Provisions

NotesVideoQuizObjective Test

A provision is a liability of uncertain timing or amount

Double entry

  • Dr Expense
    Cr Provision (Liability SFP)

If it is part of a cost of an asset (e.g. Decommissioning costs)

  • Dr Asset
    Cr Provision (Liability SFP)

Recognise when

  1. There is an obligation (constructive or legal)

  2. There is a probable outflow

  3. It is reliably measurable

At how much?

The best estimate of the expenditure

  1. Large Population of Items..

     ⇒  use expected values.

  2. Single Item...

    ⇒  the individual most likely outcome may be the best estimate.

Discounting of provisions

  • Provisions should be discounted

    Eg. A future liability of 1,000 in 2 years time (discount rate 10%)

    1,000 x 1/1.10 x 1/1.10 = 826

    Dr Expense  826
    Cr Provision 826

  • Then the discount unwound

    Year 1
    826 x 10% = 83

    Dr Interest    83
    Cr Provision 83

    Year 2
    (826+83) x 10% = 91

    Dr Interest    91
    Cr Provision 91

Measurement of a Provision

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

  • Provisions for one-off events

    • E.g. restructuring, environmental clean-up, settlement of a lawsuit

    • Measured at the most likely amount

  • Large populations of events

    • E.g. warranties, customer refunds

    • Measured at a probability-weighted expected value

A company sells goods with a warranty for the cost of repairs required in the first 2 months after purchase.

Past experience suggests:

88% of the goods sold will have no defects

7% will have minor defects

5% will have major defects

If minor defects were detected in all products sold, the cost of repairs will be $24,000;

If major defects were detected in all products sold, the cost would be $200,000.

What amount of provision should be made?

(88% x 0) + (7% x 24,000) + (5% x 200,000) = $11,680

Contingent Liabilities

  • These are simply a disclosure in the accounts

  • They occur when a potential liability is not probable but only possible

    (Also occurs when not reliably measurable)

Contingent Assets

Here, it is not a potential liability, but a potential asset.

The principle of PRUDENCE is important here, it must be harder to show a potential asset in your accounts than it is a potential liability.

This is achieved by changing the probability test.

For a potential (contingent) asset - it needs to be virtually certain (rather than just probable).

Probability test for Contingent Liabilities

  • Remote chance of paying out - Do nothing

  • Possible chance of paying out - Disclosure

  • Probable chance of paying out - Create a provision

Probability test for Contingent Assets

  • Remote chance of receiving - Do nothing

  • Possible chance of receiving - Do nothing

  • Probable chance of receiving - Disclosure

  • Virtually certain of receiving - create an asset in the accounts

NotesVideoQuizObjective Test