Provisions and Contingencies
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Provisions and Contingencies

This article will acquaint the reader with the recognition criteria and measurement that should be applied to provisions, contingent liabilities, and contingent assets. Disclosures required in the notes to financial statements are also discussed to enable users to understand their nature, timing and amount. The discussions below are based from IAS 37.

Definitions

Constructive Obligation – an obligation that is derived from an entity’s actions.

Contingency - GAAP defines contingency as an existing condition, situation, state or a set of circumstances involving uncertainty as to a possible gain or loss that will be resolved when a future event happens or fails to happen. Therefore, there may either be a gain contingency which arises to a contingent asset or a loss contingency which arises to a contingent liability.

Contingent Liability - A contingent liability could be defined as a possible obligation that arises from a previous transaction or event, whose existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events which are beyond the control of the entity.

Contingent Asset - A contingent asset on the other hand is a possible asset that arises from a previous transaction or event, whose existence will be confirmed by the occurrence or nonoccurrence of one or more uncertain future events which are beyond the control of the entity.

Guarantee – a collateral agreement to answer for the debt of another in case that the person defaults.

Legal Obligation – an obligation arising from a contract, legislation or other operation of law.

Onerous Contract – 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.

Provision – it is an existing liability of uncertain timing or uncertain amount. The liability exists at the end of the reporting period but the amount is not definite or the date when the obligation becomes due is also not definite. The payee, in some instances could also not be determined. A provision can be equivalent to an estimated liability or a loss contingency because it is both probable and measurable.

Warranty ­– a written assurance that some product or service will be provided or will meet certain specifications.

Common Questions Regarding Provisions and Contingencies

  • What are the different levels of probability?

a)      Probable—the future event or events are likely to occur. As a rule of thumb, a probable event is more than 50% likely to occur.

b)      Reasonably possible—the chance of the future event or events occurring is more than remote but less than likely.

c)      Remote—the chance of the future event or events occurring is slight or there is very little change that the future event or events will occur.

  • When would a gain or loss contingency be recognized or disclosed?
 

Loss Contingency

Gain Contingency

 

Probable

If amount could be measured reliably, recognize in the financial statements, if not, disclose to notes to financial statements

Disclose to notes to financial statements

Possible

Disclose to notes to financial statements

Do not recognize or disclose

Remote

Do not recognize or disclose

Do not recognize or disclose

  • When will a provision be recognized? Provisions should be recognized in the financial statements when:

a. An enterprise has a present obligation (either legal or constructive) as a result of a past transaction/event;

b. It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and

c. The amount of the liability could be reliably measured.

  • How would a provision be measured? The amount of a provision is to be recognized using the best estimate.
  • What is meant by best estimate? The best estimate is the amount that an enterprise would rationally pay to settle the obligation at the balance sheet date or to transfer it to a third party at that time. The best estimate could either be an amount determined by the judgment of the management of an entity that is based from experience on similar transactions, and reports from experts.
  • What if there are different probable amounts and each amount is as likely as another? If this is the case the midpoint range should be used. If the provision involves a large population of items, the liability could be estimated by “weighting” all possible outcomes by their associated possibilities (expected value method).
  • Are there other factors to be considered when measuring the amount of a provision? The following should also be considered when measuring provisions:
  1. risk and uncertainties
  2. present value
  3. future events
  4. expected disposal of assets
  5.  reimbursements
  6. changes in the provision
  7. use of provision
  8. future operating losses
  9. onerous contract
  • Give some examples of Provisions: Warranties, guarantees, environmental  contamination, decommissioning cost or abandonment costs, court cases.
  • How would a contingent liability be disclosed?
  1. There should be a brief description of the nature of the contingent liability
  2. There should be an estimate of its financial effects
  3. An indication of uncertainties that exist should be presented
  4. The possibility of any reimbursement should be indicated
  • How would a contingent asset be disclosed?
  1. There should be a brief description of the contingent asset
  2. An estimate of its financial effects should be presented

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