R.

Shyam Prasad WoW Academics 9841668890

Provision Contingent liabilities, assets

Provisions
The problem
Until the issue of IAS 37 Provisions, Contingent Liabilities and Contingent Assets, there was no
accounting standard covering the general topic of provisions. This led to various problems.

 Provisions were often recognised as a result of an intention to make expenditure, rather

than an obligation to do so.
 Several items could be aggregated into one large provision that was reported as an
exceptional item (the ‘big bath’).
 Inadequate disclosure meant that in some cases it was difficult to ascertain the
significance of the provisions and any movements in the year.

Provisions (Probable)
Provisions is a liability of uncertain timing or amount
'A liability is a present obligation of the entity arising from past events, the settlement of which
is expected to result in an outflow from the entity of resources embodying economic benefits'

To qualify for provision, all conditions are required:

1. Present obligation (Legal or constructive)
2. Probable transfer of economic benefits
3. Reliable estimate of potential costs
If provision is to be paid within 12 months = Current liability
If provision is to be paid after 12 months = Non-Current liability

A present obligation as a result of a past event The obligation needs to exist because of events
which have already occurred at the year-end and give rise to a potential outflow of economic
resources. This obligation can either be:
(a) Legal/contractual
(b) Constructive – This is where the company establish a valid expectation through a course of
past practice, regardless of whether there is a legal requirement to perform the task or not.

Example 1
A retail store has a policy of refunding purchases by dissatisfied customers, even though it is
under no legal obligation to do so. Its policy of making refunds is generally known. Should a
provision be made at the year end?

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Solution
 The policy is well known and creates a valid expectation.
 There is a constructive obligation.
 It is probable some refunds will be made.
 These can be measured using expected values.
 Conclusion: A provision is required.

A reliable estimate can be made

Provisions should be recognised at the best estimate. If the provision relates to one event, such
as the potential liability from a court case, this should be measured using the most likely
outcome. If the provision is made up of numerous events, such as a provision to make repairs
on goods within a year of sale, then the provision should be measured using expected values.

Example 2
An entity sells goods with a warranty covering customers for the cost of repairs of any defects
that are discovered within the first two months after purchase. Past experience suggests that
88% of the goods sold will have no defects, 7% will have minor defects and 5% will have major
defects. If minor defects were detected in all products sold, the cost of repairs would be
$24,000. If major defects were detected in all products sold, the cost would be $200,000. What
amount of provision should be made?
Solution
The expected value of the cost of repairs is $11,680 [(7% × 24,000) + (5% × 200,000)].

Example 3
An entity has to rectify a serious fault in an item of plant that it has constructed for a customer.
The individual most likely outcome is that the repair will succeed at the first attempt at a cost
of $400,000, but there is a chance that a further attempt will be necessary, increasing the total
cost to $500,000. What amount of provision should be recognised?
Solution
A provision for $400,000 is recognised. This is because the best estimate of the liability is its
most likely outcome, not the worst-case scenario.

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Contingent liabilities (Possible)

A possible obligation that arises from past events and whose existence will be confirmed only
by the occurrence or non-occurrence of one or more uncertain future events not wholly within
the entity's control;
OR
A present obligation that arises from past events but is not recognised because:
It is not probable that a transfer of economic benefits will be required to settle the obligation;
or The amount of the obligation cannot be measured with sufficient reliability.

To qualify for Contingent liabilities, meet all conditions:

Possible obligation (Legal or constructive)
No sufficient Reliable estimate of potential costs

Contingent asset
A possible asset that arises from past events and whose existence will be confirmed by the
occurrence of one or more uncertain future events not wholly within the enterprise's control.

Rule for classification

Probability of occurrence In terms of % Liabilities Assets

Virtual certain Above 95% Provision Assets
(Amount or timing Financial Statement
known)
Probable 51% - 95% Provision CA - Disclosure note in
financial statements
Possible 5% - 50% CL - Disclosure note in Ignore
financial statements
Remote Below 5% Ignore Ignore
Note: There is no provision asset in Financial Statements. It’s either An Asset or Disclosure!!!

Movement in provisions
Provisions should be reviewed at each statement of financial position date and adjusted to
reflect the current best estimate.

Increase in provision:
Dr Relevant expense account
Cr Provision

Decrease in provision:
Dr Provision
Cr Relevant expense
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Example
A company is engaged in a legal dispute. The outcome is not yet known. A number of
possibilities arise:
 It expects to have to pay about $100,000. A provision is recognised.
 Possible damages are $100,000 but it is not expected to have to pay them. A contingent
liability is disclosed.
 The company expects to have to pay damages but is unable to estimate the amount. A
contingent liability is disclosed.
 The company expects to receive damages of $100,000 and this is virtually certain. An asset
is recognised.
 The company expects to probably receive damages of $100,000. A contingent asset is
disclosed.
 The company thinks it may receive damages, but it is not probable. No disclosure.

Accounting for Provisions

Example 4
BPP TB A business has been told by its lawyers that it is likely to have to pay $10,000 damages
for a product that failed. The business duly set up a provision at 31 December 20X7. However,
the following year, the lawyers found that damages were more likely to be $50,000. Required
How is the provision treated in the accounts at: (a) 31 December 20X7? (b) 31 December 20X8?

Example 5
BPP TB Warren Tees Ltd. is a manufacturer of golf tees. Tees purchased are covered by a three
year warranty, whereby the company will replace any defective tees.
At the end of last year on 31 March 20X6, a provision of $150,000 was made. During this year,
$75,000 was paid for the cost of replacing tees under warranty. At the end of this year, the
company estimated that a provision of $135,000 was needed. Show accounting entries and
how this will appear in the SOFP.

Example 6
BPP TB A company has a provision for warranty claims b/f of $50,000. It does a review and
decides that the provision needed in future should be $45,000. What is the effect on the
financial statements?
Statement of profit or loss Statement of financial position
A Increase expenses by $5,000 Provision $50,000
B Increase expenses by $5,000 Provision $45,000
C Decrease expenses by $5,000 Provision $50,000
D Decrease expenses by $5,000 Provision $45,000
Ans: D

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Example 7
BPP TB During 20X9 Smack Co gives a guarantee of certain borrowings of Pony Co, whose
financial condition at that time is sound. During 20Y0, the financial condition of Pony Co
deteriorates and at 30 June 20Y0 Pony Co files for protection from its creditors. What
accounting treatment is required:
(a) At 31 December 20X9? (b) At 31 December 20Y0?
Ans: (a) Contingent liabilities [Notes] (b) Provision [SOFP, SOPL]

Probability & Provision

Example 8
12.12 When a provision is needed that involves a number of outcomes, the provision is
calculated using the expected value of expenditure. The expected value of expenditure is the
total expenditure of:
A Each possible outcome
B Each possible outcome weighted according to the probability of each outcome happening
C Each possible outcome divided by the number of outcomes
D Each possible outcome multiplied by the number of outcomes
Ans: B

Example 9
12.13 X Co sells goods with a one year warranty and had a provision for warranty claims of
$64,000 at 31 December 20X0. During the year ended 31 December 20X1, $25,000 in claims
were paid to customers. On 31 December 20X1, X Co estimated that the following claims will be
paid in the following year:
Scenario Expected Probability cost
Worst case 5% $150,000
Best case 20% $25,000
Most likely 75% $60,000
What amount should X Co record in the statement of profit or loss for the year ended 31
December 20X1 in respect of the provision?
Ans: $18,500

Example 10
BPP EK 12.11 Mobiles Co sells goods with a one year warranty under which customers are
covered for any defect that becomes apparent within a year of purchase. In calendar year 20X4,
Mobiles Co sold 100,000 units. The company expects warranty claims for 5% of units sold. Half
of these claims will be for a major defect, with an average claim value of $50. The other half of
these claims will be for a minor defect, with an average claim value of $10. What amount
should Mobiles Co include as a provision in the statement of financial position for the year
ended 31 December 20X4?
Ans:$150,000

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Example 11
BPP TB 54 Punt Co sells vacuum cleaners with a warranty. Customers are covered for the cost of
repairs of any manufacturing defect that becomes apparent within the first year of purchase.
The company's past experience and future expectations indicate the following pattern of likely
repairs.
% of goods sold Defects Estimate Cost of repairs for 100% goods
80 None –
12 Minor $545000
8 Major $800000
The warranty provision brought forward is $99,750.
What amounts should be recognised in the financial statements of Punt Co relating to the
warranty provision for the year to 20X3? Indicate the effect in SOPL & SOFP
Ans: 129,400, $29,650.

Example 12
Classification
BPP TB After a wedding in 20X0 ten people became seriously ill, possibly as a result of food
poisoning from products sold by Callow Co. Legal proceedings are started seeking damages
from Callow but it disputes liability. Up to the date of approval of the financial statements for
the year to 31 December 20X0, Callow's lawyers advise that it is probable that it will not be
found liable. However, when Callow prepares the financial statements for the year to 31
December 20X1 its lawyers advise that, owing to developments in the case, it is probable that it
will be found liable. What is the required accounting treatment:
(a) At 31 December 20X0? (b) At 31 December 20X1?
Ans: (a) Contingent liabilities [Notes] (b) Provision [SOFP, SOPL]

Example 13
12.9 Which of the following items does the statement below describe?
“A possible obligation that arises from past events and whose existence will be confirmed only
by the
occurrence or non-occurrence of one or more uncertain future events not wholly within the
entity's control”
A A provision B A current liability
C A contingent liability D A contingent asset
Ans: C

Example 14
BPP EK 12.5 Which of the following statements about the requirements of IAS 37 Provisions,
contingent liabilities and contingent assets are correct?

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1 A contingent asset should be disclosed by note if an inflow of economic benefits is probable.

2 No disclosure of a contingent liability is required if the possibility of a transfer of economic
benefits arising is remote.
3 Contingent assets must not be recognised in financial statements unless an inflow of
economic benefits is virtually certain to arise.
A All three statements are correct B 1 and 2 only
C 1 and 3 only D 2 and 3 only
Ans: A

Example 15
BPP TB 52 The following conditions exist.
 An event has occurred which means Booker Co has incurred a present obligation.
 It is possible that Booker Co will have to pay out cash in order to settle the obligation.
 A reliable estimate of the amount involved cannot be determined.
What is the effect of the above on the financial statements of Booker Co?
A A provision should be created B A contingent liability should be disclosed
C A contingent asset should be disclosed D No effect
Ans: B, CL as amount cannot be reliably estimated

Example 16
BPP TB 53 Raider Co has to include the following items in its financial statements.
1 Raider Co has been sued by Space Co for breach of trademark. Raider Co strongly disputes the
claim and Raider Co's lawyers advise that the likelihood of having to pay any money to Space Co
for the claim is remote.
2 Raider Co gives warranties on its products. Data from previous years show that about 15% of
sales give rise to a warranty claim.
How should the items be reflected in the financial statements of Raider Co? Item 1 Item 2
A create a provision / disclose by note only B disclose by note only / create a provision
C disclose by note only / disclose by note only D no provision or disclosure required /
create a provision
Ans: D