CHAPTER 4  Probable – the event is more likely than not

PROVISION to occur
Contingent Liability - probability that the event will occur (>)
GREATER THAN probability it will not occur
Provision – an existing liability of uncertain timing - more than 50% likely or substantially
and uncertain amount more

 Uncertainty – distinguishes provision from other  Possible – 50% or less likely to occur
liability  Remote – 10% or less likely to occur or very
slight occurrence
- exists at the end of reporting period, but the
amount, date when obligation is due, and some RELIABLE ESTIMATE
cases, payee is INDEFINITE/ CANNOT BE
Use of estimates – an essential part of the
IDENTIFIED/DETERMINED
preparation of FS
- equivalent of an estimated liability/loss
- does not undermine their unreliability
contingency that is accrued because it is both
probable & measurable Provision is more uncertain that most items in the
statement of financial position
RECOGNITION OF PROVISION (PAS 37, p14)
Using a range of possibilities – an entity usually
-recognized as liability under the following
would be able to make an estimate of the obligation
conditions:
that is sufficiently reliable
a. PRESENT OBLIGATION, legal/ constructive as a
Where no reliable estimate can be made, no liability
result of past event
is recognized.
b. PROBABLE OF OUTFLOW OF RESOURCES to
MEASUREMENT OF PROVISION
settle the obligation
Amount recognized as provision = best estimate of
c. the amount of obligation can be MEASURED
the expenditure required to settle the obligation at the
RELIABLY
end of the period
PRESENT OBLIGATION
Best Estimate – the amount that an entity would
Legal Obligation – arising from a contract, rationally pay to settle the obligation at the end of
legislation, or other operation of law reporting period or to transfer it to a third party at that
time
Constructive obligation – from an established
pattern of practice OR stated policy has created a  Single obligation is being measured: the
valid expectation that it will accept certain individual most likely outcome adjusted for the
responsibilities effect of other possible outcomes
 Continuous range of possible outcomes
PAST EVENT
and each point in that range is as likely as any
Obligating Event - the past event that leads to a
other: the midpoint of the range is used
present obligation(legal/constructive) because the
 Involves a large population of items:
entity has no realistic alternative but to settle the
weighting all the possible outcomes by their
obligation
associated possibilities; expected value
-the settlement can be enforced by law
-the event creates valid expectations on the Example: (Expected value)
part of the other parties that the entity will discharge
the obligation (constructive) 1. An entity sells goods with warranty

PROBABLE OUTFLOW OF ECONOMIC BENEFITS If minor defects are detected in all products sold, the
repair cost would be P1,000,000
Probable Outflow of Resources embodying
economic benefits to settle the obligation If major defects are detected in all products sold, the
repair cost would be P5,000,000
Based on entity’s past experience and future As prudence dictates, caution is needed in making
expectation: judgment under conditions of uncertainty so that
income and assets are not overstated, or expenses
75% of the goods sold have no defects
and liabilities are not understated.
20% minor defects,
Uncertainty – does not justify the creation of
5% major defects excessive provision or a deliberate overstatement of
liabilities
Expected value or cost repairs is measured as:
2. PRESENT VALUE OF OBLIGATION
75% sales None The effect of the time value of money is
20% sales (20%x1M) 200,000 MATERIAL, the amount of the provision shall be the
5% sales (5%x5M) 250,000 present value of the expenditure expected to
Total expected value/cost of settle the obligation.
450,000
repairs
Discount rate = pretax rate- reflects the current
2. An entity is a defendant in a patent market assessment of the time value of money and
infringement suit. 60% chance that the court the risk specific to the liability
will not dismiss the case and the entity will
incur an outflow of future economic benefits -NOT reflect the risk for which cash flow estimates
If the court rules against the entity: have already been adjusted
-30% chance will be required to pay 3. FUTURE EVENTS
damages of P4,000,000, Future Events that affect the amount required to
-70% chance that the damages will be settle an obligation shall be reflected in the amount of
P2,000,000 a provision where there is a sufficient evidence that
-10% risk adjustment factor they will occur
Measurement of provision Ex: New legislation, Changes in technology
Weighted probabilities 4. EXPECTED DISPOSAL OF ASSETS
30% x 4M x 60% 720,000 Gains form EXPECTED disposal of asset shall
70% x 2M x 60% 840,000 NOT be taken into account when measuring a
Expected cash outflow 1,560,000 provision.
Risk ((10% x 1,560,000)
Adjustment 156,000 Gains on disposal at the time of disposition of
factor assets shall be recognized.
Estimated Amount of Provision 1,716,000 Cash inflows from disposal are TREATED
SEPARATELY FROM MEASUREMENT OF
PROVISION.
OTHER MEASUREMENT CONSIDERATIONS
5. REIMBURSEMENTS
1. Risks and Uncertainties When SOME OR ALL OF THE EXPENDITURES
2. Present Value of Obligation required to settle the obligation is expected to be
3. Future events reimbursed by another party, the reimbursement
4. Expected disposal of assets shall be recognized when it is VIRTUALLY
5. Reimbursements CERTAIN that reimbursement would be received if
6. Changes in provision the entity settles the obligation.
7. Use of provision
8. Future operating losses Reimbursement – shall be treated as SEPARATE
9. Onerous contract ASSET & NOT NETTED against estimated liability for
the provision
1. RISKS AND UNCERTAINTIES -shall NOT EXCEED the amount of provision
Risks – variability of outcomes
*in INCOME STATEMENT- the expense relating
Risk Adjustment – may increase the amount at to the provision may be presented the net of the
which a liability is measured reimbursement
 6. CHANGES IN PROVISION 2. Environmental Contamination
- the best estimate of the cost of cleaning up
Provisions- shall be reviewed at every end if the
the contamination is recognized as the
reporting period and adjusted to reflect the current
PROVISION
best estimate.
-the obligating event is the contamination of
- reversed if it is NO LONGER PROBABLE the property (if the entity has an
that an outflow of economic benefits would be environmental policy such that other parties
required to settle the obligation would expect that the entity will clean up any
contamination) OR (if the entity has broken
-the carrying amount is increased if current environmental legislation) which gives
DISCOUNTING is used to reflect the passage of rise to legal or constructive obligation.
time 3. Decommissioning or Abandonment Cost
7. USE OF PROVISION -when an oil entity initially purchases an oil
field, it is put under a legal obligation to
Provisions shall be used ONLY for expenditure for decommission the site at the end of its life
which the provision was ORIGINALLY recognized -the cost of abandonment or decommissioning
*if used for another purpose that would shall be recognized as PROVISION and may
camouflage the impact of two different events, thus be capitalized as cost of the oil field
distorting the financial performance and possibly 4. Court Case
constituting financial reporting fraud - Legal proceedings will seek damages from
an entity if it is at fault then during the
8. FUTURE OPERATING LOSSES preparation of FS, lawyers advise that owing
to the development of the case, it is probable
Provision shall NOT be recognized for future
that the entity will be found liable.
operating losses.
- PROVISION is recognized for the best
- a PAST EVENT creating PRESENT estimate of the damages because there is a
OBLIGATION HAS NOT OCCURRED present legal obligation.
5. Guarantee
(future operating losses is an indication that some
-if an entity gives a guarantee of certain
assets may be impaired. Impairment test may be
borrowings of another entity and
necessary)
unfortunately, the borrower files a petition for
9. ONEROUS CONTRACT bankruptcy.
- PROVISION is recognized for best estimate
Onerous Contract – contract in which unavoidable
of the guarantee obligation because there is
costs of meeting the obligation under the contract
legal obligation from an obligating event which
EXCEED the economic benefits expected to be
is the guarantee
received under it.
RESTRUCTURING (PAS 37, p10)
If an entity has an onerous contract, the PRESENT
OBLIGATION under the contact shall be recognized -program that is planned and controlled by
and measured as provision. management and materially changes either the scope
of a business of an entity or the manner in which that
business is conducted
EXAMPLES OF PROVISION
Events that may qualify:
1. Warranties - sale or termination of a line of a business
-the best estimate of warranty cost is -closure of a business location in a region or
recognized as PROVISION relocation of business activities or headquarters
-there is already a constructive obligation from -change in management structure
an obligating event (sale of item with -fundamental reorganization of an entity that has a
warranty) material and significant impact on its operations
PROVISION FOR RESTRUCTURING PROBABLE that an out flow of resources embodying
-required because a constructive obligation economic benefits will be required to settle the
may arise from the decision to restructure which obligation
arises when two conditions are present:
 present obligation is either probable or
1. the entity has a detailed formal plan for measurable but NOT BOTH to be
restructuring which includes: considered a contingent liability
a. the business being restructured  if the present obligation is probable
b. the principal location affected and the amount can be measured
c. the location, function and approximate reliably, the amount is NOT a
number of employees who will be contingent liability but shall be
compensated for terminating their recognized as PROVISION
employment
d. date when the plan will be implemented TREATMET OF CONTINGENT LIABLITY
e. the expenditures that will be undertaken Contingent liability SHALL NOT be recognized
2. the entity has raised a valid expectation in the in Financial Statements but SHALL BE DISCLOSED
minds of those affected that the entity will carry out ONLY
the restructuring by starting to implement the Required disclosures:
plan and announcing the main features to those a) brief description of the nature of the contingent
affected by it (meetings) liability
b) an estimate of its financial effects
AMOUNT OF RESTRUCTURING PROVISION
c) an indication of the uncertainties that exist
-shall include ONLY direct expenditures arising
d) possibility of any reimbursement
from the restructuring
-If a contingent liability is REMOTE, no disclosure
 these expenditures are necessarily is necessary.
incurred for the restructuring

Examples: salaries & benefits of employees to CONTINGENT ASSET (PAS 37, p10)
be incurred after operations cease that are - a possible asset that arises from past event
associated with the closure of operations and whose existence will be confirmed ONLY by the
occurrence/ nonoccurrence of one or more uncertain
- PAS 37, p81 specifically EXCLUDES the ff future events NOT WHOLLY within the control of the
expenditures from restructuring provision: entity
a) cost of retaining or relocating continuing -shall NOT be recognized because this may
staff result to recognition of income that may never be
b) marketing/advertising program to promote realized
new company image
c) investment in new system and distribution HOWEVER, when the realization of income is
network virtually certain, the related asset is NO longer
 considered to be EXPENSES relating to contingent asset and its recognition is appropriate.
the future conduct of the business of the *A contingent asset is ONLY DISCLOSED when it is
entity, NOT liabilities relating to probable.
restructuring program
-disclosure includes:
CONTINGENT LIABLITY (PAS 37, p10) a) brief description of the contingent asset
- a possible obligation that arises from past b) estimate of its financial effects
event and whose existence will be confirmed ONLY by
the occurrence/ nonoccurrence of one or more  if a contingent asset is ONLY
uncertain future events NOT WHOLLY within the possible/remote NO disclosure is
control of the entity required.

-a present obligation that arises from past

event but is NOT RECOGNIZED because it is NOT
DECOMMISSIONING LIABLITY SETTLEMENT OF DECOMMISSIONING LIABILTY

-an obligation to dismantle, remove and

Dec 31, 2019 (10yrs after) – removal and dismantling
restore an item of property, plant and equipment as
of the drilling platform for P5,500,000
required by law/contract.
2029
-also called asset retirement obligation Dec 31 Decommissioning Liab 5,000,000
Loss on Settlement of DL 500,000
Example Cash 5,500,000
-Entity extracts natural gas and oil.
-Jan 1, 2020- constructed a drilling platform for Accum Dep 26,610,000
P25M and required to be removed and dismantle by Drilling Platform 26,610,000
Ph law at the end of useful life of 10yrs.
-straight line method CHANGE IN DECOMMISSIONING LIABILITY
Estimated decommissioning cost – P5M IFRIC 1
12% discount rate, PV of 1 for 10 yrs- 0.322 1. Decrease in liability=deduction from the cost
of asset
PV of decommissioning liability (5Mx0.322)1,610,000 -if Decrease>CA, the excess is
 DL initially recognized at PV recognized in profit/loss
included in the cost of the related 2. Increase in liability=added to cost
asset -asset may not be fully recoverable,
thus should be tested for impairment
Journal Entries
Example:
2020 Jan 1, 2020, plant of Seaoil Company is 10 yrs old
Jan 1 Drilling Platform 26,610,000
Cost- P12,000,000, Acc Dep-P4,000,000
Cash 25,000,000
DL 1,610,000 Useful Life- 30yrs, depreciated using straight line, no
residual value
Dec31 Depreciation 2,661,000
Unwinding discount of 6% of 10 yrs,
A/D-DL 2,661,000
decommissioning liability has grown from P1,000,000
(26,610,000/10)
to P1,790,000

31 Interest Expense 193,200 Jan 1, 2020- no change in discount rate

DL 193,200 Estimated Net Present value of the decommissioning
(1,610,000x12%) liability has decreased by P800,000
2021
Dec31 Depreciation 2,661,000 Journal Entries
A/D-DL 2,661,000 2020
Jan 1 DL 800,000
Interest Expense 216,384 Plant Asset 800,000
DL 216,384 Dec31 Depreciation 360,000
A/D-DL (7.2M/20yrs) 360,000
Cost of plant 12,000,000
DL- Jan 2020 1,610,000 Reduction (800,000)
Interest Expense -2020 193,200 Net Cost 11,200,000
Acc Dep (4,000,000)
CA- Dec31, 2020 1,803,200 CA 7,200,000
Interest Expense 2021
(1,803,200x12%) 216,384 31 Interest Expense 59,400
DL 59,400
DL 1/1 1,790,000
Reduction (800,000)
Adjusted CA 990,000
Interest Expense
(990,000x6%) 59, 400