Learning Resource 1, Liabilities Lesson 4, Provision: Contingent Liability

Learning Resource 1: Liabilities

Lesson 4
PROVISION: Contingent Liability
Learning Outcomes:

At the end of this lesson, the students shall be able to:

a. Explain the various concepts pertaining to provision - contingent liability;
b. Demonstrate understanding of the concepts by applying them in solving related
problems;
c. Analyze crucial situations besetting the rigor in solving related problems; and
d. Check on the accuracy of solutions through the concepts and principles applicable to
provision - contingent liability.

Activity 1
Discussion of Accounting Principles

1. Provision
a. It is an existing liability of uncertain timing or uncertain amount; and
b. Its essence is uncertainty about the timing or amount of the future expenditure.

Its being uncertain distinguishes a provision from other liabilities. The liability definitely
exists at the end of the reporting period but the amount is indefinite or the date when the
obligation is due is also indefinite, and in some cases, the payee cannot be identified or
determined.

A provision is the equivalent of an estimated liability or a loss contingency that is accrued

because it is both probable and measurable.

2. Recognition of Provision
PAS 37, paragraph 14, provides that a provision shall be recognized as a liability in the
financial statements under the following conditions:

a. The entity has a present obligation, legal or constructive, as a result of a past event.
b. It is probable that an outflow of resources embodying economic benefits would be
required to settle the obligation.
c. The amount of the obligation can be measured reliably.

3. Present Obligation
 May be legal or constructive.
 A legal obligation arises from a contract, legislation or other operation of law.
 A constructive obligation is derived from an entity’s actions where:
a. The entity has indicated to other parties that it will accept certain responsibilities
by reason of an established pattern of past practice, published policy, or a
sufficiently specific current statement.
b. As a result, the entity has created a valid expectation on the part of other parties
that it will discharge those responsibilities.

A constructive obligation exists when the entity from an established pattern of practice
or stated policy has created a valid expectation that it will accept certain responsibilities.

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4. Past Event
 The past event that leads to a present obligation is called an obligating event.
 An accounting provision cannot be created in anticipation of a future event.

The event must have already occurred which gives rise to the legal or constructive
obligation.

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

the entity has no realistic alternative but to settle the obligation created by the event.

 The obligating event is a case where:

a. The settlement of the obligation can be enforced by law.
b. The event creates valid expectations on the part of other parties that the entity
will discharge the obligation, as in the case of a constructive obligation.

5. Probable Outflow of Economic Benefits

a. For a provision to qualify for recognition, there must be not only a present obligation
but also a probable outflow of resources embodying economic benefits to settle the
obligation.

b. An outflow of resources is regarded as probable if the event is more likely than not
to occur; that is, the probability that the event will occur is greater than the probability
that it will not occur.

c. As a rule of thumb, probable means more than 50% likely or substantially more.
Possible means 50% or less likely to occur.
Remote means 10% or less likely to occur or very slight occurrence.

6. Reliable Estimate
a. The use of estimates is an essential part of the preparation of financial statements
and does not undermine their reliability (PAS 37, paragraph 25). This is essentially
true in the case of provision because by nature, a provision is more uncertain than
most items in the statement of financial position.

b. The standard suggests that by using a range of possible outcomes, an entity usually
would be able to make an estimate of the obligation that is sufficiently reliable.
Where no reliable estimate can be made, no liability is recognized.

7. Measurement of Provision
a. The amount recognized as a provision should be the best estimate of the expenditure
required to settle the present obligation at the end of reporting period.

b. The best estimate is the amount that an entity would rationally pay to settle the
obligation at the end of reporting period or to transfer it to a third party at that time.

c. Where a single obligation is being measured, the individual most likely outcome
adjusted for the effect of other possible outcomes may be the best estimate.

d. Where there is a continuous range of possible outcomes and each point in the range
is as likely as any other, the midpoint of the range is used.

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e. Where the provision being measured involves a large population of items, the
obligation is estimated by “weighting” all possible outcomes by their associated
possibilities. The name of this statistical method of estimation is “expected value”.

8. Other Measurement Consideration

Items that are taken into consideration in recognizing and measuring a provision:
a. Risks and uncertainties
b. Present value of obligation
c. Future events
d. Expected disposal of assets
e. Reimbursements
f. Changes in provision
g. Use of provision
h. Future operating losses
i. Onerous contract

9. Risks and Uncertainties

a. The risks and uncertainties that inevitably surround events and circumstances shall
be taken into account in reaching the best estimate of a provision.

b. Risk describes variability of outcomes.

c. A risk adjustment may increase the amount at which a liability is measured.

d. As prudence dictates, caution is needed in making judgment under conditions of

uncertainty so that income and assets are not overstated, or expenses and liabilities
are not understated.

e. Caution, uncertainty does not justify the creation of excessive provision or a

deliberate overstatement of liabilities.

10. Present Value of Obligation

a. Where the effect of the time value of money is material, the amount of provision shall
be the present value of the expenditure expected to settle the obligation.

b. The discount rate should be a pretax rate that reflects the current market assessment
of the time value of money and the risk specific to the liability.

c. The discount rate should not reflect the risk for which cash flow estimates have
already been adjusted.

11. Future Events

a. Future events that affect the amount required to settle an obligation shall be reflected
in the amount of a provision where there is a sufficient evidence that they will occur.

b. These future events include new legislation and changes in technology.

12. Expected Disposal of Assets

a. Gains from expected disposal of assets shall not be taken into account in measuring
a provision.

b. An entity shall recognize gain on disposal at the time of the disposition of the assets.

Any cash inflows from disposal are treated separately from the measurement of the provision.

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13. Reimbursements
a. The reimbursement shall be recognized when it is virtually certain that reimbursement
would be received if the entity settles the obligation.

b. The reimbursement shall be treated as a separate asset and not netted against the
estimated liability for the provision.

c. The amount of reimbursement shall not exceed the amount of the provision.

d. In the income statement, the expense relating to the provision may be presented net
of the reimbursement.

14. Changes in Provision

a. Provisions shall be reviewed at every end of the reporting period and adjusted to
reflect the current best estimate.

b. The provision shall be reversed if it is no longer probable that an outflow of economic

benefits would be required to settle the obligation.

c. Where discounting is used, the carrying amount of the provision increases each
period to reflect the passage of time.

15. Use of Provision

a. A provision shall be used only for expenditures for which provision was originally
recognized.

b. Example, a provision for plant dismantlement cannot be used to absorb

environmental pollution claims or warranty payments.

c. If an expenditure is charged against a provision that was originally recognized for

another purpose, that would camouflage the impact of two different events, thus
distorting financial performance and possibly constituting financial reporting fraud.

16. Future Operating Losses

Provision shall not be recognized for future operating losses.

a. This means that a provision for operating losses is not recognized because a past
event creating a present obligation has not occurred.

b. An expectation of future operating losses is an indication that certain assets may be

impaired. An impairment test for these assets may be necessary.

17. Onerous Contract

a. If an entity has an onerous contract, the present obligation under the contract shall
be recognized and measured as a provision.

b. It is a contract in which the unavoidable costs of meeting the obligation under the
contract exceed the economic benefits expected to be received under it.

c. PAS 37, paragraph 68, mandates that the unavoidable costs under a contract
represents the “least net cost of exiting from the contract”.

d. The lower amount between the cost of fulfilling the contract and the compensation
or penalty arising from failure to fulfill the contract is the least cost of exiting from the
contract.

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18. Examples of Provision

a. Warranties – The bestv extimate of the warranty cost is recognized as a provision
because there is clear constructive obligation arising from an obligating event which
is the sale of the product with warranty.

b. Environmental contamination – If an entity has a n environmental policy such that

otehr parties would expect the entity to clean up any contamination, or if the entity
has brken current environmental legislation then a provision for environmental
damage shall be made.

The obligating event is the contamination of the property which gives rise to
constructive or legal obligation. A provision is recognized for the best estimate of
the cost of cleaning up the contamination.

c. Decommissioning or abandonment costs – When an oil entity initially purchases an

oil field, it is put under a legal obligation to decommission the site at the end of its
life. The costs of abandonment or decommissioning shall be recognized as a
provision and may be capitalized as cost of the oil field.

d. Court case – After a wedding in the current year, ten people died possibly as a result
of food positioning from products sold by the entity. Legal proceedings are started
seeking damages from the entity.

When the entity prepares the financial statements for the current year, the lawyers
advise that owing to the developments in the case, it is probable that the entity would
be found liable. A provision is recognized for the best estimate of the damages
because there is a present obligation.

e. Guarantee – In the current year, an entity gives a guarantee of certain borrowings of

another entity. During the year, the financial condition of the borrower deteriorates
and at year-end, the borrower files a petition for bankruptcy.

A provision is recognized for the best estimate of the guarantee obligation because
there is legal obligation arising from the obligating event which is the guarantee.

19. Restructuring
It is a program that is planned and controlled by management and materially changes
either the scope of a business of an entity or the manner in which that business is
conducted (PAS 37, paragraph 10).

Events that may qualify as restructuring are:

a. Sale or termination of a line of business;

b. Closure of business location in a region or relocation of business activities from one

location to another or relocation of headquarters from one country to another;

c. Change in management structure, such as elimination of a layer of management or

making all functional units autonomous; and

d. Fundamental reorganization of an entity that has a material and significant impact

on its operations.

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20. Provision for Restructuring

Recognition of the provision for restructuring is required because a constructive
obligation may arise from the decision to restructure.

A constructive obligation for restructuring rises when two conditions are present:
1. The entity has a detailed formal plan for the restructuring which includes the
following:
a. The business being restructured;
b. The principal location affected;
c. The location, function and approximate number of employees who will be
compensated for terminitating their employment;
d. Data when the plan will be implemented; and
e. The expenditures that will be undertaken.

2. The entity has raised valid expectation in the minds of those affected that the entity
will carry out the restructuring by starting to implement the plan and announcing the
main features to those affected by it.

21. Amount of Restructuring Provision

a. A restructuring provision shall include only direct expenditures arising from the
restructuring.

b. These expenditures are necessarily incurred for the restructuring and not associated
with the ongoing activities of the entity.

Example, salaries and benefits of employees to be incurred after operations cease

and that are associated with the closure of the operations shall be included in the
amount of the restructuring provision.

c. PAS 37, paragraph 81, specifically excludes the following expenditures from the
restructuring provision:

1. Cost of retraining or relocating continuing staff.

2. Marketing or advertising program to promote the new company image.
3. Investment in new system and distribution network.

Such expenditures are categorically disallowed as restructuring provisions because

these are considered to be expenses relating to the future conduct of the business
of the entity, and thus are not liabilities relating to the restructuring program.

22. Contingent Liability

Two definitions of contingent liability (see PAS 37, paragraph 10).

1. A contingent liability is a possible obligation that arises from past event 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 entity.

2. A contingent liability is a present obligation that arises from past event but is not
recognized because it is not probable that an outflow of resources embodying
economic benefits will be required to settle the obligation or the amount of the
obligation cannot be measured reliably.

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23. Contingent Liability and Provision

a. The second definition states that a contingent liability is a present obligation.
However, the present is either probable or measurable but not both to be considered
a contingent liability.

b. If the present obligation is probable and the amount can be measured reliably, the
obligation is not a contingent liability but shall be recognized as a provision.

24. Treatment of Contingent Liability

a. A contingent liability shall not be recognized in the financial statements but shall be
disclosed only. The required disclosures are:

1. Brief description of the nature of the contingent liability.

2. An estimate of it financial effect.
3. An indication of the uncertainties that exist.
4. Possibility of any reimbursement.

b. If a contingent liability is remote, no disclosure is necessary.

25. Contingent Asset

Definitions provided by PAS 37, paragraph 10:

1. A contingent asset is a possible asset that arises from past event and whose
existence will be confirmed only by the occurrence or nonoccurrence of one or more
uncertain future events not wholly within the control of the entity.

2. A contingent asset shall not be recognized because this may result to recognition of
income that may never be realized.

3. When the realization of asset is virtually certain, the related asset is no longer
contingent asset and its recognition is appropriate.

 A contingent asset is only disclosed when it is probable.

 The disclosure includes a brief description of the contingent asset and an estimate of
its financial effects.
 If a contingent asset is only possible or remote, no disclosure is required.

26. Decommissioning Liability

1. It is an obligation to dismantle, remove and restore an item of property, plant and
equipment as required by law or contract.

2. It is called an asset retirement obligation.

Activity 2
Application Exercises

You are provided with exercises that will demonstrate the application of the accounting
principles discussed for provision: contingent liability; and, thereby come up with an
appropriate analysis to be able to solve the exercises correctly and accurately.

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Exercise 1
An entity sells goods with a warranty under which customers are covered for the cost of
repairs of any manufacturing defects that become apparent within six months after purchase.

If minor defects are detected in all products sold, repair costs would be about P2,000,000.
If major defects are detected in all products sold, repair costs of P10,000,000 would result.

The entity’s past expeireince and future expectations indicate that 75% of the goods sold
will have no defects, 20% will have minor defects and 5% will have major defects.

Required:
Determine the expected value or cost of repairs.

Solution to Exercise 1
The expected value or cost of repairs is measured as follows:

75% sales None

20% sales (20% x 2,000,000) 400,000
5% sales ( 5% x 10,000,000) 500,000
Total expected value or cost of repairs 900,000

Exercise 2
An entity is a defendant in a patent infringement suit. The lawyers believe that there is a
60% chance that the court will not dismiss the case and the entity will incur an outflow of
future economic benefits.

If the court rules against the entity and in favor of the claimant, the lawyers believe that there
is a 30% chance the entity will be required to pay damage of P2,000,000 and a 70% chance
that the damages will be P1,000,000.

A 10% risk adjustment factor to the probabilities of the expected cash flows is considered
appropriate to reflect the uncertainties in the cash flow estimate.

Required:
Determine the estimated amount of provision.

Solution to Exercise 2
Weighted probabilities:

30% x 2,000,000 x 60% 360,000

70% x 1,000,000 x 60% 420,000
Expected cash outflow 780,000
Risk adjustment factor (10% x 780,000) (78,000)
Estimated amount of provision 702,000
Note: The amount of provision shall be discounted if the effect of the time value of money is material.

Exercise 3
An entity extracts gas and oil in the Philippine Deep.

On January 1, 2020, the entity constructed a drilling platform for P50,000,000 and is required
by Philippine law to remove and dismantle the platform at the end of its useful life of 10
years. The straight line method is used in depreciating the drilling platform.

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The entity has estimated that such decommissioning will cost P10,000,000.

Based on a 12% discount rate, the present value of 1 for 10 years is 0.322.

Required:
Prepare journal entries for 2020 and 2021.

Solution to Exercise 3
Journal entries for 2020

Jan. 1 Drilling platform [50,000,000 + (10,000,000 x 0.322)] 53,220,000

Cash 50,000,000
Decommissioning liability (10,000,000 x 0.322) 3,220,000

Dec. 31 Depreciation 5,322,000

Accumulated depreciation 5,322,000
(53,220,000/10 years)

31 Interest expense 386,400

Decommissioning liability 386,400
(12% x 3,220,000)

Journal entries for 2021

Dec. 31 Depreciation 5,322,000

Accumulated depreciation 5,322,000

31 Interest expense
Decommissioning liability

Decommissioning liability – January 1, 2020 3,220,000

Interest expense for 2020 386,400
Carrying amount – December 31, 2020 3,606,400

Interest expense for 2021 (12% x 3,606,400) 432,768

Exercise 4
Toy Company provided the following facts regarding pending litigation on December 31,
2020:

 The entity is defending against a first lawsuit and believes there is a 51% chance it will
lose in court. The entity estimates that damages will be P1,000,000.

 The entity is defending against a second lawsuit for which management believes it is
virtually certain to lose in court.

If it loses the lawsuit, management estimates damages will fall somewhere in the range
of P3,000,000 to P5,000,000 with each amount in that range equally likely to occur.

 The entity is defending against a third lawsuit but the relevant loss will only occur far into
the future. The present values of the endpoints of the range are P1,500,000 and
P2,500,000.

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The management believes the effects of time value of money on these amounts are
material but also believes the timing of these amounts in uncertain.

 The entity is defending against a fourth lawsuit and believes there is only a 25% chance
it will lose in court.

If the entity loses, management believes damages will fall somewhere in the range of
P3,000,000 to P4,000,000 with each amount in that range equally likely to occur.

Required:
Indicate how the entity would disclose or account for the four lawsuits under IFRS in the
financial statements for the year ended December 31,2020.

Solution to Exercise 4
First lawsuit 1,000,000
Second lawsuit (midpoint of range) 4,000,000
Third lawsuit (midpoint of range) 2,000,000
Fourth lawsuit (25% chance – possible) -

Total accrued litigation liability 7,000,000

Activity 3
Evaluation Exercises

General Instructions: You are required to provide solutions/answers to the following

exercises. Supporting computations which are presented in good form shall be part of all
solutions. Answers/solutions to these exercises are to be submitted to the Professor through
her e-mail address or may be sent to her office/home, whichever is convenient. Please take
note of the deadline of submission which will be communicated to all concerned students.

A. Theoretical Exercises

Choose the correct answer by writing the corresponding letter-answer and a convincing
justification it is indeed the correct answer. However, an explanation shall be made as well
to the other possible answers which were not chosen. Briefly explain or provide justifiable
reason/s via applicable appropriate accounting principles discussed in Activity 1.

1. Which is the correct definition of a provision?

a. A possible obligation arising from past events
b. A liability of uncertain timing or uncertain amount
c. A liability which cannot be easily measured
d. An obligation to transfer funds to an entity

2. A provision shall be recognized when

a. An entity has a present obligation as a result of a past event.
b. It is probable that an outflow of resources embodying economic benefits will be
required to settle the obligation.
c. The amount of the obligation can be measured reliably.
d. All of these are required for the recognition of a provision.

3. A legal obligation is an obligation that is derived from all of the following, except
a. Legislation c. Other operation of law
b. A contract d. An established pattern of practice

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4. A constructive obligation is an obligation

I. That is derived from an entity’s action that the entity will accept certain
responsibilities because of past practice or published policy.
II. The entity has created a valid expectation in other parties that it will discharge those
responsibilities.
a. I only c. Both I and II
b. II only d. Either I or II

5. It is an event that creates a legal or constructive obligation because the entity has no
other realistic alternative but to settle the obligation.
a. Obligation event
b. Past event
c. Subsequent event
d. Current event

6. An entity has been served a legal notice at year-end by the Department of Environment
and Natural Resources to fit smoke detectors in its factory on or before middle of the
next year. The cost fitting smoke detector can be measured reliably.

How should the entity treat this in the financial statements at year-end?
a. Recognize a provision for the current year equal to the estimated amount.
b. Recognize a provision for the current year equal to one-half only of the estimated
amount.
c. No provision is recognized at year-end because there is no present obligation for the
future expenditure since the entity can avoid the future expenditure by changing the
method of operations, but disclosure is required.
d. Ignore the event.

7. An entity operates chemical plants. The published policies include a commitment to

making good any damaged caused to the environment by its operations. The entity has
always honored this commitment.

Which of the following scenarios relating to the entity would give rise to a provision?
a. On past experience it is likely that a chemical spill which would result in having to
pay fines and penalties will occur in the next year.
b. Recent research suggests there is a possibility that the entity’s actions may damage
surrounding wildlife.
c. The government has outlined plans for a new law requiring all environmental damage
to be rectified.
d. A chemical spill from one of the entity’s plants has caused harm to the surrounding
area and wildlife.

8. An entity did not record an accrual for a present obligation but disclose the nature of the
obligation and the range of the loss. How likely is the loss?
a. Remote c. Probable
b. Reasonably possible d. Certain

9. The likelihood that the future event will or will not occur can be expressed by a range of
outcome. Which range means that the future event occurring is very slight?
a. Probable c. Certain
b. Reasonably possible d. Remote

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10. How should a contingent liability be reported in the financial statements when it is
reasonably possible?
a. As a deferred liability c. As a disclosure only
b. As an accrued liability d. As an account payable

11. Disclosure usually is not required for

a. Contingent gain that is probable and measurable.
b. Contingent loss that is possible and measurable.
c. Contingent loss that is probable and cannot be reliably measured
d. Contingent loss that is remote and measurable

12. Reporting is the financial statements id required for

a. Loss contingency that is probable and measurable
b. Gain contingency that is probable and measurable
c. Loss contingency that is possible and measurable
d. All loss contingencies

13. A contingent liability

a. An estimated liability
b. An event which is not recognized because it is not probable that an outflow will be
required or the amount cannot be reliably estimated.
c. A potential large liability.
d. A potential small liability.

14. Which statement is incorrect concerning a contingent liability?

a. A contingent liability is not recognized.
b. A contingent liability is disclosed only.
c. No disclosure is required for remote contingent liability.
d. A contingent liability is both probable and measurable.

15. An entity received notification of legal action. How should the probable and measurable
loss be reported?
a. As a loss recorded in other comprehensive income
b. As a loss in the income statement and a contingent liability
c. As a loss in the income statement and a provision
d. In the notes to financial statements

B. Practical Exercises

Solve the following problems with supporting computations presented in good form:

1. Thursday Company provided the following selected transactions related to

contingencies. The fiscal year ends on December 31, 2020 and financial statements are
issued on March 31, 2021.

 Thursday is involved in a lawsuit resulting from a dispute with a customer over a

2020 transaction. On December 31, 2020, attorneys advised that it was probable
that Bourne would lose P3,000,000 in an unfavorable outcome.

On February 15, 2021, judgment was rendered against Thursday in the amount of
P4,000,000 plus internet P500,000. Thursday does not plan to appeal the judgment.

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 Since August 2020, Thursday has been involved in labor dispute. Negotiations
between the entity and the union have not produced a settlement. Since January
2020, strikes have been ongoing at these facilities.

It is virtually certain that material costs will be incurred but the amount of resultant
costs cannot be adequately predicted.

 Thursday is the defendant in a lawsuit filed in January 2021 in which the plaintiff
seeks P5,000,000 as an adjustment to the purchase price related to the sale of
Thursday’s hardwood division in 2020.

The lawsuit alleges that Thursday misrepresented the division’s assets and liabilities.

Legal counsel advised that it is reasonably possible that Thursday could lose
P2,000,000 but that it is extremely unlikely it could lose the P5,000,000 asked for.

 On March 1, 2021, the provincial government is in the process of investigating the

possibility of environmental violation by Thursday but has not proposed a penalty
assessment.

Management feels as assessment is reasonably possible and if an assessment is

made, a settlement of up to P4,000,000 is probable.

Required:
Prepare journal entries that should be recorded as a result of the contingencies.

2. Friday Company provided the following information on December 31, 2020:

 A personal injury liability suit for P500,000 was brought against Friday Company in
March 2020.

The management and legal counsel of Friday Company conclude that it is not
probable that Friday Company will be responsible for damages and that P150,000 is
the best estimate of the damages.

 In July 2020, Friday Company became involved in a tax dispute with the BIR
pertaining to 2019 income tax.

In December 2020, a judgment for P400,000 was assessed against Friday Company
by the tax court.

Friday Company is appealing the amount of the judgment.

The tax advisor and legal counsel of Friday Company believed it is probable that the
assessment can be reduced on appeal by 50%.

 Friday Company signed as guarantor for P200,000 loan by PNB to Flyday Company,
a principal supplier of Sunrise.

By reason of financial difficulties, it is probable that Friday Company shall pay the
P200,000 loan with only a 60% recovery anticipated from Flyday Company.

Required:
Prepare journal entries to recognize any provision on December 31, 2020.

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3. Saturday Company sells electrical goods covered by a one-year warranty for any
defects.

Of the sales of P70,000,000 for the year, the entity estimated that 3% will have major
defect, 5% will have minor defect and 92% will have no defect. The cost of repairs would
be P5,000,000 if all the products sold had major defect and P3,000,000 if all had minor
defect.

What amount should be recognized as warranty provision?

4. During 2020, Sunday Company is the defendant in a breach of patent lawsuit.

The lawyers believe there is an 80% chance that the court will not dismiss the case and
the entity will incur outflow of benefits.

If the court rules in favor of the claimant, the lawyers believe that there is a 60% chance
that the entity will be required to pay damages of P2,000,000 and a 40% chance that the
entity will be required to pay damages of P1,000,000. Other amounts of damages are
unlikely.

There is no indication that the claimant will settle out of court. The court is expected to
rule in late December 2021.

An 8% risk adjustment factor to the cash flows considered appropriate to reflect the
uncertainties in the cash flow estimates.

The appropriate discount rate is 12%. The PV of 1 at 12% for one period is 0.89.

1. What is the amount of undiscounted cash flows for the provision?

2. What is the measurement of the provision on December 31, 2020?

5. Earth Company gives warranties at the time of sale to purchasers of its product. The
entity undertakers to make good, by repair or replacement, manufacturing defects that
become apparent within one year from the date of sale.

Sales of P5,000,000 were made evenly throughout 2020. The expenditures for warranty
repairs and replacements for the products sold in 2020 are expected to be made 50% in
2020 and 50% in 2021.

The 2021 outflows of economic benefits related to the warranty will take place on
December 31, 2021.

The estimated that 75% of products sold require no warranty repairs, 15% of products
sold require minor repairs costing P100,000 and 10% of products sold require major
repairs costing P400,000.

An appropriate risk adjustment factor to reflect the uncertainties in the cash flow
estimates is an increment of 6% to the probability weighted expected cash flows.

The appropriate discount factor for cash flows expected to occur on December 31, 2021
is 0.94.

1. What is the warranty expense for 2020?

2. What is the warranty liability on December 31, 2020?

(Learning Resources in Accounting 4 – Intermediate Accounting 2) 42