PROVISION

CHAPTER 5
 PROVISION
• Is an existing liability of uncertain timing or uncertain
amount
• The essence of a provision is that there is uncertainty
about the timing or amount of the future
expenditure
• It is uncertainty that distinguishes provision from
other liabilities
• The liability definitely exists at the end of reporting
period but the amount is indefinite or the date when
the obligation is due is also indefinite, and in some
cases, the payee cannot be identified or determined
PROVISION AND OTHER LIABILITIES
• Paragraph 11 of PAS 37 states that a provision can
be distinguished from other liabilities in the sense
that there is uncertainty about the timing or amount
of the future expenditure required for settlement
• In contrast, there is certainty about the timing or
amount of other liabilities such as trade payables
and accruals
• Trade payables and accruals are liabilities to pay for
goods or services that have been received or
supplied and have been invoiced or formally agreed
with the supplier
 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:
– The entity has a present obligation, legal or
constructive, as a result of a past event
– It is probable that an outflow of resources embodying
economic benefits would be required to settle the
obligation.
– The amount of the obligation can be measured
reliably
 ILLUSTRATION OF A PROVISION
• An oil entity is exploring oil off the shores of Philippine Deep.
The entity has employed oil exploration experts from around
the globe. Despite all efforts, a major oil spill occurred and has
grabbed the attention of media.
• Environmentalists are protesting and the entity has engaged
lawyers to advise it about legal repercussions. In the past,
other oil entities have had to settle with the environmentalists
paying huge amounts in “out of court” settlements.
• The legal counsel of the entity has advised that there is no law
that would require the entity to pay for the oil spill.
• However, in its TV advertisements and promotional brochures,
the entity has clearly stated that it is very conscious of its
responsibilities toward the environment and would make good
for any losses resulting from its oil exploration activities
 ANALYSIS
• A provision shall be recognized for the best estimate of
the cost to clean up the oil spill.
• A present obligation exists as a result of a past obligating
event. The obligating event is the oil spill.
• Because there is no law requiring the mandatory clean
up of oil spill, there is no legal obligation.
• However, there is a constructive obligation because the
entity, with its advertised policy on oil spill and public
pronouncements, has created an expectation in the
minds of the public that it will honor any environmental
obligations that may arise from the oil exploration
activities.
 MEASUREMENT OF PROVISION
• The amount recognized as a provision should be the best estimate of
the expenditure required to settle the present obligation at the end
of reporting period.
• The best estimate is the amount that an entity would rationally pay
to settle the obligation at the end of reporting period or to transfer it
to a third party at that time.
• Where a single obligation is being measured, the individual most
likely outcome adjusted for the effect of other possible outcomes may
be the best estimate.
• 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
used.
• Where 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 is “ expected value”.
ILLUSTRATION – EXPECTED VALUE METHOD
• An entity sells goods with a warranty under which 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 would be
about P1,000,000
• If major defects are detected in all products sold, repair costs of
P5,000,000 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 measured 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
P4,000,000 and 70% chance that the damages will be
P2,000,000
• 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.
 MEASUREMENT OF 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 156,000
(10% x 1,560,000)
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 CONSIDERATIONS
• The 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. Change in provision
7. Use of provision
8. Future Operating losses
9. Onerous contract
 RISKS AND UNCERTAINTIES
• The risks and uncertainties that inevitably surround
events and circumstances shall be taken into account in
reaching the best estimate of a provision
• Risk describes variability of outcome
• A risk adjustment may increase the amount at which a
liability is measured.
• As prudence 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.
 PRESENT VALUE OF OBLIGATION
• Where the effect of the time value of money is
material, the amount of provision shall be the
present value of the expenditure expected to settle
the obligation.
• The discount rate should be a pretax rate that
reflects the current market assessment of the time
value of money and the risk specific to the liability.
• The discount rate should not reflect the risk for
which cash flow estimates have already been
adjusted
 FUTURE EVENTS
• Future events that affect the amount required
to settle an obligation shall be reflected in the
amount of a provision where there is a
sufficient evidence that they will occur.
• Such future events include new legislation and
changes in technology
 EXAMPLE
• An entity may believe that the cost of cleaning up a site at
the end of its life would be reduced by future changes in
technology
• The amount recognized must reflect the reasonable
expectation of technically qualified and objective observers
taking into account all available evidence as to the
technology that would be available at the time of clean up.
• The effect of possible new legislation is also taken into
consideration in measuring an existing obligation when
sufficient objective evidence exists that the legislation is
virtually certain to be enacted.
 EXPECTED DISPOSAL OF ASSETS
• Gain from expected disposal of assets shall not
be taken into account in measuring a provision
• Instead, an entity shall recognize gain on
disposal at the time of the disposition of the
assets
• In other words, any cash inflows from disposal
are treated separately from the measurement
of the provision.
 REIMBURSEMENTS
• Where some or all of the expenditure required to settle a
provision is expected to be reimbursed by another party,
the reimbursement shall be recognized when it is virtually
certain that reimbursement would be received if the entity
settles the obligation
• The reimbursement shall be treated as a separate asset
and not netted against the estimated liability for the
provision
• The amount of reimbursement shall not exceed the
amount of the provision
• However, in the income statement, the expense relating to
the provision may be presented net of the reimbursement.
 CHANGES IN PROVISION
• Provision 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 the obligation
• Where 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
• For example, a provision for plant dismantlement
cannot be used to absorb environmental pollution
claims or warranty payments
• If an expenditure is charged against a provision
that was originally recognized for another purpose,
that would camouflage the impact of two different
events, thus distorting financial performance and
possibly constituting financial reporting fraud.
 FUTURE OPERATING LOSSES
• Provision shall not be recognized for future
operating losses.
• A provision for operating losses is not
recognized because a past event creating a
present obligation has not occurred.
• An expectation of future operating losses is an
indication that certain assets may be impaired.
An impairment test for these assets may be
necessary.
 ONEROUS CONTRACT
• If an entity has an onerous contract, the present obligation
under the contract shall be recognized and measured as a
provision
• An onerous contract is a contract in which the unavoidable
costs of meeting the obligation under the contract exceed
the economic benefits expected to be received under it.
• PAS 37, paragraph 68, mandates that the unavoidable costs
under a contract represent the “least net cost of exiting
from the contract”.
• The lower amount between the cost of fulfilling the
contract and the compensation or penalty arising from
failure to fulfill the contract is the least cost of exiting from
the contract.
 ILLUSTRATION
• An entity is getting ready to move its factory from its
existing location in Bataan to Subic which is a new
industrial free zone specially created by the
Philippine government for manufacturers.
• Considering the savings in costs that would ensue
because there are no duties or taxes in the free trade
zone, the entity has to move before the end of the
year.
• However, the lease on the entity’s present location is
noncancelable and will expire two years from year-
end. The obligation under the lease is the annual
rent of P500,000
 CONTINUATION
• The lease agreement is an executory onerous
contract because after moving to the new location
in Subic, the entity would derive no benefit from
the existing factory building in Bataan but would
still pay the rental for two years.
• Thus, the unavoidable cost exceeds the benefit
expected under the lease contract. Accordingly, the
entity is required to recognize a provision for the
onerous contract.
• The amount is equal to the present value of the
rental for two years of P1,000,000
 EXAMPLES OF PROVISION
• Warranties
• Environmental contamination
• Decommissioning or abandonment costs
• Court Case
• Guarantee
 RESTRUCTURING
• PAS 37, paragraph 10, defines restructuring as a program
that is planned and controlled by management and
materially changes either the scope of a business of an
entity or the manner in which that business is conducted.
• Events that may qualify as restructuring include:
– Sale or termination of a line of business
– Closure of business location in region or relocation of business
activities from one location to another or relocation of
headquarters from one country to another
– Change in management structure, such as elimination of a layer
of management or making all functional units autonomous.
– Fundamental reorganization of an entity that has a material and
significant impact on its operations
 PROVISION FOR RESTRUCTURING
• Recognition of the provision for restructuring is
required because a constructive obligation may
arise from the decision to restructure.
• A constructive obligation for restructuring
arises when two conditions are present:
– The entity has a detailed formal plan for the
restructuring which includes the following
– 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.
 ILLUSTRATION
• The board of directors of an entity at their meeting held
at the current year-end decided to close down all its
international operations and consolidate them with its
domestic operations
• A detailed formal plan for winding up the international
operations was also formalized and agreed by the board
of directors in the meeting
• Letters were sent out to customers, suppliers, workers
thereafter. Meetings were called to discuss the features
of the formal plan to wind up international operations
and representatives of all interested parties were
present in those meetings
AMOUNT OF RESTRUCTURING PROVISION
• A restructuring provision shall include only direct
expenditures arising from the restructuring.
• These expenditures are necessarily incurred for
the restructuring and not associated with the
ongoing activities of the entity.
• For example, salaries and benefits of employees
to be incurred after operations cease and that
are associated with the closure of the operations
shall be included in the amount of the
restructuring provision.
 CONTINUATION
• PAS 37, paragraph 81, specifically excludes the
following expenditures from the restructuring
provision:
– Cost of retraining or relocating continuing staff
– Marketing or advertising program to promote the new
company image
– Investment in new system and distribution network
• Such 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
not liabilities relating to the restructuring program.