LIABILITIES

&
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

A contingent liability must not be recognised as a liability in the financial statements.

Instead it should be disclosed in the notes to the accounts, unless the possibility of an outflow of
economic benefits is remote.
A contingent asset must not be recognised as an asset in the financial statements.
Instead it should be disclosed in the notes to the accounts if it is probable that the economic benefits
associated with the asset will flow to the entity.
 QUESTIONS
Question No. 01
During 20X9 Smack Co gives a guarantee of certain borrowings of Pony Co, whose financial condition at that time is
sound. During 20Y0, the financial condition of Pony Co deteriorates and at 30 June 20Y0 Pony Co files for protection
from its creditors.
What accounting treatment is required:
(a) at 31 December 20X9?
(b) at 31 December 20Y0?
Question No. 02
After a wedding in 20X0 ten people became seriously ill, possibly as a result of food poisoning from products sold by
Callow Co. Legal proceedings are started seeking damages from Callow but it disputes liability. Up to the date of
approval of the financial statements for the year to 31 December 20X0, Callow's lawyers advise that it is probable that
it will not be found liable. However, when Callow prepares the financial statements for the year to 31 December 20X1
its lawyers advise that, owing to developments in the case, it is probable that it will be found liable.
What is the required accounting treatment:
(c) At 31 December 20X0?
(d) At 31 December 20X1?
 QUESTIONS
Question No. 03
An oil company causes environmental contamination in the course of its operations, but cleans up only
when required to do so under the laws of the country in which it is operating. One country in which it
has been operating for several years has up to now had no legislation requiring cleaning up. However,
there is now an environmental lobby in this country. At the date of the company's year end, it is
virtually certain that a draft law requiring clean up of contaminated land will be enacted very shortly.
The oil company will then be obliged to deal with the contamination it has caused over the past several
years.
What accounting treatment is required at the year end?
 QUICK QUIZ

A company is being sued for $10,000 by a customer. The company's lawyers reckon that it is likely that the claim
will be upheld. Legal fees are currently $5,000. How should the company account for this?

Given the facts in above, how much of a provision should be made if further legal fees of $2,000 are likely to be
incurred?
A $10,000
B $5,000
C $15,000
D $12,000

A company has a provision for warranty claims b/f of $50,000. It does a review and decides that the provision
needed in future should be $45,000. What is the effect on the financial statements?
Income statement Statement of financial position
A Increase expenses by $5,000 Provision $50,000
B Increase expenses by $5,000 Provision $45,000
C Decrease expenses by $5,000 Provision $50,000
D Decrease expenses by $5,000 Provision $45,000
 QUICK QUIZ
A contingent liability is always disclosed on the face of the
statement of financial position. True or false?
How does a company account for a contingent asset that is not
probable?
A By way of note
B As an asset in the statement of financial position
C It does nothing
D Offset against any associated liability
Happening of an Event / Transaction

Contingent Liabilities Provsions Liabilities

Notes to the FS (Disclose) SOFP (Recognize) SOFP (Recognize)
Remote (0% to 5%) No No No

Possible (6% to 50%) Yes No No

Probability (51% to 95%) No Yes No

Virtually Certain (96% to 100%) No No Yes

Happening of an Event / Transaction

Contingent Asset Assets

Notes to the FS (Disclose) SOFP (Recognize)
Remote (0% to 5%) No No
Possible (6% to 50%) No No
Probability (51% to 95%) Yes No
Virtually Certain (96% to 100%) No Yes