CHAPTER 25 – PROVISION, CONTINGENT LIABILITY AND ASSET

PROVISION
• Existing liability of uncertain timing OR uncertain amount.
• Uncertainty is what distinguishes provision from other liabilities, there should be uncertainty
about the timing or amount of the future expenditure for it to be essentially a provision.
• The liability exists at the end of the reporting period but:
o Amount is indefinite
o Date due is also indefinite
o In some cases, payee cannot be identified
• Shall be recognized as liability under the following conditions:
o Present obligation, legal or constructive, as a result of past event
▪ Legal obligation – arising from contract, legislation, law
▪ Constructive obligation – derived from entity’s actions
▪ Past event leads to a present obligation that is called an obligating event. The
obligating event creates a legal/constructive obligation because the entity has no
other option but to settle the obligation created by the event.
o Probable that an outflow would be required to settle the obligation
▪ The event is more likely than not to occur
▪ Probable means more than 50% likely to occur.
▪ Possible means 50% or less likely to occur.
▪ Remote means 10% or less likely to occur or very slight occurrence.
o Amount of obligation can be measured reliably
▪ 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
o Should be best estimate of the expenditure required to settle the present obligation at
the end of reporting period.
o Single obligation – individual most likely outcome adjusted for the effect of other possible
outcomes
o Continuous range of possible outcomes – midpoint of the range
o Large population of items – “weighting” all possible outcomes by their associated
possibilities

• Measurement Considerations
1. Risk and uncertainties
• Shall be taken into account in reaching the best estimate of a provision
• Risks is a variability of outcome and may increase the amount at which a liability is
measured.
• Caution is needed in making judgment so as not to overstated income and assets and
understate expenses and liabilities.
• Uncertainty does not justify the creation of excessive provision or a deliberate
overstatement of liabilities.
 2. Present value of obligation
• If there is a material effect of the time value of money, the amount of provision shall
be the present value of the expenditure expected to settle the obligation using a
discount rate that should be the pretax rate.

3. Future events
• That will affect the amount required to settle an obligation shall be reflected in the
amount of the provision where there is a sufficient evidence that they will occur.

4. Expected disposal of assets

• Gains from disposal of asset shall not be taken into account.
• Any cash inflows from disposal are treated separately from the measurement of
provision.

5. Reimbursements
• The reimbursement shall be recognized when it is virtually certain that
reimbursement would be received if the entity settles the obligation.
• Shall be treated as a separate asset and not netted against the estimated liability for
the provision.
• Amount of reimbursement shall not exceed the amount of the provision.
• However, in the income statement, expenses relating to the provisions may be
presented net of the reimbursement.

6. Changes in provision
• Provisions shall be reviewed at the end of the reporting period and adjusted to reflect
the current best estimate.
• Provision shall be reversed is it is no longer probable that an outflow would be
required to settle the obligation.
• If discounting is used, the carrying amount of the provision should reflect the passage
of time.

7. Use of provision
• Shall be used for expenditures which the provision was originally recognized.

8. Future operating losses

• Provision shall not be recognized for future operating losses.

9. Onerous contract
• The present obligation under the contract shall be recognized and measured as a
provision.
• An onerous contract is a contract in which unavoidable costs of meeting the
obligation under the contract exceed the economic benefits expected to be received
under it.

• Example of Provisions
1. Warranties
2. Environmental contamination
 3. Decommissioning or abandonment costs
4. Court case
5. Guarantee

CONTINGENT LIABILITY
• 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 event not wholly within the
control of the entity.
• Present obligation that arises from past event but is not recognized because it is not probable
that an outflow of resources will be required to settle the obligation, or the amount of the
obligation cannot be measured reliably.

• Treatment of contingent liability

o Shall not be recognized in the financial statements but shall be disclosed only. Required
disclosures are:
▪ Brief description of the nature of the contingent liability
▪ An estimate of its financial effects
▪ An indication of the uncertainties that exist
▪ Possibility of any reimbursement
o If a contingent liability is remote, no disclosure is necessary.

CONTINGENT ASSET
• 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 event not wholly within the
control of the entity.
• Shall not be recognized because this may result to recognition of income that may never be
realized.
• 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.

Illustrations
BEST ESTIMATE
In 2020, ABC Co. received a court order requiring the cleanup of environmental damages caused by one
of ABC’s factory. ABC has no other realistic alternative but to comply with the court order. Other entities
have incurred around P15M for similar cleanup; however, ABC’s best estimate of the cost of cleanup is
P20M.

1. Is there a present obligation? – Yes, environmental damages have already been caused.
2. Is the outflow probable? – Yes, “ABC has no other realistic alternative but to comply with the
court order.”
3. Can the outflow be measured reliably? – Yes, the problem indicates a “best estimate” of P20M.

Conclusion: A provision must be accrued and disclosed in the amount of P20M.

1. ABC Co. engages in transport services. Past experience shows that ABC incurs around P100M a
year in accident-related lawsuits. Can ABC accrue a year-end provision for accident related
lawsuits that can happen in the next accounting period?

Answer? No There is no present obligation arising past event, because the accident has not yet
occurred.

2. ABC Co. engages in transport services. As of year-end, there is a pending lawsuit filed against ABC
regarding an accident that happened during the year. It is probable that ABC will lose the lawsuit
and pay around P10M in damages. Should ABC accrue a provision for the estimated probable loss
on lawsuit?

Answer: Yes. There is present obligation with probable outflow of resources because the accident
has already occurred and there is a pending lawsuit for which it is probable that ABC will lose.
Also. the outflow can be reliably estimated.

3. ABC Co. engages in transport services; An accident happened during the year However, as of year-
end, no lawsuit is yet filed against ABC it is not expected that a lawsuit will be filed against ABC
and there is no reliable estimate for a loss on lawsuit that may be incurred. Can ABC recognize a
provision?

Answer: No. The outflow of resources is both improbable (i. e., no lawsuit is expected to be filed:
against ABC) and cannot be estimated reliably.

4. ABC Co. has put up a new branch during the year. The branch suffered loss of P20M during the
year. Past experience shows that newly put up branches incur losses for the first three years of
operations. Can ABC recognize a provision for future losses on its new branch?

Answer: No. There is no present obligation arising from past events. Only obligations arising from
past events existing independently of an entity’s future operations (i.e., future conduct of
business) are recognized as provisions. No provision should be recognized for future operating
losses not yet incurred.

5. ABC Co. engages in the manufacture of plastic wares. During the year, environmental auditors
from a government agency issued their findings that ABC is not compliant with existing laws. ABC
is then directed by the government to rectify damages caused to the environment and to pay
penalty for the unlawful environmental damage. ABC estimates that total cost of rectifying the
damage and settling the penalty amounts to P100M. Should ABC recognize a provision for the
environmental damage?

Answer: Yes. There is present obligation with probable outflow of resources because damages
have already been caused and ABC is being directed by the government to rectify the damages.
Also, the outflow can be reliably estimated.
 Case
Liability for pending lawsuits, tax
assessments, government-imposed
penalties and the like
A defective product causes injury to
customer. No lawsuits have yet been
filed against the seller.
Environmental damages
Restructuring by sale of an operation
Restructuring by closure or
reorganization
Warranty, Premiums and Refunds
Guarantee of indebtedness of others
Offshore oil rig must be removed and see
bed restored
Onerous contract
An entity must train its employees to
increase productivity and efficiency
An entity has a self-insurance policy
Major overhaul or repairs
Accounting treatment
Recognize a provision if there is present obligation and
outflow if both probable and estimable.
Present obligation arises from injury caused to customers.
Provision if recognized if outflow if both probable and
estimable.
Recognize a provision if the entity's policy is to clean up even
if there is no legal requirement to do so.
Recognize a provision only if a binding sale agreement is
obtained on or before the end of reporting period.
Recognize a provision only if a detailed formal plan is adopted
and announced publicly on or before the end of reporting
period.
Recognize a provision at the point of sale if there is legal or
constructive obligation.
Recognize a provision only when the liability for the
guarantee becomes probable.
Recognize a provision only when the oil rig is installed. The
provision is added to the cost of the asset.
Recognize a provision if outflow is both probable and reliably
estimable.
No provision; there is no obligation to provide the training.
No provision until an actual loss is incurred.
No provision; there is no obligating event, unless
commitment was made to a third party for the overhaul or
repair.