Provision
Provision
&
PROVISION(IAS-37)
PROVISION
A provision should be recognized
When an entity has incurred a present obligation
When it is probable that a transfer of economics benefits will be required to settle it
When a reliable estimate can be made of the amount involved
IAS 37 Provisions, contingent liabilities and contingent assets views a provision as a liability.
1) A provision is a liability of uncertain timing or amount.
2) A liability is an obligation of an entity to transfer economic benefits as a result of past transactions or
events.
Note
IAS 37 distinguishes provisions from other liabilities such as trade payables and accruals.
This is on the basis that for a provision there is uncertainty about the timing or amount of the future
expenditure.
TYPES OF OBLIGATIONS
Obligation
An obligation means in simple terms that the business owes something to someone else.
Legal Obligation
A legal obligation usually arises from a contract and includes warranties sold with products to make good any
repairs required within a certain timeframe.
The terms of Contract
Legislation
Any other operation of law
Constructive Obligation
A constructive obligation arises through past behavior and actions where the entity has raised a valid expectation
that it will carry out a particular action.
A constructive obligation would arise if a business which doesn’t offer warranties on its products has a history of
usually carrying out free small repairs on its products, so that customers have come to expect this benefit when
they make a purchase.
PROVISION: LEDGER ENTRIES
When a business first sets up a provision, the full amount of the provision should be debited to the income statement and credited
to the statement of financial position as follows:
DEBIT Expenses (income statement) Claim / Damages
CREDIT Provisions (statement of financial position)
In subsequent years, adjustments may be needed to the amount of the provision. The procedure to be followed then is as follows.
(a) Calculate the new provision required.
(b) Compare it with the existing balance on the provision account (ie the balance b/f from the previous accounting period).
(c) Calculate increase or decrease required.
If a higher provision is required now
DEBIT Expenses (income statement)
CREDIT Provisions (statement of financial position)
(with the amount of the increase)
If a lower provision is needed now than before
DEBIT Provisions (statement of financial position)
CREDIT Expenses (income statement)
(with the amount of the decrease)
PROVISION
Example No. 01
A business has been told by its lawyers that it is likely to have to pay $10,000 damages for a product that failed. The business duly
set up a provision at 31 December 20X7. However, the following year, the lawyers found that damages were more likely to be
$50,000.
Required
How is the provision treated in the accounts at:
(a) 31 December 20X7?
(b) 31 December 20X8?
Example No. 02
Parker Co sells goods with a warranty under which customers are covered for the cost of repairs of any manufacturing defect that
becomes apparent within the first six months of purchase. The company's past experience and future expectations indicate the
following pattern of likely repairs.
% of goods sold Defects Cost of repairs Sales ($m)
75 None –
20 Minor 1.0
5 Major 4.0
What should be the warranty provision in Parker Co’s financial statements?
PROVISION DISCLOSURES
Disclosures required in the financial statements for provisions fall into two parts:
1. Disclosure of details of the change in carrying amount of a provision from the
beginning to the end of the year, including additional provisions made, amounts used
and other movements.
2. For each class of provision, disclosure of the background to the making of the
provision and the uncertainties affecting its outcome, including:
(a) a brief description of the nature of the provision and the expected timing of any
resulting outflows relating to the provision
(b) an indication of the uncertainties about the amount or timing of those outflows and,
where necessary to provide adequate information, the major assumptions made
concerning future events
(c) the amount of any expected reimbursement relating to the provision and whether any
asset that has been recognised for that expected reimbursement.
CONTINGENT LIABILITIES
Contingent liabilities are defined as follows.
IAS 37 defines a contingent liability as:
A possible obligation 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 entity's
control; or
A present obligation that arises from past events but is not recognised because:
i. It is not probable that a transfer of economic benefits will be required to settle the obligation; or
ii. The amount of the obligation cannot be measured with sufficient reliability.
Contingent liabilities should not be recognised in financial statements, but they should be disclosed in the
notes. The required disclosures are:
iii. A brief description of the nature and where applicable
iv. An estimate of its financial effect
v. An indication of the uncertainties that exist
vi. The possibility of any reimbursement
CONTINGENT ASSETS
IAS 37 defines a contingent asset as:
A possible asset that arises from past events and whose existence will be confirmed by the occurrence of
one or more uncertain future events not wholly within the enterprise's control.
A contingent asset must not be recognised in the accounts, but should be disclosed if it is probable that
the economic benefits associated with the asset will flow to the entity.
A brief description of the contingent asset should be provided along with an estimate of its likely
financial effect.
If the flow of economic benefits associated with the contingent asset becomes virtually certain, it should
then be recognised as an asset in the statement of financial position as it is no longer a contingent asset.
Disclosures for Contingent Assets
Where an inflow of economic benefits is probable, an entity should disclose:
(i) a brief description of its nature, and where practicable
(ii) an estimate of the financial effect
CONTINGENT LIABILITIES AND CONTINGENT ASSETS