Pcoa 008 - Intermediate Accounting Ii Learning Outcomes: at The End of This Module, You Can

MODULE 3
PCOA 008 – INTERMEDIATE ACCOUNTING II

Learning Outcomes:
At the end of this module, you can:
 Recognize and measure a provision, a contingent liability and a contingent asset
Provisions
A provision is “a liability of uncertain timing or amount.” (PAS 37,19)
Provisions differ from other liabilities because of the uncertainty and timing of their settlement or
on the amount needed to settle them. Unlike other liabilities, provisions must necessarily be
estimated. Although some other liabilities are also estimated their uncertainty is generally much
less compared to provisions. Examples of provisions:
a. Warranty obligations
b. Estimated liabilities on pending lawsuits
c. Provisions for environmental damages
d. Provisions of decommissioning costs of an item of PPE
e. Obligations caused by an entity’s policy to make refunds to customers
f. Obligations arising from guarantees
g. Provisions on onerous contracts (e.g., purchase commitment)
h. Provisions for restructuring costs
Provisions are presented in the statement of financial position separately from other types of
liabilities.
Recognition
A provision is recognized when all of the following conditions are met:
a. The entity has a present obligation (legal or constructive) resulting from a past event;
b. It is probable that an outflow of resources embodying economic benefits will be required
to settle the obligation; and
c. The amount of the obligation can be reliably estimated.
Note: (a) and (b) was already explained in liabilities (module 1)
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Reliable estimate
Provisions necessarily need to be estimated. If a reliable estimate cannot be made, no provision is
recognized.
Contingent liabilities
In general sense, all provisions are contingent liabilities because they are of uncertain timing or
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 of the recognition criteria.
A provision and a contingent liability are differentiated below:
Provision Contingent liability
 A liability of an uncertain timing or  A possible obligation whose existence
amount that needs all of the following will be confirmed only by the
conditions: occurrence or non-occurrence of one or
a. Present obligation; more uncertain future events not
b. Probable outflow; and wholly within the control of the entity;
c. Reliably estimated or
 A present obligation but:
a. It is not probable that it will
cause an outflow in its
settlement; or
b. Its amount cannot be reliably
estimated
Contingent assets
Contingent assets are those that are not recognized because they do not meet all of the asset
recognition criteria (i.e., ‘resource controlled arising from past events’, ‘probable inflow’, and
‘reliable estimation’)
Contingent assets include possible inflows of economic benefits from unplanned or unexpected
events, such as claims that an entity is seeking through legal processes where the outcome is certain
(e.g., claims under tax disputes and disputed insurance claims).
Contingent assets are disclosed only, if the inflow of economic benefits is probable. They are not
recognized because recognizing them may result to the recognition of income that may never be
realized.
However, when the realization of income is virtually certain 100% chance of occurrence), the
asset is not a contingent asset and therefore it is appropriate to recognize it.
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Contingent Probable Possible Remote
Liability Recognized and disclose Disclose only Ignore
Asset Disclose only Ignore Ignore
Measurement
Provisions are measured at the best estimate of the amount needed to settle them at the end of the
reporting period. The estimate also considers events after the reporting period.
If the provision being measured involves a large population of items, the obligation is measured at
its “expected value.” Expected values is computed by weighting all possible outcomes by their
associated probabilities.
If there is a continuous range of possible outcomes, and each point in that range is as likely as any
other, the mid-point of the range is used.
Recording of provisions
Provisions are normally recognized as a debit to expense (or loss) and a credit to an estimated
liability account. However, sometimes a provision forms part of the cost of an asset. For example,
provisions for restoration and decommissioning costs are capitalized as part of the cost of a PPE.
Illustration 1: Best estimate
In 20x1, ABC Co. received a court order receiving a court order requiring the cleanup of the
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 cleanup;
however, ABC’s best estimate of the cost of cleanup is P20M.
The entry to recognize the provision is as follows:
Dec. 31, Environmental cleanup costs 20,000,000
20x1 Estimated liability for cleanup cost 20,000,000
Illustration 2: Expected value

In 20x1, ABC Co. recalled a product due to a possible defect caused by malfunctioning factory
equipment. The products recalled will be repaired free of charge. ABC is uncertain whether all
products recalled will have the possible defect. However, the following estimate was made by
ABC’s engineers and managerial accountants and approved by the board of directors.
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Repair cost Probability
20,000,000 5%
15,000,000 20%
10,000,000 35%
5,000,000 40%
100%
The expected value of the provision is determined as follows:
Repair cost Probability Expected value

(a) (b) (c) = (a) x (b)
20,000,000 5% 1,000,000
15,000,000 20% 3,000,000
10,000,000 35% 3,500,000
5,000,000 40% 2,000,000
100% 9,500,000
Dec. 31, Repair costs 9,500,000

20x1 Estimated liability for repair cost 9,500,000
Illustration: Mid-point
In 20x1, a lawsuit was filed against ABC Co. for patent infringement. The plaintiff is claiming
P100M in damages. ABC’s legal counsel believes that it is probable that ABC will lose the lawsuit
and pay damages of not less than P10M but not more than P100M. The probability of any amount
within range is as likely as any other amount also within the range. The plaintiff has offered to
settle the lawsuit out of court for P90M but ABC did not agree to the settlement. How much is
provision to be reported in ABC’s end financial statements?
Answer: P55M [(10M + 100M) /2]. The mid-point of the range is used because each print in the
range is as likely as any other.
Dec. 31, Probable loss on lawsuit 55,000,000
20x1 Estimated liability on pending lawsuit 55,000,000
Risk and uncertainties

Estimates take into account risks and uncertainties. Thus, estimates may be increased by a risk
adjustment factor to provide an allowance for imprecision inherent in estimates. This, however,
does not mean that the entity can make excessive provisions or can deliberately overstate liabilities.
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Present value
If the effect of time value of money is material, the estimate of a provision is discounted to its
present value using a pre-tax discount rate. This is usually the case for provisions for restoration
and decommissioning cost where cash outflows occur only after a relatively long period of time
from the date of initial recognition.
Future events
Future events may affect the amount needed to settle an obligation. However, future events are
considered in estimating a provision only if there is objective evidence that supports their
anticipation. For example, the penalty for an environmental damage may be affected by legislation.
If a new law that will increase the amount of penalty is expected to be enacted, that new law is
anticipated only when it is virtually certain that it will be enacted. Otherwise, it would not be
appropriate to anticipate it.
Expected disposal of assets
Gains from the expected disposal of assets are not taken into account when measuring a provision.
Gains are recognized separately when the disposal occur.
Reimbursements
If another party is expected to reimburse the settlement amount of a provision, a reimbursement
asset is recognized if it is virtually certain that the reimbursement will be receive. The
reimbursement asset is presented in the statement of financial position separately from the
provision. However, in the statement of comprehensive income, the expense related to the
provision may be presented net of the reimbursement. The amount recognized for the
reimbursement should not exceed the amount of the provision
Changes in provision
Provisions are reviewed at the end of each reporting period and adjusted to reflect the current best
estimate. Changes in provisions are accounted for prospectively by accruing an additional amount
or by reversing a previously recognized amount.
When the provision is discounted, the unwinding (amortization) of the related discount which
increases the carrying amount of the provision is recognized as interest expense.
Use of provisions
A provision is used only for the expenditure it was originally intended for. Charging expenditure
against a provision that is intended for another purpose is inappropriate as it would conceal the
impact of two different events.
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Application of the recognition and measurement rules
Future operating losses
No provision is recognized for future operating losses because they do not meet the definition of
a liability. The expectation of future operating losses may indicate that certain assets may be
impaired. Those assets are tested for impairment under PAS 36.
Onerous contracts
The provision recognized from an onerous contract reflects the least net cost exiting from the
contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising
from failure to fulfill it.
Illustration:
ABC Co. entered into a non-cancelable 10-year operating lease. Annual lease payment is
P100,000. At inception of lease, ABC paid P200,000 deposit to the lessor to be applied to the last
two years of the lease. In addition, ABC guarantees a 10% residual value of the leased property.
On December 31, 20x1, ABC cancels the lease when the remaining lease term is 6 years. ABC is
obligated to pay the rentals for the remaining term of the lease but it uncertain as to whether it will
be held liable for the guarantee on the residual value.
The amount of the provision is computed as follows:
Rentals for the remaining lease term (100,000 x 6) P 600,000
Deposit applied to last two years of lease (200,000)
Estimated liability on lease cancellation P 400,000
The entry to record the provision is as follows:

Dec. 31, Probable loss on lease cancellation 600,000
20x1 Estimated liability for probable loss on lease 400,000
Deferred charges – prepared rent 200,000
Restructuring
Restructuring is “a program that is planned and controlled by management, and materially changes
either:
1. The scope of a business undertaken by an entity; or
2. The manner in which that business is conducted. “(PAS 37,10)
Examples:
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a. Sale or termination of a line of business
b. Closure of business locations in a country or region or the relocation of business
activities from one country or region to another;
c. Changes in management structure, for example, eliminating a layer of management;
and
d. Fundamental reorganizations that have a material effect on the nature and focus of the
entity’s operations. (PAS 37,70
An entity applies the general recognition criteria provided earlier when recognizing provisions for
restructuring costs. In addition, the entity considers the following:
Sale of operation
A legal obligation exists (and therefore a provision is recognized) only if, at the end of the reporting
period, a biding sale agreement is obtained. This is because, until a binding sale agreement is
obtained, the entity can still change its mind and may withdraw its plan to sell if it cannot find a
purchaser under acceptable terms.
If the binding sale agreement is obtained only after the end of the reporting period, no provision is
recognized because no present obligation exists at the end of the reporting period. This, however,
may be disclosed as a non-adjusting event after the reporting period.
Closure or Reorganization
A constructive obligation exists (and therefore a provision is recognized) only if at the reporting
date, the entity has created valid expectations from others that it will discharge certain
responsibilities. This would be the case if, at the end of the reporting period, both the following
conditions are met:
a. Detailed formal plan for the restructuring is adopted; and
b. The plan is announced to those affected by it.
A mere board decision to restructure is not enough. No provision is recognized if the detailed plan
is adopted or announce after the end of the reporting period. This may also be disclosed as non-
adjusting event after reporting period.
Measurement of restructuring provision
A restructuring provision includes only the direct costs that are necessarily entailed with the
restructuring. It does not include costs that relate to the ongoing activities of the entity or the future
conduct of its business. A restructuring provision excludes the following costs:
a. Retraining or relocating continuing staff
b. Marketing
c. Investment in new systems and distribution networks. (PAS37, 81)
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a. Sale of operation  Accrue provision only if a binding sale
agreement is obtained on or before the
end of reporting period.
 If binding sale agreement is obtained
only after the end of the reporting
period, no provision shall be
recognized. Only a note disclosure
shall be made for the non-adjusting
event after reporting period.
b. Closure or reorganization  Accrue only if a detailed formal plan
is adopted and announced publicly on
or before the end of reporting period.
A board decision is not enough.
 If detailed plan is adopted or
announced after the end of the
reporting period, no provision shall be
recognized. Only a note disclosure
shall be made for the non-adjusting
event after reporting period.
c. Restructuring provision on acquisition  Accrue provision for terminating
(merger) employees, closing facilities, and
eliminating product lines only if
announce at acquisition and, then only
if a detailed formal plan is adopted
within a short period of time after
acquisition (e.g., 3 months).
d. Future operating losses  Provisions are not recognized for
future operating losses, even in a
restructuring.
Other common types of provisions

In addition to those discussed earlier, the following are also common sources of provisions:
a. Product warranties and guarantees
b. Premiums
c. Guarantee of indebtedness of others becoming probable
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Product warranties and guarantees
some products like computers, appliances, cellphones, equipment, and the like are often sold under
warranty or guarantee to provide post-sale services, such as free repair service, replacement of
parts or entire product, during a specified period if the products are proven to be defective. The
present obligation for warranties arises at the point of sale.
If the cost of discharging the liability is judged to be significant, a provision should be made in
order not to understate liabilities and expenses and overstate profit.
However, if the cost of discharging the liability is judged to be negligible, non-recognition of
provision is permitted. In such case, warranty expense is recognized only when the warranty is
actually discharged.
In making the judgment on whether warranty costs may be significant or not, PAS 37, 24, provides
the following guidance “where there are number of similar obligations, the probability that an
outflow will be required in settlement is determined by considering the class of obligations as a
whole. Although the likelihood of outflow for any one item may be small, it may well be probable
that some outflow of resources will be needed to settle the class of obligations as a whole. If that
is the case, a provision is recognized.
Liability for premiums
Premiums refer to goods, services, cash prizes, or special rebates which are included in the main
product or services being offered. Premiums intended to promote sales. Common examples of
premiums include:
a. Goods such as T-shirts, caps, umbrella, kitchen wares, toys, and CDs which are included
in a main product or service purchased.
b. Free health spa (or at discounted price), free movie tickets, and free load included in a main
product or service purchased.
c. Cash prize found at the back of bottle crowns or entitlement to an entry to a raffle draw.
Customers may be entitled to such premiums for past purchases by presenting proof of purchase.
Guarantee for indebtedness of others
There are instances where an entity guarantees the indebtedness of another entity. The guarantor
does not recognize any liability when the guarantee is made. However, when it becomes probable
that the guarantor will be held liable for the guarantee, such as when the original debtor defaults
on the loan, a provision is recognized for the estimated amount that the guarantor will be held
liable for the guarantee.
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Illustration:
On January 1, 20x1, ABC Co. guaranteed a P1,000,000 loan obtained by XYZ, Inc. from a bank.
On December 31, 20x1, XYZ defaulted on its loan and it became probable that ABC will be held
liable to the bank for the P1,000,000 loan taken by XYZ.
The entries are as follows:
Jan. 1, NO ENTRY
20x1
Dec. 31, Probable loss on guarantee 1,000,000

20x1 Estimated liability for guarantee 1,000,000
Notes:
 No provision is required on guarantee unless it becomes probable that the guarantor will
be held liable.
 Before the liability on a guarantee becomes probable, only disclosure is made in the notes.
Disclosure is normally made even in cases where the liability for a guarantee is remote.
Reference
Millan, Z. V. B. (2019). Intermediate Accounting II. Bandolin Enterprise.
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MODULE 3

PCOA 008 – INTERMEDIATE ACCOUNTING II

Illustration 2: Expected value

The expected value of the provision is determined as follows:

Repair cost Probability Expected value

Dec. 31, Repair costs 9,500,000

Risk and uncertainties

The entry to record the provision is as follows:

Other common types of provisions

Dec. 31, Probable loss on guarantee 1,000,000

Millan, Z. V. B. (2019). Intermediate Accounting II. Bandolin Enterprise.

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