1 Chapter 4 – Provision / Contingent Liability

Marx Yuri Jayme

Provision
An existing liability of uncertain timing or uncertain amount. A provision may be equivalent of an estimated liability
or loss a contingency that is accrued because it is both probable and measurable.
Recognition of Provision
PAS 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 present obligation, legal or constructive.
b. There is a probable outflow of resources embodying economic benefits would be required to settle the
obligation.
c. The amount of the obligation can be measured reliably.

Present Obligation
It might be Legal Obligation or Constructive Obligation.
Legal Obligation – arising from a contract, legislation or other operation of law.
Constructive Obligation – derived from an entity’s action where:
a. The entity has indicated to other parties that it will accept certain responsibilities by reason of an
established pattern of past practice, published policy, or a sufficiently specific current statement.
b. As a result, the entity has created a valid expectation on the part of other parties that it will
discharge those responsibilities.

Past Event
This leads to a present obligation called as an obligating event. Obligating event is an event that creates a legal or
constructive obligation because the entity has no realistic alternative but to settle the obligation created by the
event.
This is the case where:
a. The settlement of the obligation can be enforced by 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

The probability that the event will occur is greater than the probability that it will not occur. As a rule of thumb,
probable means more than 50% likely or substantially more. Possible means 50% or less likely to occur. Remote
means 10% or less likely to occur or very slight occurrence.

Reliable Estimate
A provision is naturally uncertain, thus as stated in PAS 37 paragraph 25 that the use of estimate is an essential part
of the preparation of financial statements and does not undermine their reliability.
The standard suggests that by using a range of possible outcomes, an entity usually would be able make an estimate
of the obligation that us sufficiently reliable.
If no reliable estimate can be made, no liability is recognized.
Measurement of Provision
The Best Estimate of the expenditure required to settle the present obligation at the end of reporting period shall be
the amount recognized as Provision.

When a single obligation is being measured, the individual most likely outcome adjusted for the effect of other
possible outcomes may be the best estimate.

When there is a continuous range of possible outcomes and each point in that range is as likely as any other, the
midpoint of the range is used.

The provision being measured involves a large population of items; the obligation is estimated by “weighting” all
possible outcomes by their associated possibilities. The name for this statistical method of estimation is “expected
value”.
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Illustration of expected value method

An entity sells good with a warranty under which the customers are covered for the cost of repairs of any
manufacturing defects that become apparent within 6 months after purchase. If minor defects are detected in all
products sold, repair costs of 5,000,000 would result. The entity’s past experience and future expectations 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 measure as follows:

75% sales none

20% sales (20% x 1,000,000) 200,000
5% sales (5% x 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% chance that the court
will not dismiss the case and the entity will incur an outflow of future economic benefits. 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 damages of 4,000,000 and a 70% chance that the damages will be 2,000,000. 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.

Measure of the provision

Weighted Probabilities:

30% x 4,000,000 x 60% 720,000

70% x 2,000,000 x 60% 840,000
Expected Cash Outflow 1,560,000
Risk Adjustment Factor (10% x 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 Consideration

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
6. Changes in Provision
7. Use of Provision
8. Future Operating Losses
9. Onerous Contract

Risk and Uncertainties

This shall be taken into account in reaching the best estimate of a provision.

A risk adjustment may increase the amount at which a liability is measured.

As a prudence (Conservativism) 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.

Note that uncertainty does not justify the creation of excessive provision or deliberate overstatement of liabilities.
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Present Value of Obligation

If the effect of the time value of money is material the present value of the expenditure shall be the amount of the
expenditure. Meaning we need to discount the provision.

The discount rate should be pretax rate that reflects the current market assessment of the time value of money and
the risk specific to the liability, and not the cash flow estimates that have already been adjusted.

Future Events

This affects the amount required to settle an obligation that shall be reflected in the amount of the provision where
there is sufficient evidence that they will occur. This includes new legislation and changes in technology.

Expected Disposal of Assets

Gains in disposal of the assets shall not be taken into account in measuring a provision. Instead, the entity shall
recognize gain on disposal at the time of the disposition of the asset. In other words, any cash inflows from disposal
are treated separately from the measurement of the provision.

Reimbursements

If the provision is to be reimbursed by a third party, the reimbursement is recognized only if it is virtually certain or
there a huge chance that the reimbursement would be received if the entity settles the obligation.

The reimbursement is treated as a separate asset from the estimated liability of the provision. Meaning, the amount
of the reimbursement shall not be deducted from the amount of the provision.

The amount of the reimbursement shall not exceed the amount of the provision.

The expense related to the provision may be presented net of the reimbursement, in the INCOME STATEMENT.

Changes in Provision

Provisions 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 down the obligation.

When 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. Otherwise, it would
distort the financial performance and a possible financial reporting fraud.

Future Operating Losses

Provisions shall not be recognized for future operating losses. Future operating loss is not a liability.

Onerous Contract

The present obligation under onerous contract shall be recognized and measured as a provision. Under the onerous
contract the unavoidable cost exceeds the expected economic benefit to be received under the contract.

PAS 37, paragraph 68 states that the unavoidable costs under the contract represents the least net cost of exiting
from the contract.

The least net cost of exiting the contract is the cost of fulfilling the contract or the compensation or penalty arising
from the failure to fulfill the contract whichever is lower.

Examples of Provisions:

1. Warranties – you have a sale of product with warranty which is an obligating event that arises to your
obligation.
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2. Environmental Contamination – the contamination of the property is the obligating event which gives
rise to constructive or legal obligation. The best estimate of the cost of cleaning up the contamination is
recognized as provision.
3. Decommissioning or Abandonment Cost – if an entity purchases a property that is to be
decommissioned at the end of its useful life. The cost of decommissioning or abandonment shall be
recognized as provision and may be capitalized as the cost of the property.
4. Court Case – when an entity prepares a financial statement after an accident, if the lawyer stated that
the entity would be liable for the accident, a provision shall be recognized for the best estimate of the
damages.
5. Guarantee – the best estimate of the guarantee obligation is recognized as provision, commonly arising
from bankruptcy.

Restructuring

PAS 37, paragraph 10, defines restructuring as a program that is planned and controlled by the management and
materially changes either the scope of the 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 business

b. Closure of a business in a specific location or relocation of business from one region to another.
c. Change in management structure.
d. Fundamental reorganization of an entity that has a significant impact on its operation.

Provision for Restructuring

Since there is a constructive obligation arises from the decision of restructuring a provision shall be recognized.

A constructive obligation for restructuring arises when two conditions are present:

1. There is a detailed formal plan for restructuring which includes:

a. The business being restructured.
b. The principal location being affected.
c. The location, function and approximate number of employees who will be compensated for
terminating their employment.
d. Data of when the plan will be implemented.
e. The expenditure that will be undertaken.
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.

Amount of Restructuring Provision

Only the direct expenditures arising from the restructuring shall be included in restructuring provision.

Direct expenditures are necessarily incurred for the restructuring and not associated with the ongoing activities of
the entity.

PAS 37, paragraph 81, specifically excludes the following expenditures from the restructuring provision:

1. Cost of retaining or relocating continuing staff.

2. Marketing or advertising program to promote the new company image.
3. Investment in new system and distribution network.

These 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 nor liabilities relating to the
restructuring program.
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CONTINGENT LIABILITY

PAS 37 paragraph 10 defines contingent liability in two ways:

1. It is a possible obligation that arises from past event and whose existence will be confirmed only by the
occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of the
entity.
2. It is a present obligation that arises from past events 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

Provision is both probable and measurable while the Contingent Liability is either probable or measurable but not
both.

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 provision.

Treatment of contingent liability

In provision an expense and liability are recognized in the Financial Statements while the Contingent Liability shall
not be recognized in the Financial Statements but shall be disclosed. The required disclosures are:

1. Brief description of the nature of the contingent liability

2. An estimate of its Financial Effects
3. An indication of uncertainties that exist
4. Possibility of any reimbursements

If a contingent liability is remote or there is less than 10% of possibility, no disclosure is necessary.

Contingent Asset

PAS 37, paragraph 10 provides the following definition:

1. It is a possible asset that arises from past event and whose existence will be confirmed only by the
occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of the
entity.
2. It shall not be recognized because this may result to recognition of income that may never be realized.

When the realization of income is virtually certain the related asset is no longer a contingent asset and its
recognition is appropriate.

When the contingent asset is probable it is disclosed. The disclosure includes a brief description of the contingent
asset and an estimate of its financial effects.

When the contingent asset is only probable or remote, no disclosure is required.

Decommissioning Liability

It is an obligation to dismantle, remove and restore an item of property, plant and equipment as required by law or
contract. A decommissioning liability is also called asset retirement obligation.

Illustration

On January 1, 2020, the entity constructed a drilling platform for 25,000,000 and is required by Philippine Law to
remove and dismantle the platform at the end of its useful life of 10 years. Straight Line Method is used is
depreciating the drilling platform. The entity has estimated that such decommissioning will cost 5,000,000. Based on
12% discount rate, the present value of 1 for 10 years is 0.322. Thus, the present value of the decommissioning
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liability is 5,000,000 times 0.322 or 1,610,000. The decommissioning liability recognized at present value and
included in the cost of the related asset.

Journal Entries

2020

Jan. 1 Drilling Platform 26,610,000

Cash 25,000,000
Decommissioning Liability 1,610,000
Dec. 31 Depreciation 2, 661,000
Accumulated Depreciation 2,661,000
(26,610,000 / 10 Years)
Interest Expense 193,200
Decommissioning Liability 193,200
(12% x 1,610,000)
2021

Dec.31 Depreciation 2,661,000

Accumulated Depreciation 2,661,000

Dec. 31 Interest Expense 216,384

Decommissioning Liability 216,384
(1,803,200 x 12%)

Decommissioning Liability – Jan.1 2020 1,610,000

Interest Expense for 2020 193,200
CA of Decommissioning Liability – Dec. 31, 2020 1,803,200

Settlement of Decommissioning Liability

On December 31, 2029, after 10 years, the entity contracted with another entity to dismantle and remove the
drilling platform for 5,500,000.
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

The Journal Entry to derecognize the carrying amount of the drilling platform on December 31, 2029 is:
Accumulated Depreciation 26,610,000
Drilling Platform 26,610,000

Change in Decommissioning Liability

Under IFRIC 1, changes in the measurement of an existing 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 or loss.
2. An increase in liability is added to the cost of 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 12,000,000 with
accumulated depreciation of 4,000,000. The plant has a useful life of 30 years and was depreciated using the
straight-line method with no residual value. Because of the unwinding discount of 6% over 10 years, the
decommissioning liability has grown from 1,000,000 to 1,790,000. On January 1, 2020, the discount rate has not
changed. However, the entity has estimated that as a result of technological advances, the net present value of the
decommissioning liability has decreased by 800,000.
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Journal entries
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

Less: Reduction of Decommissioning Liability 800,000
Net Cost 11,200,000
Less: Accumulated Depreciation 4,000,000
Carrying Amount 7, 200,000
Divide: Remaining Useful Life 20 Years
Depreciation for 2020 360,000

Dec. 31 Interest Expense 59,400

Decommissioning Liability 59,400

Decommissioning Liability – Jan.1 2020 1,790,000

Less: Reduction of Decommissioning Liability 800,000
Adjusted Carrying Amount – Jan.1 2020 990,000
Multiply: 6% Discount 0.06
Interest Expense – 2020 59,400