CURRENT LIABILITIES, PROVISIONS, AND CONTINGENCIES

(Adapted from Intermediate Accounting, 2014 Edition by Nenita S. Robles and Patricia M. Empleo)
By Ms. Sharon A. Bactat and Prof. Suerte R. Dy

 If a single obligation is being measured, the amount to be recognized as a liability is the most likely
outcome.

 Where the amount of the obligation is still uncertain as of the end of the reporting period, but the
obligation is settled subsequently before the issuance of the fiancial statements, the amount shown
in the statement of fiancial position is the amount actually settled subsequently.

 Where the provision being measured involves a large population of items, the obligation is estimated
by weighting all possible outcomes by their associated possibilities (statistical method called
“expected value”). Where 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.

 Where the effect of the time value of money is material, the amount of a provision should be the
present value of the expenditures expected to be required to settle the obligation.

 Where some or all of the expenditure required to settle a provision is expected to be reimbursed by
another party, the reimbursement should be recognized when, and only when, it is virtually certain
that reimbursement will be received if the enterprise settles the obligation. The reimbursement, if
virtually certain, should be treated as a separate asset. The amount recognized, for the
reimbursement should not exceed the amount of the provision.

Let us apply the principles and concepts in the following CASES:

1. In September 2019, Happy filed a suit against Lonely Company, alleging violation of patent rights and
it is seeking payment for damages of P7,000,000. Lonely disclaims the charges and the legal counsel
advises that as of the date of the issuance of Lonely Company’s financial statements, it is probable
that the enterprise will not be found liable.
 No provision is recognized, because based on the evidence available as of the fiancial statement,
there is no obligation as a result of past events. The matter is disclosed as a contingent liability,
unless the probability of any outflow is regarded as remote.

2. ABC Company operates in a city where there is no environmental legislation. However, the company
has a widely published policy in which it udertakes to clean up all contamination it causes. As of the
date of the issuance of its 2019 financial statements, a reasonable estimate of the cost of this clean
up related to 2019 oprations is P2,000,000.
 A provision is recognized for the estimated amount of the costs of the clean-up, which is P2,000,000.
The obligating event is one of a constructive obligation. The entry for the recognition of the
provision is:

Environmental Clean-Up Expense 2,000,000

Provision for Environmental Clean-Up 2,000,000

3. As a result of an uninsured accident during the year 2019, a personal injury suit for P3,000,000 has
been filed against XYZ Company. It is the judgment of the company’s legal counsel that an unfavorable
verdict will result in a loss ranging from P1,800,000 to P2,800,000. The lawyer believes that the most
reasonable estimate is P2,200,000.
 A provision is recognized for the best estimate of the obligation. The best estimate is the most likely
outcome which is P2,200,000. The entry for the provision is:

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 Loss from Accident 2,200,000
Provision for Damages 2,200,000

Additional possible obligation of P600,000 (the difference between the recorded amount of
P2,200,000 and the highest in the range of estimated amounts of P2,800,000) is to be disclosed in
the notes to the financial statements.

4. GHI Company sells goods with a warranty under wjich customers are covered for the cost of any
manufacturing defects that become apparent within the first year after purchase. If minor defects
were detected in all products sold, repair costs of P2 million would result. If major defects were
detected in all products sold, repair costs of P5 million would result. The enterprise’s past experience
and future expectations indicate that 60% of the goods sold have no defects, 30% of the goods sold
have minor defects, and 10% of the goods sold have major defects.
 It is probable that the sale of defective merchandise will result in an outflow of economic benfits.
Thus, the sale created an obligation. The best estimate of the obligation is the “expected value of
the outcome,” which is derived by weighting all possible outcomes by their associated probabilities.
Thus, the provision shall be measured as follows:

No defects P0 x 60% P 0
Minor defects P2M x 30% 600,000
Major defects P5M x 10% 500,000
Amount of provision P1,100,000
=========
The entry to recognize the provision is:

Warranty Expense 1,100,000

Provision for Warranty 1,100,000
(or Estimated Liability Under Warranty)

5. JKL is charged with multiple lawsuit because of an incident that happened in February 2019, cusing
death of about 80 persons due to stampede in a sales promotion program it was airing through
Channel 6 on February 10, 2019. Based on similar incidents suffered by other entities, JKL’S legal
counsels are of the opinion that it is probable that JKL would be found liable for the incident. As of
the date of the issuance of the 2019 financial statements, a reasonable estimate of the obligation is
between P16,000,000 to P24,000,000. Each point within the range is as likely as any other.
 The provision being measured above involves a large population of items and there is a continuous
range of possible outcomes. There is no better estimate in the range, and each point within that
range is as likely as any other point. Thus, the provision shall be measured at the midpoint of the
range. The midpoint is the simple average or the mean, thus, (P16,000,000 + P24,000,000) divided
by 2 equals P20,000,000.

The entry to set up the provision is:

Loss from Damages 20,000,000

Provision for Damages 20,000,000

Review of the Amount Previously Recognized as Provision

If based on subsequent review of the amount of the provision, there is a need to adjust the
previously recorded amount, the adjustment is treated as a change in accounting estimate and would
affect profit or loss of the current year. Thus, if based on the review of the provision, the amount needs
to be decreased, the entry in a subsequent reporting period is to debit the provision and credit an
appropriate expense, loss or in some cases, an income account.

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 If at the end of the reporting period, it is no longer probable that an outflow of resources will be
required to settle the obligation, the provision previously recognized should be reversed.

CLASSIFICATION OF LIABILITIES – Illustrative Cases

1. Dorina, Inc. has P4 million of notes payable due June 15, 2019. At December 31, 2018, Dorina signed
an agreement to borrow up to P4 million to refinance the notes payable on a two-year basis. The
financing agreement called for borrowings not to exceed 75% of the value of the collateral Dorina was
providing. At the date of issue of the December 31, 2018 financial statements, the value of the
collateral was P4.8 million and was not expected to fall below this amount.
 Because as of December 31, 2018, the reporting date, Dorina has the discretion to defer the
settlement of a portion of the maturing obligation for a period of more than twelve months, that
portion shall be classified as non-current. Of the P4 million notes payable, P3,6000,000 (which is
75% of the P4.8 million) shall be classified as non-current while the remaining P400,000 shall be
classified as current liabilities.

2. Dorina, Inc. has P4 million of notes payable due June 15, 2019. At February 15, 2019, Dorina signed
an agreement to borrow up to P4 million to refinance the notes payable on a long-term basis. The
refinancing agreement called for borrowings not to exceed 75% of the value of the collateral Dorina
was providing. The value of the collateral was P4.8 million and was not expected to fall below this
amount. The financial statements are authorized for issuance on March 5, 2019.
 On December 31, 2018 statement of financial position, the full amount of P4 million shall be
classified as current liabilities even if the enterprise signed an agreement to refinance the maturing
notes payable on a long-term basis before the issuance of the 2018 financial statements. The full
amount is classified as a current liability because as of December 31, 2018, Dorina has an
unconditional right yet to defer the settlement of the P4 million. The refinancing of the P4 million
is considered as an event after the reporting period not requiring adjustment in the financial
statements. This refinancing after the reporting period, if considered significant, qualifies for
disclosure in the notes to the financial statements.

3. In October 2016, Vivian Corp. acquired a special equipment from Carlo, Inc. by paying P1,000,000
down and signing a note with a face value of P4,000,000 due October 2019. Under the terms of the
financing agreement, Vivian has the discretion to roll over the obligation for at least fifteen months.
In October 2018, management decides to exercise its discretion to roll over the liability up to October
31, 2020.
 The P4,000,000 note is classified as non-current on December 31, 2018 statement of financial
position. The enterprise already exercised its discretion as of the reporting date (December 31,
2018) to roll over the obligation. The maturity date of the obligation has been reset to October 31,
2020, which is 22 months away from December 31, 2018, the reporting date.

4. In October 2016, Vivian Corp. acquired equipment from Carlo, Inc. by paying P1,000,000 down and
signing a note with a face value of P4,000,000 due October 2018. The existing loan agreement does
not carry a provision to refinance. In October 2018, Vivian was experiencing financial difficulty and
was unable to pay the maturing obligation. On February 1, 2019, Carlo has agreed not to demand
payment for at least 12 months as a consequence of the breach of payment on the principal of the
loan. The financial statements were authorized for issue on March 31, 2019.
 The P4,000,000 note payable shall be classified on Vivian’s December 31, 2018 statement of
financial position as current liabilities. It is classified as current, because as of December 31, 2018,
the entity has no discretion yet to roll over the obligation for at least twelve months after that date.

5. In October 2016, Vivian Corp. acquired equipment from Carlo, Inc. by paying P750,000 down and
signing a note with a face value of P4,000,000 due October 2018. The existing loan agreement does

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 not carry a provision to refinance. In October 2018, Vivian was experiencing financial difficulty and
was unable to pay the maturing obligation. On December 31, 2018, Carlo signed an agreement to
provide Vivian a grace period of 15 months from that date, during which period, Carlo will not demand
immediate payment in order to give Vivian the chance to rectify the breach. The financial statements
were authorized for issue on March 31, 2019.
 In the December 31, 2018 statement of financial position of Vivian, the P4,000,000 note payable
shall be classified as non-current, because Carlo has agreed not to demand payment for 15 months
from December 31, 2018. Thus, under the new terms offered by the creditor, Vivian is given a grace
period of 15 months, within which the creditor could not demand immediate payment.

6. On October 1, 2016, Vilma Corporation acquired land from Fortune Corporation by paying P1,000,000
down and signing a note with a face value of P6,000,000 due in installments of P1,000,000 plus annual
interest on the balance of the principal at the rate of 10%, the first installment being due on
September 30, 2017. The existing loan agreement does not carry a provision to refinace and further
states that any failure to pay the required installment and interest will make the full amount of the
loan due and demandable. Further, the full amount of the principal and accrued interest shall be
subject to interest of 10%. As of December 31, 2018, Vilma Corporation is already three months
behind in the payment of the 2018 annual installment and interest.
 The violation of the debt agreement makes the obligation due and demandable. The ramining
balance of the loan principal amounting to P5,000,000 plus accrued interest of P500,000 shall be
subject to further interest of 10%. Thus, the total amount of obligation related to this note of
P5,637,500 which is P5,500,000 + (P5,500,000 x10% x 3/12) shall be classified as current liabilities.