Provisions and contingencies

In financial reporting, entities often deal with uncertain future events that could lead to economic benefits or obligations. IFRS Accounting Standards explain how to account for these uncertainties using provisions, contingent liabilities, and contingent assets. This chapter introduces the key definitions and the recognition criteria you’ll use to classify and account for these items.

Learning objectives

By the end of this chapter, you should be able to:

• Define “provision”, “contingent liability”, and “contingent asset” in accordance with IFRS Accounting Standards.
• Distinguish between and classify items as provisions, contingent liabilities, or contingent assets.
• Illustrate the different methods of accounting for provisions, contingent liabilities, and contingent assets.
• Calculate provisions and changes in provisions.
• Prepare manual journal entries for the movement in provisions.
• Report provisions in the financial statements.

Definitions

Provision

According to IAS 37, a provision is a liability of uncertain timing or amount. Liability

It is a present obligation arising from past events, the settlement of which is expected to result in an outflow of economic resources.

A provision differs from other liabilities because there is uncertainty about the timing or amount of the future expenditure needed to settle it.

So, a provision is:

• a present obligation that arose from past events,
• where the entity has little or no discretion to avoid the outflow of resources, and
• where a reliable estimate of the amount can be made.

Definitions

Contingent liability

IAS 37 defines contingent liability as either:

1. A possible obligation that arises from past events 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
2. A present obligation that arises from past events but is not recognized because it is not probable that an outflow of resources will be required to settle the obligation, or the amount cannot be measured with sufficient reliability.

Contingent asset

It is a possible asset that arises from past events 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.

Classification and recognition criteria

The definitions of provisions and contingent liabilities are closely related, so it can be difficult to distinguish between them in practice. Classification depends on three key conditions.

Key conditions or factors

1. Present obligation (legal or constructive) as a result of a past event
2. Probability of outflow of resources
3. Reliability of measurement of the amount

IAS 37 requires that a provision is recognised only if all three conditions are met. If any condition is not met, the item is treated as a contingent liability.

Present obligation as a result of past event

This condition asks whether the entity has an obligation - a duty or commitment - to transfer economic resources or provide services to another party.

An obligation can be either legal or constructive.

Definitions

Legal obligation

It derives from a contract, legislation, or other operation of law. Constructive obligation

It arises from an entity’s actions where the entity has indicated to other parties that it will accept certain responsibilities or the entity has created a valid expectation that it will discharge those responsibilities.

Probability of outflow of resources

This condition looks at the likelihood that the entity will need to transfer economic benefits (cash, other assets, or services) to settle the obligation. IFRS commonly uses these probability descriptions:

• Virtually certain: More than 95% likelihood
• Probable: More likely than not (>50%)
• Possible: Not probable but not remote (5-50%)
• Remote: Less than 5% likelihood

Reliability of measurement of the amount

This condition asks whether the amount of the obligation can be estimated with sufficient accuracy using reasonable assumptions, even if the exact amount is uncertain.

Decision tree for classification

Below is a list of questions that should guide the decision on whether to classify an item as a provision, contingent liability, or contingent asset.

Provisions and contingent liabilities:

1. Is there a present obligation as a result of past events?
   • No → Contingent liability (possible obligation)
   • Yes → Continue to step 2
2. Is it probable that an outflow of resources will be required?
   • No → Contingent liability (present obligation, not probable)
   • Yes → Continue to step 3
3. Can the amount be estimated reliably?
   • No → Contingent liability (cannot measure reliably)
   • Yes → PROVISION (recognised in financial statements)

Contingent Assets: 4. Is there a possible asset from past events? - No → No accounting treatment required - Yes → Continue to step 2 5. Is it probable that an inflow of economic benefits will occur? - No → No disclosure required - Yes → CONTINGENT ASSET (disclose but do not recognise)

Illustration 1: Product warranty

A company sells electronics with a 2-year warranty. Based on past experience, 3% of products require repair within the warranty period, costing an average of $50 per repair.

Required:

• Is there a present obligation? What is the form, if yes?

Do you know the answer?

• Is there a probable outflow?

• Can the amount be reliably estimated?

• How should the warranty be recorded?

Illustration 2: Pending lawsuit

A company is being sued for $1 million. Legal counsel believes there is a 30% chance the company will lose the case. How should it be recognised? Suggested solution:

Do you know the answer?

Illustration 3: Insurance claim

A company has filed an insurance claim for $200,000 following a fire. The insurance company has acknowledged liability and indicated payment is likely. How should the item be recorded in the company’s books?

Suggested solution:

Do you know the answer?

Provisions: initial recognition and measurement

Provisions arerecognised (i.e., shown) as liability on the face of the financial statement when all three recognition criteria (conditions) discussed above are met.

Provisions should be measured at the best estimate of the expenditure required to settle the present obligation at the reporting date.

1. For single obligations, the most likely outcome or expected value method is used.
2. For large populations, statistical methods and expected values weighted by probabilities are used to estimate the expenditure.
3. When the time value of money is material (typically for long-term provisions), discount the provision to present value using the pre-tax discount rate to reflect current market assessments.

Upon initial recognition of a provision, the accounting entry involves:

Debit: Expense

Credit: Provisions

Provisions: subsequent measurement

Provisions should be reviewed at each reporting date and adjusted to reflect the current best estimate. Changes in a provision (decrease or increase) may result from new information about the obligation, changes in probability assessments, or the passage of time (unwinding of discount).

Definitions

Increase in provision

Occurs where the current best estimate of the provisions at the reporting date is more than the initial provision made. The accounting records should be adjusted to reflect the provision at the reporting date.

The journal entry to pass the increase (i.e., the difference between the initial recognised amount and the reporting date amount) is given as:

Debit: Expense

Credit: Provisions

Decrease in provision

Occurs where the current best estimate of the provisions in the current year is less than the initial provision made. The accounting records should be adjusted to reflect the provision at the reporting date.

The journal entry to pass the decrease (i.e., the difference between the initial recognised amount and the reporting date amount) is given as:

Debit: Provisions

Credit: Expense

Actual settlements

Upon actual occurrence of the uncertainty that gave rise to the recognition of the provision, actual payment may be made. When actual payment is made for the event that gave rise to the provision, the whole provision is required to be reversed.

Debit: Provisions

Credit: Bank and cash

Any difference between the provisions and actual settlement would be posted to the expense ledger account.

Illustration 1: Provisions

ABC Company is facing a lawsuit at the end of 2024. Legal advisors estimated there is a 70% probability that ABC will lose the case and pay $100,000 in damages. The case is expected to be settled within one year.

Required:

1. What is the initial provision amount? What is the journal entry to recognize the provision?

Do you know the answer?

1. At the end of 2025, new evidence suggests the probability of losing has increased to 85% and that they stand the chance of paying $120,000 as damages. Prepare the adjustment entry.

Do you know the answer?

1. Later in 2025, the case was partially settled for $110,000. Prepare the settlement entry.

Do you know the answer?

This shows how provisions are measured at the best estimate, adjusted when new information becomes available, and cleared when the obligation is settled.

Illustration 2

QPR Electronics sold the following products during 2024 with 2-year warranties:

• Smartphones: 10,000 units at $500 each
• Tablets: 5,000 units at $300 each
• Laptops: 2,000 units at $800 each

Based on past experience, the company estimates warranty claim rates and average repair costs as follows:

Product	Warranty claim rate	Average repair cost per claim
Smartphone	10%	$40
Tablets	8%	$80
Laptops	20%	$150

Required:

1. Calculate the initial warranty provision for each product line and the totals.

Do you know the answer?

1. Prepare the journal entry for the initial recognition.

Do you know the answer?

Disclosure for contingent liabilities

Contingent liabilities are NOT recognized in the statement of financial position. However, disclosure is required in the note to the financial statement about the following:

• Brief description of the nature of the contingent liability
• Estimate of financial effect (if practicable)
• Indication of uncertainties about the amount or timing
• Possibility of any reimbursement

No disclosure is required when remote (i.e. < 5%).

Contingent liabilities must be continuously assessed. If probability changes from “possible or remote” to “probable,” reclassification to provision is required.

Disclosure for contingent assets

Contingent assets are recognized on the face of the statement of financial position only when the probability of the inflow is virtually certain (>95%).

Contingent assets are disclosed only when an inflow of economic benefits is probable (> 50% but less than 95%). Disclosure includes:

• Brief description of the nature
• Estimate of financial effect (where practicable)

No disclosure is required when the probability of inflow is remote (i.e., < 5%) or possible (5 - 50%).