MODULE 01 CILO 02 WEEK 02 TO 03

PROVISIONS AND CONTINGENT LIABILITIES

OVERVIEW
Provision is an obligation whose existence is certain as of the balance sheet date and
only the timing of settlement or the amount to be settled is uncertain. It is recorded
in the books of accounts and reported in the financial statements.

Contingency is an obligation whose existence is uncertain as of the balance sheet

date, or when the amount of the obligation cannot be reliably estimated even if it is
probable to result to an outflow of resources; only one of the conditions for
recognition of liability is met. It is only reported in the financial statements.

PROVISIONS
A provision is an existing liability of uncertain timing or uncertain amount. The
nature of a provision is that there is uncertainty about the timing or amount of the
future expenditure. It is true that the liability exists at the end of reporting period.
However, the amount is indefinite or the date when the obligation is due is also
indefinite. In some cases, the payee cannot be identified or determined. A provision
may be the equivalent of an estimated liability or a loss contingency that is accrued
because it is both probable and measurable.

PAS 17, paragraph 14, provides that a provision shall be recognized as a liability in
the financial statements under the following conditions:

I. The entity has a present obligation, legal or constructive, as a result of a past event.

The present obligation may be legal or constructive. A legal obligation is an obligation

arising from a contract, legislation or other operation of law. A constructive obligation
is an obligation that is derived from an entity’s actions where 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,
and the entity has created a valid expectation on the part of other parties that it will
discharge those responsibilities. The past event that leads to a present obligation is
called an obligating event. The event must have already occurred which gives rise to
the legal or constructive obligation.
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PROVISIONS AND CONTINGENT LIABILITIES
II. It is probable that an outflow of resources embodying economic benefits would be
required to settle the obligation.

For a provision to be recognized there must also be a probable outflow of resources

embodying economic benefits to the obligation. If the probability that the event will
occur is greater than the probability that it will not occur, an outflow of resources is
regarded as probable.

As a rule of thumb, probable means more than 50% or substantially more likely to
occur; possible means 50% or less likely to occur; remote means 10% or less likely to
occur or very slight occurrence.

III. The amount of the obligation can be measured reliably.

The use of estimates is an essential part of the preparation of financial statements

and does not undermine their reliability, as provided in Paragraph 25 of PAS 37.
This is true in the case of provision because in essence, a provision is more uncertain
than most items in the statement of financial position. The standard suggests that
by using a range of possible outcomes, an entity would usually be able to make an
estimate that is sufficiently reliable of the obligation. Where no reliable estimate can
be made, no liability is recognized

The amount recognized as a provision should be the best estimate of the expenditure
required to settle the present obligation at the end of the reporting period. Best
estimate is the amount that an entity would logically pay to settle at the end of the
reporting period or to transfer it to a third party at that time.

Provisions are normally recognized as a debit to expense (or loss) and a credit to an
estimated liability account.

Illustration A: In 2018, North Diamond Inc. received a court order requiring the
restoration of environmental damages caused by its quarrying operations. North
Diamond has no other realistic alternative but to comply. The best estimate of the
restoration cost is P15,000,000.

In the books of the company, the following journal entry should be prepared to
recognize the provision:

Environmental Restoration Cost 15,000,000

Estimated Liability for Restoration Cost 15,000,000
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PROVISIONS AND CONTINGENT LIABILITIES
Illustration B: Domino, Inc. sells digital toys with a warranty that covers the cost of
repairs caused by manufacturing defects that becomes evident within six (6) months
after purchase. If minor defects are detected in all products sold, repair would cost
Domino P1,000,000, while for major defects, repair would cost P5,000,000. Domino’s
past experiences and future expectations indicate that 75% of sales have no defects,
20% will have minor defects, and 5% will have major defects. The expected cost of
repairs is computed as follows:

75% of Sales 0
Minor defects 20% of Sales (P1,000,000 X 20%) 200,000
Major defects 5% of Sales (P5,000,000 X 5%) 250,000
-----------
Total expected cost of repairs 450,000
========

In the books of the company, the following journal entry should be prepared to
recognize the provision:

Repair Cost 450,000

Estimated Liability for Repair Cost 450,000

Illustration C: Aloha Company is a defendant in a patent infringement case. Aloha’s

lawyers believe that there is a 60% chance that the case will not be dismissed. If the
court rules in favor of the plaintiff, there is a 30% chance that Aloha will be required
to pay P4,000,000, and a 70% chance that the damages will be P2,000,000. The
plaintiff has offered to settle out of court for P6,000,000. The amount of provision is
computed as follows:

Weighted probabilities
30% X P4,000,000 X 60% 720,000
70% X P2,000,000 X 60% 840,000
------------
Estimated amount of provision 1,560,000
=========

The following journal entry should be prepared to recognize the provision:

Probable Loss on Patent Infringement 450,000

Estimated Liability for Patent Infringement 450,000
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PROVISIONS AND CONTINGENT LIABILITIES
Illustration D: Aloha Company is a defendant in a patent infringement case. Aloha’s
legal counsels believe the court will rule in favor of the plaintiff, and that damages of
P2,000,000 but not more than P4,000,000 will be paid. The probability of any
amount is as likely as any other amount within the range. The amount of provision
is computed as follows:

(P2,000,000 + 4,000,000) / 2 = P3,000,000

The following journal entry should be prepared to recognize the provision:

Probable Loss on Patent Infringement 3,000,000

Estimated Liability for Patent Infringement 3,000,000

CONTINGENT LIABILITIES
In general, all provisions are contingent because they are of uncertain timing and
amount. However, PAS 37 uses the term “contingent” to refer to those liabilities and
assets that are not recognized because they do not meet all the recognition criteria.
Contingent liability can be described more aptly as:

1. A possible obligation whose existence will only be confirmed by the occurrence or

non-occurrence of one or more uncertain future events that are not within the control
of the entity; or

2. A present obligation but it is not probable that it will cause an outflow of

resources in its settlement or its amount cannot be reliably estimated.

For a more extensive read on the above-mentioned topics, the following references are
recommended:
1. Empleo, Patricia M., Robles, Nenita S., The Intermediate Accounting Series Volume 2
2. Millan, Zeus Vernon B., Intermediate Accounting 2, 2019 edition, Bandolin
Enterprise
3. Valix, Peralta, Valix, Intermediate Accounting 2019 Volume 2, GIC Enterprises
4. Retrievable from:
https://www.ifrs.org/issued-standards/list-of-standards/ias-37-provisions-
contingent-liabilities-and-contingent-assets/
https://www.iasplus.com/en/standards/ias/ias37

Disclaimer: This module is for class discussion purposes only, and not for publication.
The illustration problems were adapted from the sources & references.
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PROVISIONS AND CONTINGENT LIABILITIES
REFERENCES

Empleo, Patrica M., Robles, Nenita S., The Intermediate Accounting Series Volume 2

Millan, Zeus Vernon B., Intermediate Accounting 2, 2019 edition, Bandolin Enterprise

Valix, Peralta, Valix, Intermediate Accounting 2019 Volume 2, GIC Enterprises

Retrievable from:

https://www.iasplus.com/en/standards/ias/ias37

https://www.ifrs.org/issued-standards/list-of-standards/ias-37-provisions-contingent-liabilities-

and-contingent-assets/