PROVISIONS, CONTINGENT ASSETS &

CONTINGENT LIABILITIES – IAS 37

- Uncertain assets and liabilities

WHETHER to recognize a liability…
A decision made by directors to pay bonus to
employees
Rent is payable for last 6 months
A decision made by directors to purchase a new
machine
New legislation requiring company to dismantle a plant
Future losses expected from business
Goods are sold on warranty
An announcement made by directors to pay bonus at
5% of annual basic salary
Important Definitions
LIABILITY PROVISION CONTINGENT
LIABLITY
-A present - A liability - A possible
obligation - Legal or Constructive obligation as a result of
-As a result of past past events whose existence
events will be confirmed only by
- Outflow of resources the,
to settle is certain 1. Occurrence/ Non-
occurrence of
2. One/ more uncertain
- Uncertain future events
- Certain amount timing or amount 3. Not wholly within control
(amount can only be of entity
reliably measured)

- Recognised - Recognised - Disclosed

Obligation pyramid in
Financial statements

Contingent
Liability

Provision

Liability
Examples
1. ABC Ltd has to pay rent for last 3 months
2. LMF Ltd operates in oil industry and the law requires to clear
the site after 50 years at the time of dismantling of operations
3. LIJ Ltd is in a court for settlement of certain cases amounting
Rs 500m filed against it, there has not yet been any hearing on
the issues but the legal advisors of the company are hopeful
that the cases would turn in the favour of the company.
4. DMN Ltd has contaminated a certain land and the company
intends to clear the land. However no law requires it to clear it
and neither does it have any history of doing so.
5. The company has announced a restructuring plan including
severance of 500 employees. The details of termination
benefits has yet to be finalized.
Solution to examples
1. Liability
2. Provision
3. Contingent liability
4. Nothing, as no legal and constructive obligation and
company only intends to, no final step is taken
towards this
5. Provision – as plan has been announced, so company
has a legal and constructive obligation to fulfill it but
the amount of termination benefits is not yet certain
How to determine amount for provisions and
contingencies
When measuring provision and contingent liabilities, use
JUDGEMENT for BEST POSSIBLE ESTIMATE.
Following may be considered

Previous experience
Similar transactions
Possible expert advice
Events after reporting period
Important Definitions
ASSETS
-A resource
- Controlled by the entity
-which results in inflow of
future economic benefits
- Certain inflow of
economic benefits
- Recognised
CONTINGENT ASSET
- A possible asset
- Arises from past events whose
existence will be confirmed only by the,
1. Occurrence/ Non-occurrence of
2. One/ more uncertain future events
3. Not wholly within control of entity
E.g. Reimbursements, recoveries etc.
- Probable and material
inflow of economic benefits
- Only disclosed
- Possible/ remote are ignored
How to answer a discussion type Q?
Structure your answer as follows:
• quote the definition or the relevant recognition
criteria and then discuss whether the element meets each
of the recognition criteria; and
• conclude
 Situation 1
QIL sells all its products on one-year warranty which
covers all types of defects. Previous history indicates that
2% of the products contain major defects whereas 10%
have minor defects. It is estimated that if major defects
were detected in all the products sold, repair cost of Rs. 150
million would result. If minor defects were detected in all
products sold, repair cost of Rs. 70 million would result.
Total sales for the year are amounted to Rs. 830 million.
Solution - Situation 1
There is a present obligation due to sale of goods in
past but the amount to settle the obligation is
uncertain.
Provision must be made for estimated future claims by
customers for goods already sold.
The expected value i.e. Rs. 10 million ([Rs. 150m x
2%] + [Rs. 70m x 10%]) is the best estimate of the
provision.
 Situation 2
On November 1, 2016 a new law was introduced requiring all
factories to install specialized safety equipment within four
months. The Equipment costing Rs. 5.0 million was ordered
on December 15, 2016 against 100% advance payment but the
supplier delayed installation to July 31, 2017. On August 5,
2017 the company received a notice from the authorities
levying a penalty of Rs. 0.4 million i.e. Rs. 0.1 million for
each month during which the violation continued. QIL has
lodged a claim for recovery of the penalty from the supplier of
the equipment. How shall this be treated at June 30, 2017?
Solution - Situation 2
A provision of Rs. 0.4 million is required in relation to
penalty for March 1 to June 30, 2010 because at the
reporting date there is a present obligation in respect of
a past event.
The reimbursement of penalty amount from the vendor
shall be disclosed as contingent asset in the balance
sheet only if it is probable (>50%). And subsequently
recognized as asset when it is virtually certain.
 Situation 3
On July 18, 2010, QIL was sued by an employee claiming
damages for Rs. 6 million on account of an injury caused to him
due to alleged violation of safety regulations on the part of the
company, while he was working on the machine on June 15,
2010. Before filing the suit, he contacted the management on
June 29, 2010 and asked for compensation of Rs. 4 million
which was turned down by the management. The lawyer of the
company anticipates that the court may award compensation
ranging between Rs. 1.5 million to Rs. 3 million. However, in
his view the most probable amount is Rs. 2 million.
 Solution – Situation 3
A provision is to be made by QIL against a contingent liability as:

(i) There is a present obligation (legal or constructive) as a result of

a past event; i.e. accident occurred on June 15, 2010.

(ii) It is probable that outflow of resources will be required to

settle the obligation; and

(iii) A reliable estimate can be made of the amount of the

obligation.
The amount of provision shall be Rs. 2.0 million i.e. the most
probable amount as determined by the lawyer.
Situation 4
SL has filed a claim against one of its vendors for
supplying defective goods. SL’s legal consultant is
confident that damages of Rs. 1 million would be
paid to SL. The supplier has already reimbursed the
actual cost of the defective goods.
 Solution – Situation 4

SL should not recognize the contingent gain until it is realized.

However, if recovery of damages is probable and material to
the financial statements, SL should disclose the following facts
in the financial statements:

Brief description of the nature of the contingent asset

An estimate of the financial effect.

Situation 5
A suit for infringement of patents, seeking damages of
Rs. 2 million, was filed by a third party. SL’s legal
consultant is of the opinion that an unfavorable outcome
is most likely. On the basis of past experience he has
advised that there is 60% probability that the amount of
damages would be Rs. 1 million and 40% likelihood that
the amount would be Rs. 1.5 million.
 Solution – Situation 5
SL should make a provision of the expected amount i.e. Rs.
1.2 million (Rs. 1.0 million x 60% + Rs. 1.5 million x 40%)
because
it is a present obligation as a result of past event;
it is probable that an outflow of resources embodying
economic benefits will be required to settle the obligations;
and
a reliable estimate can be made of the amount.
Assignment

Obtain a copy of published financial

statements of any listed manufacturing
company for the latest year end and identify
the 3 different components of
OBLIGATIONS as identified in IAS 37.