following content from the ACCA Study Guide.
D. Recording Transactions and Events

9. Provisions and contingencies
a) Understand the definition of "provision", "contingent liability" and
"contingent asset".
b) Distinguish between and classify items as provisions, contingent liabilities
or contingent assets.
c) Identify and illustrate the different methods of accounting for provisions,
contingent liabilities and contingent assets.
d) Calculate provisions and changes in provisions.
e) Account for the movement in provisions.
f) Report provisions in the final accounts.
F. Preparing Basic Financial Statements

3. Disclosure notes
b) Draft the disclosure note for provisions.
Session 25 Guidance
Understand the basics of this very important IFRS. The implications of its requirements are far
reaching and in later papers you will need to deal with its more detailed requirements.
Learn the terminology in section 1. In particular, a provision must be a liability.
Understand the recognition criteria (s.2.1) and that an item meeting the criteria must be recognised
as a liability (s.2.2).
(continued on next page)

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VISUAL OVERVIEW
Objective: To explain the accounting treatment for provisions and contingencies.
IAS 37
• Scope
• Terminology
PROVISIONS CONTINGENCIES
• Recognition Criteria • Nature
• Accounting Treatment • Uncertainty
• Measurement • Contingent Liabilities
• Contingent Assets
ACCOUNTING TREATMENT
• Summary
• Disclosures
Session 25 Guidance
Read the guidance on measurement (s.2.3) and appreciate its application to a single obligation
(Illustrations 2 and 3) or multiple obligations (Illustrations 4 and 5). Do Example 1.
Appreciate that a contingency is not necessarily uncertain (s.3.1). Do Example 2 as a review of
your understanding.
Read through the remainder of the session and understand the summary points.
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Session 25 • IAS 37 Provisions, Contingent Liabilities and Contingent Assets F3 Financial Accounting
1 IAS 37
1.1 Scope
IAS 37 Provisions, Contingent Liabilities and Contingent Assets
applies to all entities and details the accounting for provisions,
contingent liabilities and contingent assets excluding those
covered by other Standards.
For example, IAS 37 excludes provisions arising from:
 construction contracts;
 income taxes;
 leases; and The more specific
 employee benefits. IFRSs covering these
topics are all outside
1.2 Terminology the scope of the FFA/
F3 syllabus.
Provisions: liabilities of uncertain timing or amount.
Liability: a present obligation arising from past events, the
settlement of which is expected to result in an outflow of
resources embodying economic benefits.
Contingent liability: either a
 possible obligation arising from past events 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*
*A possible obligation
 present obligation arising from past events (an obligating cannot be provided as
event) which is not recognised because: a contingent liability
(i) an outflow of resources is not probable; or until it becomes
probable (i.e. when it
(ii) it cannot be measured with sufficient reliability.*
meets the definition of
Contingent asset: a possible asset arising from past events a liability).
whose existence will be confirmed only by the occurrence or non- *That is, it does not
occurrence of one or more uncertain future events. meet the recognition
criteria for a provision
in that again it is
not probable or it
cannot be measured.
(Elements of financial
statements must be
measurable.)
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F3 Financial Accounting Session 25 • IAS 37 Provisions, Contingent Liabilities and Contingent Assets
2 Provisions
2.1 Recognition Criteria

For any liability, including provisions, to be recognised, all three
criteria must be satisfied:
1. A present obligation (legal or constructive) exists as a result of
a past event.
2. An outflow of resources to settle the obligation is probable.*
3. A reliable estimate of the obligation amount can be made.
2.2 Accounting Treatment *Probable means more

likely than not (i.e.
The accounting entry is usually:* greater than 50%).
Only in extremely
Dr Profit or loss (expense)
rare cases will it not
Cr Provision (liability) be possible to make a
reliable estimate.
*The debit (Dr) entry sometimes may be included in the initial cost
of a non-current asset (e.g. a decommissioning cost, in accordance
Provisions must be
with IAS 16) rather than as an expense. The credit (Cr) entry,
recognised in the
however, always will be a liability in the statement of financial
financial statements.
position.
2.3 Measurement
 This should be a best estimate. For example, a best estimate
might be:
 evidenced by events after the end of the reporting period
(see Session 26);
 an expected value (i.e. weighting all possible outcomes
by their probabilities) which can be used to estimate
obligations such as warranties for products sold or other
multiple obligations;
 the midpoint of a range of possible values;
 the most likely outcome (for single, one-off obligations).
 Separately identifiable provisions (e.g. for legal claims) should

be measured individually.

Illustration 1 Substantial
Legal Claims
Factors taken into account in evaluating the provision include:
 progress of claim at date on which financial statements are authorised

for issue;
 opinions of legal experts or otherwise;
 experience of the entity in similar cases; and
 experience of other entities in similar situations.
 For provisions common to a group of similar transaction (e.g.

product warranties), costs may be incurred frequently.
 If, by experience, a liability (e.g. for warranties) can
be estimated with reasonable precision, a provision is
recognised in the same accounting period in which the related
transactions (e.g. sales) occur.*
*A provision recognised in the same accounting period in which

the related transactions occur is an example of the accrual and
matching concepts.
Illustration 2 Best Estimate
In 2013, Bendick was sued for damages by a major customer for breach of contract. In
March 2014, the court ruled in favour of the customer but deferred its ruling on the amount
of damages until June. For legal advice in defence of this claim Bendick paid $15,000
in 2013; a further $20,000 to date (to be paid once the matter is settled in June); and
Bendick expects to pay an additional $10,000 before the matter is wholly settled.
Bendick's legal advisor is of the opinion that Bendick will be directed to reimburse the
customer's legal costs, which he estimates will be as much as those of Bendick. Based on
the level of damages being claimed, he also is of the opinion that these are likely to be in
the region of $250,000 to $300,000.
Analysis of best estimate
Bendick should provide for the sum of:
1. its own legal costs incurred after the end of the reporting period ($15,000 incurred in
2013 is already expensed);
2. the best estimate of the customer's legal costs;
3. the best estimate of the damages—this is the most subjective. As the estimated range
of the outcome is quite narrow, any amount in this range may be considered as good
an estimate as any other. However, as the lower end of the range may be considered
imprudent and the upper end over prudent, a midpoint may be selected.
Thus a best estimate may be:
$000
For Bendick's legal costs ($20,000 + 10,000) 30
For the customer's legal costs ($15,000 + 20,000 + 10,000) 45
For the award of damages (midpoint of range) 275
350

Illustration 3 Single Outcome

Best Estimate
The facts are the same as in Illustration 2 except that the legal
advisor is of a different opinion regarding the award of damages.
The legal advisor suggests that the most likely award of damages
will be $120,000. He thinks there is an outside chance, however,
that the court may rule for punitive damages amounting to
$500,000. He thinks there also is an outside chance that the
ruling may consider some contributory negligence on the part of
the customer and award only nominal damages (i.e. of minimal
monetary amount).
Even if specific probabilities could be assigned to the extremes (say
10% each), the calculation of an expected value is not appropriate.
For example, taking $0 as an approximation of nominal: *This illustration
(10% × $0) + (80% × $120,000) + (10% × $500,000) = $146,000 shows that where
a best estimate is
This amount does not correspond to any of the outcomes envisaged. made for a single
(Also, as a rather specific amount, it suggests an inappropriate
outcome, an expected
degree of precision.)
value approach is not
The best estimate is therefore the most likely item, $120,000.* appropriate.
Illustration 4 Warranties
Provision
Amber sells goods with a warranty to cover the costs of repairing
manufacturing faults found within 12 months of purchase. The
estimated costs of repairs in 2014 for products sold in 2013 depend
on whether the faults are major or minor. If all products returned
under warranty are returned with only minor faults, the repair costs
are estimated at $100,000. However, if all returned products have
major faults, repair costs are estimated at $400,000. In Amber's
experience, 75% of goods sold have no faults, 20% have minor
faults and 5% have major faults.
An expected cost of repairs can be calculated as the amount to
be provided in the financial statements in respect of the warranty
claims for the year ended 31 December 2013:
(75% × $0) + (20% × $100,000) + (5% × $400,000) = $40,000*
*This is only one possible estimate. A more accurate estimate might

be made by considering also the likelihood that all products with
minor defects will be returned for repair.
For example, it also may be Amber's experience that goods are
returned for minor repairs mostly in the first few months after
purchase (when goods are relatively new) and that customers
generally do not return products when the warranty is close to
expiry (e.g. because they lose warranty documentation or cannot
be bothered).

Example 1 Warranty Provision
Following on from Illustration 4, Amber has made a provision

of $40,000 at 31 December 2013. Amber must remeasure the
amount of provision required at the end of 2014 and now estimates
costs of $120,000 if all products sold have minor faults to be
repaired, but only $350,000 if all have major faults. Due to some
improvements in the manufacturing process during the year, Amber
now estimates that 80% of products sold will be without fault, 15%
will have minor faults and 5% will have major faults.
Required:
Calculate the expected cost of warranty claims to be
provided in the financial statements for the year ended 31
December 2014 and state the journal entry to account for
the movement on (change in) the provision.
Solution
Expected cost:
Journal entry:
Dr
Cr
Illustration 5 Movement on Provision
Following on from Illustration 4 and Example 1.

In 2014, Amber incurred $32,500 in making repairs to goods returned under
warranty. The entries in the ledger accounts will be as follows:
Warranty provision*
$ $
Transfer to warranty repairs 4,500 1 Jan Balance b/fwd 40,000
31 Dec Balance c/fwd 35,500
40,000 40,000
1 Jan Balance b/fwd 35,500
Warranty repairs expense

$ $
Cash/trade payables 32,500 Transfer provision 4,500
Transfer profit or loss 28,000
32,500 32,500
*In reviewing provisions, management should consider the suitability

of the prior year estimate—is it sufficient or excessive? An over-
provision (as illustrated here) may indicate that management has
been overly prudent and needs to adjust future estimates accordingly.

3 Contingencies
3.1 Nature
For a contingent asset or liability, a key issue is whether its
existence is confirmed or not confirmed.*
 If confirmed, it is contingent because recognition criteria for
a provision have not (yet) been met.
 If not confirmed, then it is contingent because uncertain
future events may or may not occur.
*The fact that an estimate is involved does not of itself create the
type of uncertainty which characterises a contingency.
Example 2 Contingencies
Determine which of the following uncertainties meet the criteria of a
contingency. Write "Yes" (if it does) or "No" (if it does not).
Solution
Contingency:
Uncertainty Yes or No
(a) Litigation pending
(b) Estimating useful lives of asset
(c) Guarantee (e.g. of a bank loan)
(d) Recoverability of a liquidated debt
(e) Options (e.g. to sell or purchase shares)
(f) Estimates of amounts owed for services

received
(g) Net realisable value of slow-moving

inventories

3.2 Uncertainty
The uncertainty of a contingency can be expressed by a range of
outcomes. The approaches range from specific to general.
 Quantified probabilities (e.g. 40% chance of A and 60%
chance of B) are specific. This suggests a level of precision
which is unlikely to be supported by available information.
 General descriptions, which are better supported by the
available information, use terms ranging from probable to
remote.
3.3 Contingent Liabilities

Contingent liabilities should be:
 Disclosed (unless the possibility of a loss is remote) in the
notes to the financial statements. Contingent liabilities
should not be
 Recognised as a provision when the loss (outflow of economic recognised as
benefits) becomes probable.* liabilities.
*A provision recognised when a loss becomes probable is an

example of the prudence concept.
3.4 Contingent Assets

For contingent assets, the following apply:
 Existence should be disclosed if it is probable that a gain Contingent assets
(i.e. economic benefits) will be realised. Disclosure must should not be
avoid giving misleading implications about the likelihood of recognised as assets
realisation. (because this may
 When realisation is virtually certain, there is no contingency result in recognition
and recognition is then appropriate. of revenue which may
never be realised).
4 Accounting Treatment
4.1 Summary
Flow of Resources Obligation Asset
Remote No disclosure No disclosure
Probably not, but possible Contingent liability disclosure No disclosure
Probable Provision (if reliable estimate)— Disclosure required

otherwise a contingent liability
Expected/ Provision Asset (not contingent)

virtually certain

4.2 Disclosures
4.2.1 Provisions
For each class of provision, the following must be disclosed:
 A reconciliation of carrying amounts (including increases,
utilisation and reversals).
 A brief description of the obligation.
 An indication of uncertainties about the amount or timing of
outflows.
 Expected reimbursement (if any).
Exhibit 1 RECONCILIATION OF
CARRYING AMOUNTS
The following extract is from the notes to SKF's 2011 Annual Report.
19. Other provisions (extract)

2011 Reversal 2011
Closing Provisions Utilized unutilized Translation Opening
SEKm balance for the year amounts amounts Other effect balance
Restructuring 148 15 −243 −46 −9 — 431
Environmental 91 4 −7 — 6 1 87
Claims 649 96 −143 −65 16 2 743
Long-term
474 111 −72 −4 49 −11 401
employee benefits
Other 474 57 −78 −9 4 — 500
1,836 283 −543 −124 66 −8 2,162
Environmental provisions and provisions for claims cover obligations not settled at year-
end. Long-term employee benefits primarily include jubilee bonuses and part-time retirement
programmes which are provided to employees in certain countries and are expected to be
settled before employment ends. The increase in long-tern employee benefits for 2011 refers
mainly to the Jubilee provisions in Italy. Other provisions primarily include litigation, insurance
and anti-dumping duties.
4.2.2 Contingencies
The following disclosures are required for contingencies:
 Nature of the contingent liability/asset.
 Estimate of financial effect (where practicable).
 Uncertainties affecting amount or timing.

Summary
 A provision is a liability (i.e. a present obligation) of uncertain timing or amount.
 A provision must be recognised in the statement of financial position if it is probable (i.e.
more likely than not) and can be measured reliably.
 The credit entry for setting up a provision is as a liability; the debit entry is to profit or loss
unless it is a component of a cost of an asset (under IAS 16).
 Measurement of a provision is a best estimate (e.g. an expected value, a mid-point of a
range or a most likely outcome).
 An expected value is not a suitable estimate for one-off events.
 A provision must be remeasured at each reporting date and any movement accounted for
(usually in profit or loss).
 Contingent liabilities should not be recognised but are disclosed (unless remote).
 Contingent assets should not be recognised but disclosed (if probable).
 When the realisation of an asset is virtually certain, then it is not contingent.
Session 25 Quiz
Estimated time: 15 minutes
1. Define liability and contingent liability. (1.2)

2. State the recognition criteria for a liability. (2.1)
3. True or false? A provision cannot be made if its amount cannot be reliably estimated. (2.1)
4. Suggest FOUR ways of making a best estimate of a provision (2.3)
5. State TWO ways in which uncertainty may be expressed. (3.2)
6. State the accounting treatment of contingent liabilities and contingent assets. (3.3, 3.4)
Study Question Bank

Estimated time: 10 minutes
Priority Estimated Time Completed
Q137 MCQs 10 minutes

Session 25
EXAMPLE SOLUTIONS
Solution 1—Warranty Provision

Expected cost:
(80% × $0) + (15% × $120,000) + (5% × $350,000) = $35,500
Journal entry: The movement in provision is a decrease which will
be credited back to profit or loss:
Dr Provision $4,500
Cr Profit or loss $4,500
Solution 2—Contingencies
Contingency:
Uncertainty Yes or No
(a) Litigation pending is contingent on the court's decision. Yes
(b) Estimating useful lives of asset is not a contingency. Estimation No
used to determine depreciation does not make depreciation a
contingency. Eventual expiry of useful life is not an uncertain
event.
(c) Guarantee (e.g. of a bank loan): Whether the bank will call upon Yes
the guarantee to obtain reimbursement of the loan is an unknown
future event; therefore, it is a contingency.
(d) Recoverability of a liquidated debt: The fact that the amount of a No
provision against the recorded trade receivable has to be estimated
does not result in a contingency. There is nothing uncertain about
the fact that the customer has gone into liquidation.
(e) Options (e.g. to sell or purchase shares): An option is a right that Yes
is exercised at the behest of the person who paid for the option.
Whether the option will be exercised is not known with certainty
therefore it is a contingency.
(f) Estimates of amounts owed for services received are not No
contingencies. These obligations have been incurred.
(g) Net realisable value of slow-moving inventories: That a provision No
needs to be estimated does not create a contingency. The
inventory is slow moving. The exercise of prudence will be a
consideration in determining an appropriate accounting estimate.

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Session 25

D. Recording Transactions and Events

F. Preparing Basic Financial Statements

(continued on next page)

Ali Niaz - ali.niaz298@gmail.com

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Ali Niaz - ali.niaz298@gmail.com

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2.1 Recognition Criteria

2.2 Accounting Treatment *Probable means more

 Separately identifiable provisions (e.g. for legal claims) should

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 progress of claim at date on which financial statements are authorised

 opinions of legal experts or otherwise;

 experience of the entity in similar cases; and

 experience of other entities in similar situations.

 For provisions common to a group of similar transaction (e.g.

*A provision recognised in the same accounting period in which

Illustration 2 Best Estimate

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Illustration 3 Single Outcome

*This is only one possible estimate. A more accurate estimate might

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Example 1 Warranty Provision

Following on from Illustration 4, Amber has made a provision

Illustration 5 Movement on Provision

Following on from Illustration 4 and Example 1.

Warranty repairs expense

*In reviewing provisions, management should consider the suitability

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(a) Litigation pending

(b) Estimating useful lives of asset

(c) Guarantee (e.g. of a bank loan)

(d) Recoverability of a liquidated debt

(e) Options (e.g. to sell or purchase shares)

(f) Estimates of amounts owed for services

(g) Net realisable value of slow-moving

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3.3 Contingent Liabilities

*A provision recognised when a loss becomes probable is an

3.4 Contingent Assets

Flow of Resources Obligation Asset

Remote No disclosure No disclosure

Probably not, but possible Contingent liability disclosure No disclosure

Probable Provision (if reliable estimate)— Disclosure required

Expected/ Provision Asset (not contingent)

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19. Other provisions (extract)

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1. Define liability and contingent liability. (1.2)

Study Question Bank