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.

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 recognised 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. IAS 37 defines probable as “more likely than not” (over 50%). The other percentages below are widely used rules of thumb, not figures in the standard:

• 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 5 5. Is the inflow virtually certain? - Yes → Recognise an asset (it is no longer a contingent asset) - No → Continue to step 6 6. 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?

• 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:

Illustration 3: Insurance claim

A company has filed an insurance claim for $200,000 following a fire. The insurer has indicated that payment is probable, but has not yet accepted the claim. How should the item be recorded in the company’s books?

Suggested solution:

Provisions: initial recognition and measurement

Provisions are recognised (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 a single obligation, the individual most likely outcome is usually the best estimate, adjusted where other possible outcomes are mostly higher or mostly lower.
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).

Increase in provision: where the best estimate at the reporting date is more than the provision already recognised, record the difference as Debit: Expense, Credit: Provisions.

Decrease in provision: where the best estimate is less than the provision already recognised, record the difference as Debit: Provisions, Credit: Expense.

Actual settlement: when the obligation is paid, remove the whole provision with Debit: Provisions, Credit: Bank and cash. Any difference between the provision and the amount paid goes to the expense account.

Provisions are presented in the statement of financial position as current or non-current liabilities, depending on when the entity expects to settle the obligation. For each class of provision, the notes must reconcile the opening balance, provisions made during the period, amounts used, unused amounts reversed, the unwinding of the discount, and the closing balance, along with a brief description of the obligation’s nature.

Illustration 4: Lawsuit provision lifecycle

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 recognise the provision?

2. 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.

3. In 2026, the case was settled in full for $110,000. Prepare the settlement entry.

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

Illustration 5: Warranty provision calculation

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: Calculate the initial warranty provision for each product line and in total.

Disclosure for contingent liabilities

Contingent liabilities are not recognised 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 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)