Provision, Contingent Liabilities and Contingent Assets

Standard: PAS 37 Provision, contingent liabilities and contingent assets.

Provision: a liability of uncertain timing or amount.

❖ It differs from other liabilities because of the uncertainty in the TIMING OF THEIR
SETTLEMENT OR ON THE AMOUNT NEEDED TO SETTLE THEM.
❖ Provision must necessarily be ESTIMATED.
❖ Examples:
o Warranty obligations
o Estimated liabilities on pending lawsuits
o Provision for environmental damages
o Provision for decommissioning cost of an item of PPE
o Obligation to make refund
o Obligation arising from guarantees
o Provision on onerous contracts
o Provision for restructuring costs.
❖ Provisions are presented in the SFP separately from other liabilities.

RECOGNITION: when all the following conditions are met

a. The entity has a present obligation
b. It is probable that an outflow of resources embodying economic benefits will be required
to settle the obligations
c. The amount of the obligation can be reliably measured.
- if any of the conditions is not met, no provision is recognized.

Probable- means more likely than not. Ie. There is a higher chance that the event will cause an
outflow of future economic benefits than not.

Contingent Liability

❖ Contingent refers to the liabilities and assets that are not recognized because they do not
meet all the recognition criteria.
❖ A possible obligation 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
entity -or-
❖ A present obligation, but,
o Not probable that it will cause an outflow of resources, or
o Amount cannot be reliably estimated
❖ Contingent liabilities are disclosed only except when the possibility of an outflow of
resources is remote.
❖
Contingent Assets
 ❖ A possible asset 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
entity
❖ Contingent assets are not recognized because they do not meet the asset recognition
criteria.
❖ They are not recognized because it may result in recognizing income that may never be
realized.
❖ Contingent assets are disclosed if they are probable.
❖ Asset is not contingent if the realization of income is virtually certain.

Likelihood Outcome Liability Asset

more than 95% Virtually Certain Accrue as asset
Provision (Accrue)
51% - 95% Probable Contingent asset
5%-50% Possible Contingent Liability
Ignore
less than 5% Remote Ignore

Illustration :
An entity is involved in a tax dispute. The entity is claiming that it has made an overpayment of
taxes and is now demanding a refund with the BIR. As of December 31, 20x1, the entity’s
attorney is very confident that he will win the case in the coming year and recover the tax claim
of P10M.
Question: What is the entry to recognize the probable receipt of tax refund?
Answer: None. Contingent asset is disclosed only when it is deemed probable. Otherwise, it is
ignored.

In 2024, there was a robbery in one of ABC’s branches. There has been a dispute on the 100M
insurance claim that ABC has presented to its insurance provider. On December 31, 2024, the
insurance company approved the payment of 80% of ABC claims and notified that the check had
been mailed. However ABC received the check only on January 5, 2025. What is the entry on
December 31, 20x1?
Answer:
Claims Receivable 80,000,000
Gain on settlement of insurance 80,000,000
❖ The claim is not contingent asset since it is virtually certain.

Measurement of Provision
❖ Provisions are measured at the best estimate of the amount needed to settle them as at
the end of the reporting period.
❖ Making the estimate requires management’s judgement, supplemented by experience
from similar transactions, and in some cases, reports from independent experts. The
estimates also consider events after the reporting period.
❖ If the provision being measured involves a large population of items, the obligation is
measured at its expected value.
 o Expected value- computed by weighting all possible outcomes by their
associated probabilities.
❖ If 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.

RECORDING THE PROVISION

❖ Usually recorded as a debit to an expense account and credit to an estimated liability
❖ However, sometimes a provision forms part of the cost of an asset. For example provision
for restoration and decommissioning cost are capitalized as part of the cost of a PPE.

In 2024, ABC Co. received a court order requiring the clean up of environmental damages
caused by one of its factory. ABC has no other realistic alternative but to comply with the court
order. Other entities have incurred around 15M for similar cleanup, however ABC’s best
estimate is 20M.

Analysis:
1. Is there a present obligation?
2. Is the outflow probable?
3. Can the outflow be measured reliably?

Environmental cleanup cost 20,000,000

Estimated liability for cleanup costs 20,000,000

Expected Value
ABC recalled a product due to a possible defect. The product recalled will be free of charge.
ABC is uncertain whether all product will have possible defect. However, the following estimate
was made by ABC’s engineers and managerial accountants and approved by the BOD:

REPAIR COST PROBABILITY

20,000,000 5% 1,000,000
15,000,000 20% 3,000,000
10,000,000 35% 3,500,000
5,000,000 40% 2,000,000

TOTAL 9,500,000

Repair Cost 9,500,000

Estimated Liability for Repair Costs 9,500,000

MIDPOINT
A lawsuit was filed against ABC Co. for patent infringement. The plaintiff is claiming 100M in
damages. ABC legal counsel believes that it is probable that ABC Co. will lose the lawsuit and
pay damages of not less than 10M but not more than P100M. The probability of any other
amount within the range is as likely as any other amount within that range. The plaintiff has
offered to settle the lawsuit out of court for 90M, but ABC did not agree to the settlement. What
amount of provision is reported in ABC Co.’s financial statements?

Answer: 55M [( 100m + 10m)/2]

Probable loss on lawsuit 55,000,000
Estimated Liability on lawsuit 55,000,000

RISK AND UNCERTAINTIES

❖ Estimates takes into consideration the risk and uncertainties. The estimates may increase
due to risk adjustment factors to provide an allowance for imprecision inherent in
estimates.

PRESENT VALUE

❖ If the effect of Time Value of Money is material the estimate of a provision is discounted
to its present value using a pretax discount rate

ABC Co., a manufacturer, provides warranties for its products. Under the warranty, ABC Co.
undertakes to repair defective products within one year from the date of sale. Based on ABC Co's
past experience:

❖ 95% of sales require no warranty repairs, while 3% require minor repairs costing 10% of
the sale price, and 2% require major repairs costing 90% of the sale price;

❖ 50% of the estimated repair costs are incurred in the year of sale and 50% are incurred in
the following year, and

❖ the appropriate risk adjustment factor to reflect the uncertainties in estimates is an

increment of 6% to the probability-weighted expected cash flows.

ABC Co. made total sales of P10M in 20x1. On Dec. 31, 20x1, the cash flows for repair costs in
20x2 are expected to occur on June 30, 20x2. The appropriate present value factor is 0.95238.

Requirement: Compute for the provision as of Dec. 31, 20x1.

Minor repairs 30,000

Major repairs 180,000
Total warranty repair costs for 20x1 sales 210,000
Portion to be settled in 20x2 x 50%
Warranty cost not yet paid as of dec 31, 20x1 105,000
Risk adjustment x 106%
Total 111,300
Present Value Factor x 0.95238
Warranty Provision – Dec. 31, 20x1 106,000
ABC Co. is a defendant in a lawsuit. ABC Co.'s lawyers believe that there is a 30% chance that
ABC Co. will win the case and pay no damages. However, if ABC Co. loses, there is a 20%
chance that it will pay damages of P200,000 (the amount sought by the plaintiff) and an 80%
chance that it will pay damages of P100,000 (the amount that was recently awarded by the same
judge in similar case). Other outcomes are unlikely. A 7% risk adjustment factor to the
probability-weighted expected cash flows considered appropriate to reflect the uncertainties in
the cash flow December 20x2. The appropriate discounted to be finalized rate is 10%.

Requirement: Compute for the provision as of Dec. 31, 20x1

81,709

FUTURE EVENTS

❖ Future events may affect the amount needed to settle an obligation, but only if there is
objective evidence that supports their anticipation; for example, when estimating the
penalty for environmental damage, a company might consider a new law that is virtually
certain to be enacted which could significantly impact the cost of remediation.

EXPECTED DISPOSAL OF ASSETS

❖ Gains from the expected disposal of assets are not taken account when measuring a
provision. Gains are recognized separately when the disposals occur.

REIMBURSEMENTS

❖ If another party is expected to reimburse the settlement amount a provision, a

reimbursement asset is recognized if it is virtually certain that the reimbursement will be
received. The reimbursement asset is presented in the statement of financial position
separately from the provision. However, in the statement of comprehensive income, the
expense related to the provision may be presented net of the reimbursement. The amount
recognized for the reimbursement should not exceed the amount of the provision.

Illustration 1: Reimbursement

ABC Co. is a courier company. During the year, a fire destroyed ABC Co.'s warehouse. ABC
Co. estimated that it will probably pay P50M in damages caused to customer-owned goods
contained in the warehouse. The contents of the warehouse were insured .The insurer approved
the payment of ABC Co.'s insurance claims of P20M.

Loss on Fire 50,000,000

Estimated liability 50,000,000

Insurance Claims receivable 20,000,000

Gain on insurance 20,000,000
Illustration 2.1: Deductible clause

On January 1, 20x2 an explosion occurred at ABC Co.'s plant causing extensive property
damage to area buildings. Although no claims had yet been asserted against ABC Co. as of
March 10, 20x2, ABC Co.'s management and counsel concluded that it is likely that claims will
be asserted and that it is probable that ABC Co will be held liable for damages. ABC Co.'s
P5,000,000 comprehensive public liability policy has a P250,000 deductible clause, ABC Co.
estimates an outflow equal to its net liability on the comprehensive public liability policy. ABC
Co.'s financial statements were authorized for issue on March 30, 20x2.

Requirement: How should ABC Co. report the event above in its December 31, 20x1 financial
statements?

Answer: As a note disclosure only indicating the probable loss of 250,000 (deductible clause).

No provision is recognized because there is no present obligation as of Dec. 31, 20x1, i.e., the
explosion occurred in 20x2.

Illustration 2.2: Deductible clause

What if the explosion in Illustration 2.1 above occurred on December 31, 20x1, how should ABC
Co. report the event in its December 31, 20x1 financial statements?
Answer: As a provision of P250,000, ie, the expected outflow.

CHANGES IN PROVISIONS

Provisions are reviewed at the end of each reporting period and adjusted to reflect the current
best estimate. Changes in provisions are accounted for prospectively by accruing an additional
amount or by reversing a previously recognized amount.
When the provision is discounted, the unwinding (amortization) of the related discount, which
increases the carrying amount of the provision, is recognized as interest expense.+

Illustration: Changes in provisions

20x1: An entity recognizes a provision of P500,000 for probable loss on a pending lawsuit.

Dec. 31, 20x1

Probable loss on lawsuit 500,000
Estimated liability on pending lawsuit 500,000

20x2: The lawsuit remains unsettled. The entity reviews position on the case and revises its
estimate of loss to P700,000

Dec. 31, 20x2

Probable loss on lawsuit (700K-500K) 200,000
Estimated liability on pending lawsuit 200,000
20x3 (Scenario 1): The entity settles the lawsuit for P850,000.
20x3
Estimated liability on pending lawsuit 700,000
Loss on lawsuit 150,000
Cash 850,000

20x3 (Scenario 2): The entity settles the lawsuit for P600,000.
20x3
Estimated liability on pending lawsuit 700,000
Cash 600,000
Gain on settlement of provision 100,000
20x3 (Scenario 3): The entity wins the case and pays nothing
20x3
Estimated liability on pending lawsuit 700,000
Gain on reversal of provision 700000

Use of provisions

❖ A provision is used only for the expenditure it was original intended for. Charging
expenditure against a provision thats intended for another purpose is inappropriate as it
would conceal the impact of two different events.

Application of the recognition and measurement rules

1. Future operating losses

No provision is recognized for future operating losses because they do not meet the definition of
a liability (i.e:, 'arising from past events). The expectation of future operating losses may indicate
that certain assets may be impaired. Those assets are tested for impairment under PAS 36.

2. Onerous contracts
The provision recognized from an onerous contract reflects the least net cost of exiting from the
contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising
from failure to fulfill it.

Illustration: Onerous contract - Purchase commitment

In 20x1, an entity enters into 3 year, non-cancellable purchase contract whereby the entity
obtains the right to purchase up 60,000 units of a product annually for P25 per unit. The entity
guarantees a minimum annual purchase of 15,000 units. On Dec 31. 20x1, the product becomes
obsolete. (The entity has 10,000 units on hand, which the entity believes can be sold as scrap for
P5 each.

Compute for loss on purchase commitment

Guaranteed Min. purchase 15,000
Remaining years x 2
Total 30,000
Purchase price less scrap value x 20
Loss on purchase commitment 600,000

RESTRUCTURING
❖ A program that is planned and controlled by the management and materially changes
either:
a. The scope of business undertaken by an entity, or
b. The manner in which that business is conducted.

Examples:
o Sale or termination of a line of business.
o Closure of business location in a country or region or the relocation of business
activities from one country or region to another.
o Changes in management structure, for example, eliminating a layer of
management
o Fundamental reorganizations

❖ An entity applies the general recognition criteria when recognizing provisions for
restructuring costs and in addition, considers the following:

1. SALE OF OPERATION
- A legal obligation exists only if at the end of the reporting period, a binding sale
agreement is obtained. This is because until a binding sale agreement is obtained,
the entity can still change its mind and may withdraw its plan to sell.
- If binding sale agreement is obtained after the end of reporting period, no
provision is recognized. This however may be disclosed.

2. CLOSURE OR REORGANIZATION
- A constructive obligation exists only if at the end of the reporting period, the
entity has created a valid expectation from others that it will discharge certain
responsibilities. This would be the case if both the conditions are met:
o A detailed formal plan for the restructuring is adopted
o The plan is announced to those affected by it.

3. ABANDONMENT OF RESTRUCTURING PROVISION

- Includes only the direct cost that are necessarily entailed with the restructuring.
- Does not include costs that are related to the ongoing activities of the entity or the
future conduct of its business.
It excludes the following costs:
a. Retraining or relocating continuing staff
b. Marketing
c. Investment in new systems and distribution networks.
 4. FUTURE OPERATING LOSSES
- Provisions are not recognized for future operating losses, even in restructuring.

Illustration; Restructuring provision

On December 31, 20x1, ABC Co. adopted a detailed formal plan close its toys divisions and put
up a new division to manufacture warfare weapons. The plan was communicated through a
public announcement and all those affected by the closure was informed. ABC Co. estimated the
following costs:

• Termination benefits of employees terminated as a result of the closure 1,000,000

• Costs of retraining and relocating retained employees 2,000,000
• Payment for the toys division's unpaid purchases 4,000,000
• New systems and distribution networks for the weapons division 20,000,000
• Marketing costs of the weapons division 6,000,000
• Expected losses in the first year of operations of the weapons division 20,000,000
Requirement: Compute for the provision on December 31, 20x1.

Answer: P1,000,000 the termination benefits of employes terminated as a result of the closure.