PROVISION

Contingent Liability
 PROVISION
A provison is an existing liability of uncertain
timing or uncertain amount.

The esscence of a provision is that there is

uncertainty about the timing or amount of
the future expenditure.

It is this uncertainty that distinguishes

provision from other liabilities.
 PROVISION
The liability definitely exists at the end of
reporting period but the amount is indefinite or
the date when the obligation is due is also
indefinite, and in some cases, the payee cannot
be identified or determined.

Actually, a provision may be the equivalent of an

estimated liability or a loss contingency that is
accrued because it is both probable and
measurable.
 Recognition of Provision
PSA 37, paragraph 14, provides that a
provision shall be recognized as a
liability in the financial statements
under the following conditions:
a. The entity has a present obligation,
legal or constructive, as a result of a
past event.
 Recognition of Provision

b. It is probable that an outflow

of resources embodying
economic benefits would be
required to settle the obligation.
c. The amount of the oblligation
can be measured reliably.
 Present Obligation

The present obligation may be legal or

constructive. it is fairly clear what a legal
obligation is.
A legal obligation is an obligation arising
from a contract, legislation or other
operation of law.
A constructive obligation is an obligation
that is derivd from n entity's actions
where:
 Present Obligation

a. The entity has indicated to other parties

that it will accept certain responsibiities by
reason of an established pattern of past
practice, published policy, or a sufficiently
specific current statement.
b. And as a result, the entity has created a
valid expectation on the part of other
parties that it will discharge those
responsibilities.
 Present Obligation

Otherwise defined, a constructive

obligation exists when the entity
from an established pattern of
practice or stated policy has
created a valid expectation that it
will accept certain responsibilities.
 Past Event
The past event that leads to a present
obligation is called an obligating event.
An accounting provision cannot be
created in anticipation of a future event.
The event must have already occured
which gives rise to the legal or
constructive obligation.
 Past Event
An obligating event is an event that creates a
legal or constructive obligation because the
entity has no realistic aternative but to settle the
obligation created by the event.
This is the case where:
a. The settlement of the obligation can be
enforced by the law.
b. The event creates valid expectations on the
part of other parties that the entity will
discharge the obligation, as in the case of a
constructive obligation.
 Probable outflow of economic
benefits
For a provision to qualify for recognition, there
must be not only a present obligation but also a
probable outflow of resources embodying
economic benefits to settle the obligation.
An outflow of resources is regarded as probable if
the event is more likely than not to occur,
meaning, the probability that the event will
occur is greater than the probability that it will
not occur.
Probable outflow of economic
benefits
As a rule of thumb, probable means
more than 50% likely or substantialy
more.
Possible means 50% or less likely to
occur.
Remote means 10% or less likely to
occur or very slight occurence.
 Reliable Estimate
Paragraph 25 of PAS 37 provides that the use of
estimates is an essential part of the preparation
of financial statements and does not undermine
their realibility.
This is especially true in the caseof provision
because by nature, a provision is more
uncertain that most items in the statement of
financial position.
 Reliable Estimate
The standard suggests that by using a range of
possible outcomes, an entity usually would be
able to make an estimate of the obligation that
is sufficiently reliable.
Where no reliable estimate can be made, no
liability is recognized.
 Measurement of Provision
The amount recognized as a provision should be
the best estimate of the expenditure required
to settle the present obligation at the end of
reporting.
The best estimate is the amount that an entity
would rationally pay to settle the obligation at
the end of reporting period or to transfer it to a
third party at that time.
 Measurement of Provision
Where a single obligation is being measured, the
individual most likely outcomes adjusted for the
effect of other possible utcomes may be the
best estimate.
Where there is continous range of possible
outcomes and each point in that range is as
likely as any other, the midpoint of the range is
used.
 Measurement of Provision
Where the provision being measured involved a
large population of items, the obligation is
estimated by "weighting" all possible outcomes
by their associate possibilities. The name for
this statistical method of estimation is
"expected value."
 Illustration - "Expected Value"
Method
An entity sells good with a warranty under which
customers are covered for the cost of repairs
of any manufacturing defects that become
apparent within 6 month after purchase.
If minor defects are detected in all products sold,
repair cost would be about P1,000,000.
If major defects are defected in all products sold,
repair costs of P5,000,000 would result.
 Illustration - "Expected Value"
Method
The entity's past experience and
future expectation indicate that
75% of the goods sold will have
no defects, 20% will have minor
defects and 5% will have major
defects.
The expected value or cost of repairs is measured a follows:

75% sales None

20% sales (20%× 1,000,000) 200,000
5% sales (5%× 5,000,000) 250,000
Total expected value or cost of repairs 450,000
 Another Illustration

An entity is a defendant in a patent

infringement suit. The lawyers
believe that there is a 60% change
that the court will not dismiss the
case and the entity will incur an
outflow of future economic
benefits.
 Another Illustration

If the court rules against the entity and in favor of

the claimant, the lawyers believe that there is a
30% chance the entity will be required to pay
damage of P4,000,000 and a 70% chance that
the damages will be P2,000,000.
A 10% risk adjustment factor to the probabilities
of the expected cash flows is considered
appropriate to reflect the uncertainties in the
cash flow estimate.
 Measurement of Provision

Weighted probabilities:
30% × 4,000,000 × 60% 720,000
70% × 2,000,000 × 60% 840,000
Expected cash outflow 1,560,000
Risk adjustment factor(10%×1,560,000) 156,000
Estimated amount of provision 1,716,000

The amount of the provision shall be discounted if the

effect of the time value of money is material.
 Other measurement
considerations
The following items are taken into consideration
in recognizing and measuring a provision:
1. Risks and uncertainties
2. Present value of obligation
3. Future events
4. Expected disposal of assets
5. Reimbursements
 Other measurement
considerations
6. Changes in provision
7. Use of provision
8. Future operating losses
9. Onerous contract
 Risks and uncertainties

The risks and uncertainties that inevitably

surround events and circumstances
shall be taken into account in reaching
the best estimate of a provision.
Risk describes variability of outcome.
A risk adjustment may increase the
amount at which a liability is measured.
 Risks and uncertainties

As prudence dictates, caution is needed in

making judgment under conditions of
uncertainty so that income and assets are
not overstated, or expenses and liabilities
are not understated.
However, uncertainty does not justify the
creation of excessive provision or a
deliberate overstatement of liabilities.
 Present value of
obligation
Where the effect of the time value of money is
material, the amount of provision shall be the
present value of the expenditure expected to
settle the obligation.
The discount rate should be a pretax rate that
reflects the current market assessment of the
time value of money and the risk specific to the
liability.
The discount rate should not reflect the risk for
which cash flow estimates have already been
adjusted.
 Future Events
Future events that affect the amount
required to settle an obligation shall be
reflected in the amount of a provision
where there is a sufficient evidence that
they will occur.

Such future events include new legislation

and changes in technology.
 Expected disposal of
assets
Gains from expected disposal of assets shall
not be taken into account in measuring a
provision.
Instead, an entity shall recognize gain on
disposal at the time of the disposition of the
assets.
In other words, any cash inflows from disposal
are treated separately from the measurement
of the provision.
 Reimbursements
Where some or all of the expenditure
required to settle a provision is
expected to be reimbursed by another
party, the reimbursement shall be
recognized when it is virtually certain
that reimbursement would be received
if the entity settles the obligation.
 Reimbursements
The reimbursement shall be treated as a
separate asset and not netted against the
estimated liability for the provision.
The amount of reimbursement shall not
exceed the amount of the provision.
However, in the income statement, the
expense relating to the provision may be
presented net of the reimbursement.
 Changes in provision
Provision shall be reviewed at every end of the
reporting period and adjusted to reflect the
current best estimate.
The provision shall be reversed if it is no longer
probable that an outflow of economic benefits
would be required to settle the obligation.
Where discounting is used, the carrying amount
of the provision increases each period to reflect
the passage of time.
 Use of provision
A provision shall be used only for
expenditures for which the provision
was originally recognized.
For example, a provision for plant
dismantlement cannot be used to
absorb environmental pollution claims
or warranty payments.
 Use of provision
If an expenditure is charged against a
provision that was originally
recognized for another purpose, that
would camouflage the impact of two
different events, thus distorting
financial performance and possibly
constituting financial reporting fraud.
 Future operating losses

Provision shall not be recognized for future

operating losses.
In other words, a provision for operting losses is
not recognized because a past event creating a
present obligation has not occured.
However, an expectation of future operating
losses is an indication that certain assets may
be impaired. An impairment test for these
assets may be necessary.
 Onerous contract
If an entity has an onerous contract, the
present obligation under the contract shall
be recognized and measured as a
provision.
An onerous contract is a contract in which the
unavoidable costs of meeting the obligation
under the contract exceed the economic
benefits expected to be received under it.
 Onerous contract
PAS 37, paragraph 68, mandates that the
unavoidable costs under a contract
represent the "least net cost of exiting from
the contract".
The lower amount between the cot of fulfilling
the contract and the compensation or penalty
arising from failure to fulfill the contract is the
least cost of exiting from the contract.
 Examples of provision
a. Warranties - The best estimate of the warranty cost
is recognized as a provision because there is clear
constructive obligation arising from an obligating
event which is the sale of the product with warranty.
b. Environmental contamination - If an entity has an
environmental policy such that other parties would
expect the entity to clean up any contamination, or if
the entity has broken current environmental
legislation then a provision for environmental damage
shall be made.
 Examples of provision
The obligating event is the contamination of the
property which gives rise to constructive or legal
obligation. A provision is recognized for the best
estimate of the cost of cleaning up the
contamination.
c. Decommissioning or abandonment costs -
When an oil entity intially purhases an oil field, it
is put under a legal obligation to decommission
the site at the end of its life.
 Examples of provision

The costs of abandonment or decommissioning

shall be recognized as a provsion and may
be capitalized a cost of the oil field.
d. Court case - After a wedding in the current
year, ten people died possibly as a result of
food poisoning from products sold by the
entity. Legal proceedings are started seeking
damages from entity.
 Examples of provision

When the entity prepares the financial

statements for the current year, the
lawyers advise that owing to the
developments in the case, it is probable
that the enntity would be found liable. A
provision is recognized for the best
estimate of the damages because there is
a present obligation.
 Examples of provision

e. Guarantee - In the current year, an entity

gives a guarantee of certain borrowing of
another entity. During the year, the financial
condition of the borrower files a petition for
bankruptcy.
A provision is recognized for the best estimate
of the guarantee obligation because there is
a legal obligation arising from the obligating
event which is the guarantee.
 Restructuring
PAS 37, paragraph 10, defines restructuring as
a "program that is planned and controlled by
management and materially changes either
the scope of a business of an entity or the
manner in which that business is conducted".
Events that may qualify as restructuring include:
a. Sale or termination of a line of business.
b. Closure of business location in a region or
relocation of business activities from one
location to another or relocation of
 Restructuring
headquarters from one country to another.
c. Change in management structure, such
as elimination of a layer of management
or making all functional units
autonomous.
d. Funcdamental reorganization of an
entity that has a material and significant
impact on its operations.
 Provision for Restructuring
Recognition of the provisionfor restructuring is required
because a constructive obligation may arise from the
decision to restructure.
A constructive obligation for restructuring arises when
two condition are present:
1. The entity has a detailed formal plan for the
restructuring which includes the following:
a. The business being restructed
b. The principal location affected
c. The location, function and apporoximate number of
employees who will be compensated for terminating
their employment.
 Provision for Restructuring

d. Date when the plan will be

implemented.
e. The exenditures that will be undetaken.
2. The entity has raised valid
expectation in the minds of those
affected that the entity will carry out the
restructuring by starting to implement
the plan and announcing the main
features to those affected by it.
 Illustration
The board of directors of an entity at their
meeting held at the current year - end
decided to close than all its international
branches and shift its international
operations and consolidate them with its
domestic operations.
A detailed formal plan for winding up the
international operations was also formalized
and agreed by the board of directors in that
meeting.
 Illustration
Letters were sent out to customers,
suppliers, workers thereafter. Meetings
were called to discuss the features of
the formal plan to wind up international
operations and representatives of all
interested parties were present in
those meetings.
 Amount of restructuring
provision
A restructuring provision shall include only
direct expenditures arising from the
restructuring.
These expenditures are necessarily incurred for
the restructuring and not associated with the
ongoing activities of the entity.
For example, salaries and benefits of
employees to be incurred after operations
cease and that are associated with closure of
the operations shall be included in the amount
of the restructuring provision.
 Amount of restructuring
provision
PAS 37, paragraph 81, specially excludes the
following expenditures from the restructuring
provision:
a. Cost of retraining or relocating continuing staff.
b. Marketing or advertising program to promote
the new company image.
c. Investment in new system and distribution
network.
 Amount of restructuring
provision
Such expenditures are categorically
disallowed as restructuring provisions
because these are considered to be
expenses relating to the future
conduct of the business of the entity,
and thus are not liabilities relating to
the restructuring program.
 Contingent liability
PAS 37, paragraph 10, defines a contigent
liability in two ways:
A contingent liability is a possible obligation
that arises from past event and whose
existence will be confirmed only by the
occurence or nonoccurence of one or
more uncertain future events not wholly
within the control of the entity.
 Contingent liability
A contingent liability is a present
obligation that arises from past event
but is not recognized because it is not
probable that an outflow of resources
embodying economic benefits will be
required to settle the obligation or the
amount of the obligation cannot be
measured reliably.
 Contingent liability and
provision
The second definition states that a contingent
liability is a present obligation.
However, the present obligation is either
probable or measurable but not both to be
considered a contingent liability.
If the present obligation is probable and the
amount can be measured reliably, the
obligation is not a contingent liability but shall
be recognized as a provision.
 Treatment of contingent
liability
A contingent liability shall not be recognized in
the financial statements but shall be
disclosed only. The required disclosures are:
a. Brief description of the nature of the
contingent liability.
b. An estimate of its financial effects.
c. An indication of the uncertainties that exist.
d. Possibility of any reimbursement.
If a contingent liability is remote, no disclosure
is necessary.
 Contingent asset
PAS 37, paragraph 10, provides the following
definition:
A contingent asset is a possible asset that arises
from past event and whose existence will be
confirmed only by the occurence or
nonoccurence of one or more uncertain future
events not wholly within the control of the entity.
A contingent asset shall not be recognized
because this may result to recognition of
income that may never be realized.
 Contingent asset
However, when the realization of income is
virtually certain, the related asset is no longer
contingent asset and its recognization is
appropriate.
A contingent asset is only disclosed when it is
probable.
The disclosure includes a brief description of the
contingent asset and an estimate of its financial
effects.
If a contingent asset is only possible or remote,
no disclosure is required.
 Decommissioning
liability
A decommissioning liability is an
obligation to dismantle remove and
restore an item of property, plant and
equipment as required by law or
contract.
A decommissioning liabilty is also
called asset retirement obligation.
 Illustration
An entity extracts natural gas and oil in the Philippine Deep.
On January 1, 2020, the entity constructed a drilling platform for
P25,000,000 and is required by Philippine law to remove and
dismantle the platform at the end of its useful life of 10 years.
The straight line method is used in depreciating the drilling
pllatform.
The entity has estimated that such decommissioning will cost
P5,000,000.
Based on a 12% discount rate, the present value of 1 for 10 years
is 0.322.
Thus, the preseent value of the decommissioning liability is
P5,000,000 times 0.322 or P1,610,000.
The decommissioning liability is initially recognized at present
value and included in the cost of the related asset.
 Journal entries for 2020
and 2021
2020
Jan. 1 Drilling platform 26,610,000
Cash 25,000,000
Decommissioning liabilty 1,610,000
Dec. 31 Depreciation 2,661,000
Accumuluted depreciation 2,661,000
(26,610,000/10 years)
31 Interest expense 193,200
Decommissioning liability 193,200
(12% × 1,610,000)
 Journal entries for 2020
and 2021
2021
Dec. 31 Depreciation 2,661,000
Accumulated depreciation 2,661,000
31 Interest expense 216,384
Decommissioning liability 216,384
DL - Jan. 1, 2020 1,610,000
IE for 2020 193,200
Carrying amount - Dec. 31,2020 1,803,200
IE for 2021 (12%×1,803,200) 216,384
 Settlement of
decommissioning liability
On December 31, 2029, after 10 years, the enity
contracted with another entity to dismantle and
remove the drilling platform for P5,500,000.
The journal entry to record the settlement of the
decommissioning liability is:
Decommissioning liability 5,000,000
Loss on settlement of decommissioning
liability 500,000
Cash 5,500,000
 Settlement of
decommissioning liability
On January 1, 2020, the
decommissioning liability is
P1,610,000. This amount plus 12%
interest compounded annually will
build up to P5,000,000 after 10 years
on December 31, 2029.
Thus, the decommissioning liability is
debited at P5,000,000.
 Settlement of
decommissioning liability
The journal entry to derecognize the
carrying amount of the drilling
platform on December 31, 2029 is:
Accumulated depreciation 26,610,0000
Drilling platform 26,610,000
 Change in
decommissioning liability
Under IFRIC 1, changes in the measurement
of an exisiting decommissioning liability
shall be accounted for as follows:
1. A decrease in the liability is deducted from
the cost of the asset.
If the decrease in liability exceeds the
carrying amount, the excess is recognized
in profit/loss.
 Change in
decommissioning liability
2. An increase in liability is added to the cost at
the asset.
However, the entity shall consider whether this is
an indication that the carrying amount of the
asset may not be fully recoverable.

If there is such an indication, the asset should be

tested for impairment...
 Illustration
On January 1, 2020, the plant of Seaoil Company is 10 years
old. The cost of the plant is P12,000,000 with accumulated
depreciation of P4,000,000.
The plant has a useful life of 30 years and was depreciated
usig the straight line with no residual value.
Because of the unwinding discount of 6% over 10 years, the
decommissioning liability has grown form P1,000,000 to
P1,790,000.
On January 1, 2020, the discount rate has not changed.
However, the entiy has estimated that as a result of
technological advances, the net present value of the
decommissioning liability has decreased by P800,000.
 Journal entries for 2020
Jan. 1 Decommissioning liability 800,000
Plant asset 800,000
Dec. 31 Depreciation 360,000
Accumulated depreciation 360,000
Cost of plant 12,000,000
Reduction of DL (800,000)
Net Cost 11,200,000
AD (4,000,000)
CA 7,200,000
Depreciation for 2020 360,000
(7,200,000/20 years)
 Journal entries for 2020
Dec. 31 Interest expense 59,400
Decommissioning liability 59,400
Decommissioning liab. - Jan 1,2020 1,790,000
Reduction (800,000)
Adjusted CA - Jan 1, 2020 990,000
Interest Expense for 2020 59,400
(6% x 990,000)
 Problem 1
On November 5, 2020, a Dunn Corp truck was in
an accident with an auto driven by Bell. The
entity received notice on January 12, 2021 of a
lawsuit for P700,000 damages for personal
injuries suffered by Bell. The entity's counsel
believed it is probable that Bell will be awarded
an estimated amount in the range between
P200,000 and P500,000. The accounting year
ends on December 31, and the 2020 financial
statements were issued on March 31, 2021.
What amount of provision should Dunn
accrued at December 31,2020?
a.0
b. 200,000
c. 500,000
d. 350,000
 Problem 2
During 2020, Manfred Company guaranteed a
supplier’s P500, 000 loan from a bank. On
October 1, 2020, the entity was notified that the
supplier had defaulted on the load and filed for
bankruptcy protection. Counsel believed that
the entity would probably have to pay P250,000
under the guarantee. As a result of the
supplier’s bankruptcy, the entity entered into a
contract in December 2020 to retool its
machines so that the entity could accept parts
from other suppliers. Retooling costs are
estimated to be P300,000.
What amount should be reported as
liability on December 31,2020?
a. 250,000
b.450,000
c.550,000
d.750,000
 Problem 3
During 2020, Beal Company became
involved in a tax dispute with the BIR. On
December 31, 2020, the tax advisor
believed that an unfavorable outcome was
probable and a best estimate of additional
tax was P500,000. But could be as much
a P650,000. After the 2020 financial
statements were issued, the entity
received and accepted a BIR settlement
offer of P550,000.
What amount of accrued liability should
be reported on December 31, 2020?
a. 650,000
b. 550,000
c. 500,000
d. 0
 Problem 4
On February 5, 2021 an employee filed a
P2,000,000 lawsuit against Steel Company
for damages suffered when a plant exploded
on December 29, 2020. The entity's legal
counsel believed the entity will probably
expects lose the lawsuit and estimated the
loss to be between P500,000. The employee
has offered to settle the lawsuit out of court
for P900,000 but the entity will not agree to
the settlement.
On its December 31, 2020, what
amount should be reported as
accrued liability?
a. 2,000,000
b. 1,000,000
c. 900,000
d. 500,000
 Problem 5
On November 25, 2020, an explosion occurred at
a Rex Company plant causing extensive
property damage to area buildings. By March
10, 2021, claims had been asserted against
Rex Company. The management and counsel
concluded that it is probable Rex Company will
be responsible for damages, and that
P3,500,000 would be a reasonable estimate of
the liability. The entity's P10,000,000
comprehensive public liability policy has a
P500,000 deductible clause. The financial
statements for 2020 issued on March 25, 221.
1. What amount of loss from lawsuit
should be reported in the income
statement for 2020?
a. 3,500,000
b. 3,000,000
c. 500,000
d. 0
2. What amount of liability from lawsuit
should be reported on December 31,
2020?
a. 3,500,000
b. 1,750,000
c. 1,500,000
d. 750,000