PUT YOUR COURSE TITLE HERE • NU LAGUNA 1

INTERMEDIATE
ACCOUNTING II
Course Material No. 2 –
Provisions and
Contingencies

Justine Ray P. Alomia,

CPA, MBA
Course Instructor
PUT YOUR COURSE TITLE HERE • NU LAGUNA 2

Provisions and
Contingencies 2
LEARNING OUTCOMES

Here’s what I will teach you in this course material:

LESSON OUTLINE
LO1. Discuss and apply the GAAP on the nature, measurement, valuation,
 Provisions recognition, de-recognition, classification, presentation and disclosure of
provisions and contingencies by solving accounting problems.
LO2. Conduct a comparative research on the disclosure practices of selected
 Contingent companies in accounting for provisions and contingencies.
Unit Outline
Liability

 Contingent Asset

 Premiums
Liability RESOURCES NEEDED

 Warranty Liability For this lesson, you would need the following resources:

 Reference Book – Intermediate Accounting II by Conrado Valix

Provisions and Contingencies

Nature of Provision
Provision is a liability of uncertain timing or amount.

Recognition of a Provision
An enterprise must recognize a provision if, and only if:
 a present obligation (legal or constructive) has arisen as a result of a past event
(the obligating event),
 payment is probable (‘more likely than not’), and
 the amount can be estimated reliably.

An obligating event is an event that creates a legal or constructive obligation and,

therefore, results in an enterprise having no realistic alternative but to settle the
obligation.

A legal obligation is an obligation that derives from:

(a) a contract (through its explicit or implicit terms);
(b) legislation; or
(c) other operation of law.

A constructive obligation is an obligation that derives from an entity’s actions where:

(a) by an established pattern of past practice, published policies or a sufficiently
specific current statement, the entity has indicated to other parties that it will
accept certain responsibilities; and
(b) as a result, the entity has created a valid expectation on the part of those
other parties that it will discharge those responsibilities.

A possible obligation (a contingent liability) is disclosed but not accrued. However,

disclosure is not required if payment is remote.

In rare cases, for example in a lawsuit, it may not be clear whether an enterprise has
a present obligation. In those cases, a past event is deemed to give rise to a present
obligation if, taking account of all available evidence, it is more likely than not that a
present obligation exists at the end of the reporting period. A provision should be
recognized for that present obligation if the other recognition criteria described above
are met. If it is more likely than not that no present obligation exists, the enterprise
should disclose a contingent liability, unless the possibility of an outflow of resources
is remote.

Measurement of Provisions
The amount recognized as a provision should be the best estimate of the expenditure
required to settle the present obligation at the end of the reporting period, that is,
the amount that an enterprise would rationally pay to settle the obligation at the end
of the reporting period or to transfer it to a third party. This means:
 Provisions for one-off events (restructuring, environmental clean-up, settlement
of a lawsuit) are measured at the most likely amount.
Provisions for large populations of events (warranties, customer refunds) are
measured at a probability-weighted expected value.
 Where 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.
 The provision is measured before tax, as the tax consequences of the provision,
and changes in it, are dealt with under PAS 12 Income Taxes.

In reaching its best estimate, the enterprise should take into account the risks and
uncertainties that surround the underlying events. Expected cash outflows should be
discounted to their present values, where the effect of the time value of money is
material.

If some or all of the expenditure required to settle a provision is expected to be

reimbursed by another party, the reimbursement should be recognized as a reduction
of the required provision when, and only when, it is virtually certain that
reimbursement will be received if the enterprise settles the obligation. The amount
recognized should not exceed the amount of the provision.

In measuring a provision consider future events as follows:

 forecast reasonable changes in applying existing technology
 ignore possible gains on sale of assets
 consider changes in legislation only if virtually certain to be enacted

Remeasurement of Provisions
 Review and adjust provisions at the end of each reporting period
 If outflow no longer probable, reverse the provision to income.

Restructurings
A restructuring is:
 Sale or termination of a line of business
 Closure of business locations
 Changes in management structure
 Fundamental reorganization of company

Restructuring provisions should be accrued as follows:

 Sale of operation: accrue provision only after a binding sale agreement If the
binding sale agreement is after the end of the reporting period, disclose but do
not accrue
 Closure or reorganization: accrue only after a detailed formal plan is adopted and
announced publicly. A board decision is not enough.
 Future operating losses: Provisions should not be recognized for future operating
losses, even in a restructuring
 Restructuring provision on acquisition (merger): Accrue provision for terminating
employees, closing facilities, and eliminating product lines only if announced at
acquisition and, then only if a detailed formal plan is adopted 3 months after
acquisition.

Restructuring provisions should include only direct expenditures caused by the

restructuring, not costs that associated with the ongoing activities of the enterprise.
What Is the Debit Entry?
When a provision (liability) is recognized, the debit entry for a provision is not always
an expense. Sometimes the provision may form part of the cost of the asset.
Examples: obligation for environmental cleanup when a new mine is opened or an
offshore oil rig is installed.

Use of Provisions
Provisions should only be used for the purpose for which they were originally
recognized. They should be reviewed at each reporting period and adjusted to reflect
the current best estimate. If it is no longer probable that an outflow of resources will
be required to settle the obligation, the provision should be reversed.

Contingent Liabilities
 a possible obligation depending on whether some uncertain future event occurs,
or
 a present obligation but payment is not probable or the amount cannot be
measured reliably

PAS 37 requires that enterprises should not recognize contingent liabilities - but
should disclose them, unless the possibility of an outflow of economic resources is
remote.

Contingent Assets
 a possible asset 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 control of the enterprise.

Contingent assets should not be recognized - but should be disclosed where an inflow
of economic benefits is probable. When the realization of income is virtually certain,
then the related asset is not a contingent asset and its recognition is appropriate.

Difference between Provisions and Other Liabilities

Provisions can be distinguished from other liabilities such as trade payables and
accruals because there is uncertainty about the timing or amount of the future
expenditure required in settlement. By contrast:

(a) trade payables are liabilities to pay for goods or services that have been
received or supplied and have been invoiced or formally agreed with the
supplier; and
(b) accruals are liabilities to pay for goods or services that have been received or
supplied but have not been paid, invoiced or formally agreed with the supplier,
including amounts due to employees (for example, amounts relating to
accrued vacation pay). Although it is sometimes necessary to estimate the
amount or timing of accruals, the uncertainty is generally much less than for
provisions.

Accruals are often reported as part of trade and other payables, whereas provisions
are reported separately.

Relationship between Provisions and Contingent Liabilities

In a general sense, all provisions are contingent because they are uncertain in timing
or amount. However, within PAS 37 the term ‘contingent’ is used for liabilities and
assets that are not recognized because their existence will be confirmed only by the
occurrence or non-occurrence of one or more uncertain future events not wholly
within the control of the entity. In addition, the term ‘contingent liability’ is used for
liabilities that do not meet the recognition criteria.

PAS 37 distinguishes between:

(a) provisions - which are recognized as liabilities (assuming that a reliable estimate
can be made) because they are present obligations and it is probable that an
outflow of resources embodying economic benefits will be required to settle the
obligations; and
(b) contingent liabilities - which are not recognized as liabilities because they are
either:
i. possible obligations, as it has yet to be confirmed whether the entity has a
present obligation that could lead to an outflow of resources embodying
economic benefits; or
ii. present obligations that do not meet the recognition criteria in this Standard
(because either it is not probable that an outflow of resources embodying
economic benefits will be required to settle the obligation, or a sufficiently
reliable estimate of the amount of the obligation cannot be made).
 Here are some review questions, computational problems and
theories to help us understand more this topic

MULTIPLE CHOICE PROBLEMS

1. Maybe Company is evaluating whether each of the following would be a liability, a
provision or a contingent liability, or none of the above, in the financial statements
of Maybe as at its balance date of 30 June 2019. Assume that Maybe’s financial
statements are authorized for issue on 24 August 2019:

a) An amount of P350,000 owing to Perhaps Company for services rendered during

May 2019.
b) Long-service leave, estimated to be P5,000,000, owing to employees in respect
of past services.
c) Costs of P260,000 estimated to be incurred for relocating employee D from
Maybe’s head office location to another city. The staff member will physically
relocate during July 2019.
d) Provision of P500,000 for the overhaul of a machine. The overhaul is needed
every 5 years and the machine was 5 years old as at 30 June 2019.
e) Damages awarded against Maybe resulting from a court case decided on 26
June 2019. The judge has announced that the amount of damages will be set
at a future date, expected to be in September 2019. Maybe has received advice
from its lawyers that the amount of the damages could be anything between
P50,000 and P8 million.

How much should be reported as Provisions in Maybe Company’s statement of

financial position as of 30 June 2019?
a. P10,135,000 b. P6,110,000 c. P5,350,000 d. P5,000,000

2. Draft income statement of Raffles Inc. showed profit of P100,000 before

considering the following:
i. Closing inventory includes goods costing P20,000 which are expected to
realize P19,000.
ii. A customer has taken legal action for damages of P50,000 against Raffles.
The lawyer of Raffles has advised that he has a 25% chance of success.
iii. After the end of the reporting period, a vehicle was damaged in an accident.
The carrying amount of the vehicle was P6,000. It was not insured.
iv. Raffles has sued one of its competitors for P60,000. The chances Raffles
winning the case are 75%. The outcome will be known in three months.

What is the correct profit after considering the foregoing adjustments?

a. P159,000 b. P103,000 c. P99,000 d. P49,000
3. In May 2019, Chubby Company relocated an employee from the company's head
office to an office in another city. As of June 30, 2019, the company's period end,
the relocation costs are estimated as follows:
Cost of shipping goods P30,000
Airfare 60,000
Temporary accommodation costs for May and June 80,000
Temporary accommodation costs for July and August 90,000
Reimbursement for lease break cost paid in July. The
lease was terminated May 20,000
Reimbursement for costs of living increases for the
period May 2019 to April 2020 120,000
Total P400,000

How much is the provision for relocation costs as of June 30, 2019?
a. P400,000 b. P210,000 c. P280,000 d. P190,000

Use the following information for the next three questions.

Emong Candy Company offers a coffee mug as a premium for every ten 50-cent
candy bar wrappers presented by customers together with P1.00. The purchase price
of each mug to the company is 90 cents; in addition it costs 60 cents to mail each
mug. The results of the premium plan for the years 2018 and 2019 are as follows:
2018 2019
Coffee mugs purchased 480,000 400,000
Candy bars sold 3,750,000 4,500,000
Wrappers redeemed 1,900,000 2,800,000
2018 wrappers expected to be redeemed in 2019 1,300,000
2019 wrappers expected to be redeemed in 2020 1,800,000

4. The premium expense for the year ended December 31, 2019 is
a. P165,000 b. P230,000 c. P495,000 d. P690,000

5. The inventory of premium mugs as of December 31, 2019 is

a. P369,000 b. P410,000 c. P423,000 d. P540,000

6. The estimated liability for premiums as of December 31, 2019 is

a. P 90,000 b. P162,000 c. P165,000 d. P270,000

7. Included in the sales revenue of Imbiah Company for the year 2019 is an amount
of P3 million relating to sales made under a special promotion in December 2019.
These goods were sold with an accompanying voucher equal to the selling price.
Five years after the sale, these vouchers will be exchanged for goods of the
customer’s choice. The profit margin on these goods is expected to be 30% of the
selling price, and market research estimates that 50% of the vouchers will be
redeemed. The present value (at December 31, 2019) of P1 at the time the
vouchers will be exchanged can be taken as 0.60.

The provision for voucher scheme as of December 31, 2019 is

a. P1,050,000 b. P692,300 c. P900,000 d. P630,000

8. In 2018, Slimon Corporation began selling a new line of products that carry a two-
year warranty against defects. Based upon past experience with other products,
the estimated warranty costs related to peso sales are as follows:
 First year of warranty 2%
Second year of warranty 5%

Sales and actual warranty expenditures for 2018 and 2019 are presented below:
2018 2019
Sales P450,000 P600,000
Actual warranty expenditures 15,000 30,000

What is the estimated warranty liability at the end of 2019?

a. P28,500 b. P73,500 c. P43,500 P12,000
POST TEST
IMPORTANT LESSON
TERMS SUMMARY

Provisions Premium Liability

Contingent Liability Warranty Expense
Contingent Asset Warranty Liability
Premium Expense

POST TEST

1. It is an existing liability of uncertain amount or uncertain timing.

a. Contingent liability c. Unearned income
b. Discount on note payable d. Provision

2. PAS 37 shall be applied by all entities in accounting for provisions, contingent

liabilities and contingent assets including
a. Those covered by another Standard.
b. Financial guarantees that are within the scope of PFRS 9 Financial Instruments.
c. Those resulting from executory contracts
d. Those resulting from onerous contracts

3. Onerous contract is a contract

a. Under which neither party has performed any of its obligations or both parties
have partially performed their obligations to an equal extent.
b. That require the issuer to make specified payments to reimburse the holder for
a loss it incurs because a specified debtor fails to make payment when due in
accordance with the original or modified terms of a debt instrument.
c. A contract under which one party accepts significant insurance risk from another
party by agreeing to compensate the policyholder if a specified uncertain future
event adversely affects the policyholder.
d. In which the unavoidable costs of meeting the obligations under the contract
exceed the economic benefits expected to be received under it.

4. Which ONE of the following is within the scope of PAS37 Provisions, contingent
liabilities and contingent assets?
a. Financial instruments carried at fair value
b. Future payments under employment contracts
c. Future payments on vacant leasehold premises
d. An insurance company's policy liability

5. Which of the following “provisions” does PAS 37 address?

a. Provision for depreciation c. Provision for doubtful debts
b. Provision for impairment of assets d. Provision for restructurings

6. A restructuring is a programme that is planned and controlled by management,

and materially changes:
a. The scope of a business undertaken by an entity
b. The manner in which that business is conducted
c. Either a or b
d. Neither a nor b
7. Which statement is incorrect regarding distinction between provisions and
accruals?
a. Provisions can be distinguished from accruals because there is uncertainty about
the timing or amount of the future expenditure required in settlement.

b. Accruals are liabilities to pay for goods or services that have been received or
supplied but have not been paid, invoiced or formally agreed with the supplier,
including amounts due to employees.
c. Although it is sometimes necessary to estimate the amount or timing of
accruals, the uncertainty is generally much less than for provisions.
d. Accruals and provisions are often reported as part of trade and other payables.

8. When can a "provision" be recognized in accordance with PAS 37?

a. When there is a legal obligation arising from a past (obligating) event, the
probability of the outflow of resources is more than remote (but less than
probable), and a reliable estimate can be made of the amount of the obligation.
b. When there is a constructive obligation as a result of a past (obligating) event,
the outflow of resources is probable, and a reliable estimate can be made of the
amount of the obligation.
c. When there is a possible obligation arising from a past event, the outflow of
resources is probable, and an approximate amount can be set aside toward the
obligation.
d. When management decides that it is essential that a provision be made for
unforeseen circumstances and keeping in mind this year the profits were enough
but next year there may be losses.

9. A contingent liability
a. Definitely exists as a liability but its amount and due date are indeterminable.
b. Is accrued even though not reasonably estimated.
c. Is the result of a loss contingency.
d. Is not recognized in the financial statements.

10. Which of the following is the proper way to report a probable contingent asset?
a. As an accrued amount.
b. As deferred revenue.
c. As an account receivable with additional disclosure explaining the nature of the
contingency.
d. As a disclosure only.

11. To record an environmental liability, the cost associated with the liability is
a. Expensed.
b. Included in the carrying amount of the related long-lived asset.
c. Included in a separate account.
d. None of these.

12. A company is legally obligated for the costs associated with the retirement of a
long-lived asset
a. Only when it hires another party to perform the retirement activities.
b. Only if it performs the activities with its own workforce and equipment.
c. Whether it hires another party to perform the retirement activities or performs
the activities itself.
 d. When it is probable the asset will be retired.

13. Assume that a manufacturing corporation has (1) good quality control, (2) a
one-year operating cycle, (3) a relatively stable pattern of annual sales, and (4) a
continuing policy of guaranteeing new products against defects for three years that
has resulted in material but rather stable warranty repair and replacement costs.
Any liability for the warranty
a. Should be reported as non-current.
b. Should be reported as current.
c. Should be reported as part current and part non-current.
d. Need not be disclosed.

14. Ortiz Corporation, a manufacturer of household paints, is preparing annual

financial statements at December 31. Because of a recently proven health hazard
in one of its paints, the government has clearly indicated its intention of having
Ortiz recall all cans of this paint sold in the last six months. The management of
Ortiz estimates that this recall would cost P800,000. What accounting recognition,
if any, should be accorded this situation?
a. No recognition
b. Note disclosure only
c. Operating expense of P800,000 and liability of P800,000
d. Appropriation of retained earnings of P800,000

15. Information available prior to the issuance of the financial statements indicates
that it is probable that, at the date of the financial statements, a company has a
present obligation related to product warranties. The amount of the expense
involved can be reasonably estimated. Based on the above facts, the estimated
warranty expense should be
a. Accrued.
b. Disclosed but not accrued.
c. Neither accrued nor disclosed.
d. Classified as an appropriation of retained earnings.

16. Which of the following are not factors that are considered when evaluating
whether or not to record a liability for pending litigation?
a. Time period in which the underlying cause of action occurred.
b. The type of litigation involved.
c. The probability of an unfavorable outcome.
d. The ability to make a reasonable estimate of the amount of the loss.

17. A competitor has sued an entity for unauthorized use of its patented technology.
The amount that the entity may be required to pay to the competitor if the
competitor succeeds in the lawsuit is determinable with reliability, and according
to the legal counsel it is less than probable (but more than remote) that an outflow
of the resources would be needed to meet the obligation. The entity that was sued
should at year-ended:
a. Recognize a provision for this possible obligation.
b. Make a disclosure of the possible obligation in footnotes to the financial
statements.
c. Make no provision or disclosure and wait until the lawsuit is finally decided and
then expense the amount paid on settlement, if any.
 d. Set aside, as an appropriation, a contingency reserve, an amount based on the
best estimate of the possible liability.

18. McCann Limited announced its plans for a major restructuring of its operations.
Under PAS 37, the entity is able to:
a. Capitalize all direct and indirect restructuring costs;
b. Set up a provision for the best estimate of all restructuring costs;
c. Provide only for restructuring costs that are directly and necessarily caused by
the restructuring;
d. Provide for restructuring costs that are associated with the ongoing activities of
the entity.

19. Amazon Inc. has served a legal notice on December 15, by the local
environmental protection agency (EPA) to fit smoke detectors in its factory on or
before June 30 next year. The cost of fitting smoke detectors in its factory is
estimated at P250,000. How should Amazon Inc. treat this in its financial
statements for the year ended December 31?
a. Recognized a provision for P250,000 in the financial statements for the year
ended December 31.
b. Recognized a provision for P125,000 in the financial statements for the year
ended December 31, because the other 50% of the estimated amount will be
recognized in the financial statement next year.
c. Because Amazon Inc. can avoid the future expenditure by changing the method
of operations and thus there is no present obligation for the future expenditure,
no provision is required at December 31, but as there is a possible obligation,
this warrants disclosure in footnotes to the financial statements.
d. Ignore this for the purposes of the financial statements for the year ended
December 31, and neither disclose nor provide the estimated amount of
P250,000.

20. The board of directors of ABC Inc. decided on December 15, to wind up
international operations in the Middle East and move them to China. The decision
was based on a detailed formal plan of restructuring as required by PAS 37. This
decision was conveyed to all workers and management personnel at the
headquarters in Manila. The cost of restructuring the operations in the Middle East
as per this detailed plan was P100 million. How should ABC Inc. treat this
restructuring in its financial statements for the year-end December 31?
a. Because ABC Inc. has not announced the restructuring to those affected by the
decision and thus has not raised an expectation that ABC Inc. will actually carry
out the restructuring (and as no constructive obligation has arisen) only disclose
the restructuring decision and the cost of restructuring of P100 million in
footnotes to the financial statements.
b. Recognize a provision for restructuring since the board of directors has approved
it and it has been announced in the headquarters of ABC Inc. in Manila.
c. Mention the decision to restructure and the cost involved in the chairman's
statement in the annual report since it is a decision of the board of directors.
d. Because the restructuring has not commenced before year-end, based on
prudence, wait until next year and do nothing in this year's financial statements.
REFERENCE

Conrado Valix. (2019) Intermediate Accounting II

Reynaldo Ocampo (2019). Intermediate Accounting II