Provisions and Contingent Liabilities 2020
LECTURE NOTES
Provision - An existing liability of uncertain timing or uncertain amount.
Recognition of provision – Conditions set forth by PAS 37
a. The entity has a preset obligation, legal or constructive, as a result of past event;
b. It is probable that an outflow of resources embodying economic benefits would be
required to settle the obligation; and
c. The amount of the obligation can be measured reliably.
Measurement of a provision - best estimate of the expenditure required to settle the present
obligation at the end of the reporting period.
✓ When there is a continuous range of possible outcomes and each point in that range
is as likely as any other, the midpoint range shall be the best estimate.
✓ Where the provision being measured involves a large population of items, the
obligation is measured by weighting all possible outcomes by their associated
possibilities.
Present value of obligation - The provision shall be discounted using pretax rate that reflects
current market assessment of time value of money and risk specific to the liability where
the effect of discounting the provision is material.
Changes in the provision
✓ Provisions shall be reviewed at every end of the reporting period and adjusted to
reflect the best estimate with the change effected in profit or loss.
✓ When a provision is no longer probable as to outflow of economic benefits, such
provision shall be reversed and shall also be recognized in profit or loss.
✓ Where a provision is discounted, the carrying amount of the provision shall be
increased equal to the amortization of the effect of discounting.
Restructuring - 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.
✓ Events that may qualify as restructuring include:
o Sale or termination of a line of business
o 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.
o Change in management structure, such as elimination of a layer of a
management or making all functional units autonomous
o Fundamental reorganization of an entity that has a material and significant
impact on its operations
FEU – IABF
Provision for restructuring - A constructive obligation for restructuring arises when two
conditions are present:
a. The entity has a detailed formal plan for the restructuring outlining at least the
business or part of the business being restructured, the principal location affected,
the location, function, and approximate number of employees who will be
compensated for terminating their employment, when the plan will be implemented,
and the expenditures that will be undertaken; and
b. 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
its main features to those affected by it.
Amount of restructuring provision - A restructuring provision shall include only direct
expenditures arising from the restructuring, meaning, those expenditures that are
necessarily incurred for the restructuring and not associated with the ongoing activities of
the entity.
✓ PAS 37 specifically excludes the following expenditures from the restructuring
provision:
o Cost of retaining or relocating continuing staff
o Marketing or advertising program to promote the new company image
o Investment in new system and distribution network
✓ These costs which are excluded from the restructuring provision are considered to
be incurred for the future conduct of the business of the entity and thus are not
liabilities relating to the restructuring.
Contingent Liability - PAS 37 defines contingent liability in two ways:
✓ A contingent liability is a possible obligation 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.
✓ 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.
Contingent liability vs. Provision
✓ Both a contingent liability and a provision are present obligations, the difference lies
between the probability and the measurability of such obligation.
✓ In order for a provision to be recognized, settlement must be probable and the
amount of settling the obligation must be measurable in a reliable way. While in a
contingent liability, it is either that the settlement of the obligation is probable or
that the amount of settling the obligation can be measured reliably however, both
probability and measurability must not exist.
Page 1
Provisions and Contingent Liabilities 2020
Accounting for contingent liability - A contingent liability shall not be recognized in the
financial statements, necessary disclosures are enough. Remote contingent liability does not
require any disclosure.
APPLICATION
Problem 1: Iron Man 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 probable 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. The management believes the effects of time value of money on these amounts
are material but also believes the timing of these amounts is 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.
Problem 2: Captain America 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.
* Captain America is involved in a lawsuit resulting from a dispute with a customer over a
2020 transaction. On December 31, 2020, the lawyers advised that it was probable that
Captain America would lose P3,000,000 in an unfavorable outcome. On February 15, 2021,
judgement was rendered against Iron Man in the amount of P4,000,000 plus interest of
P500,000. Captain America does not plan to appeal the judgement.
* Since August 2020, Captain America has been involved in a labor dispute. Negotiations
between the entity and the union have not produced a settlement. Since January 2020,
FEU – IABF
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.
* Captain America 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 Captain
America's hardwood division in 2020. The lawsuit alleges that Captain America
misrepresented the division's assets and liabilities. Legal counsel advised that it is
reasonably possible that Captain America 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 Bourne but has not proposed a penalty assessment.
Management feels an 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.
Problem 3: Thor Company provided the following selected transactions related to
contingencies. The fiscal year ends December 31, 2020. Financial statements are issued on
April 1, 2021.
* No customer accounts have been shown to be uncollectible as yet but Thor estimated that
3% of credit sales will eventually prove uncollectible. Credit sales amounted P30,000,000
for 2020.
* Thor offers a one-year warranty against manufacturer's defects for all its products.
Industry experience indicates that warranty costs will approximate 2% of credit sales. Actual
warranty expenditures totaled P350,000 in 2020 and were recorded as warranty expense
when incurred.
* In December 2020, Thor became aware of an engineering flaw in a product that poses a
potential risk of injury. As a result, a product recall appears inevitable. This move would
likely cost the entity P1,500,000.
* In November 2020, the City of Manila filed suit against Thor asking civil penalties and
injunctive relief for violations of clean water laws. Thor reached a settlement with the city
government authorities to pay P4,200,000 in penalties on February 15, 2021.
* Thor is the plaintiff in a P4,000,000 lawsuit filed against a customer for costs and lost
profit from contracts rejected in 2020.
The lawsuit is in final appeal and lawyers advised that it is probable that Thor will be awarded
P3,000,000.
Page 2
Provisions and Contingent Liabilities 2020
Required: Prepare the appropriate journal entries that should be recorded as a result of
each of these contingencies. If no journal entry is indicated, state the reason why.
Problem 4: During 2020, Wanda Company was sued by a competitor for P5,000,000 for
infringement of a trademark. Based on the advice of the entity's legal counsel, the entity
accrued the sum of P3,000,000 as a provision in the financial statements for the year ended
December 31, 2020.
Subsequent to the end of the reporting period, on February 15, 2021, the Supreme Court
decided in favor of the party alleging infringement of the trademark and ordered the
defendant to pay the aggrieved party a sum of P3,500,000.
The financial statements were prepared by the entity's management on January 31, 2021,
and approved by the board of directors on February 20, 2021.
Required: What amount of provision should have been accrued on December 31, 2020?
Problem 5: On November 5, 2020, a Vision Company truck was in an accident with an auto
driven by Bell. The entity received notice on January 12, 2021 of a lawsuit for P700,000
damages for personal injuries suffered by Bell. The entity's counsel believed that it is
probable that Bell will be awarded an estimated amount in the range between P200,000 and
P500,000. The possible outcomes are equally likely.
The accounting year ends on December 31 and the 2020 financial statements were issued
on March 31, 2021.
Required: What amount of provision should be accrued on December 31, 2020?
Problem 6: On November 25, 2020, an explosion occurred at a War Machine Company
plant causing extensive property damage to area buildings. By March 10, 2021, claims had
been asserted against War Machine. The management and counsel concluded that it is
probable War Machine will be responsible for damages, and that P3,500,000 would be a
reasonable estimate of the liability.
The entity's P10,000,000 comprehensive public liability policy has a P500,000 deductible
clause. The financial statements for 2020 were issued on March 25, 2021.
Required:
1. What amount of loss from lawsuit should be reported in the income statement for
2020?
2. What amount of liability from lawsuit should be reported on December 31, 2020?
FEU – IABF
Problem 7: Winter Soldier Company is being sued for illness caused to local residents as a
result of negligence on the entity's part in permitting the local residents to be exposed to
highly toxic chemicals from its plant.
The entity's lawyer stated that it is probable that the entity will lose the suit and be found
liable for a judgment costing the entity anywhere from P1,200,000 to P6,000,000. However,
the lawyer estimated that the most probable cost is P3,600,000.
Required: What amount should be accrued and disclosed?
Problem 8: During the current year, Spiderman Company won a litigation award for
P1,500,000 which was tripled to P4,500,000 to include punitive damages. The defendant,
who is financially stable, has appealed only the P3,000,000 punitive damages.
The entity was awarded P5,000,000 in an unrelated suit it filed, which is being appealed by
the defendant. Counsel is unable to estimate the outcome of these appeals.
Required: What amount of pretax gain should be recorded?
Problem 9: In May 2020, Vulture Company filed suit against Wayne Company seeking
P1,900,000 damages for patent infringement. A court verdict in November 2020 awarded
Vulture P1,500,000 in damages, but Wayne Company's appeal is not expected to be decided
before 2021.
The legal counsel believed it is probable that Vulture will be successful against Wayne for
an estimated amount in the range between P800,000 and P1,100,000, with P1,000,000
considered the most likely amount.
Required: What amount should Vulture Company record as income from the lawsuit for the
year ended December 31, 2020?
Problem 10: On November 1, 2020, Mysterio Company was awarded a judgment of
P1,500,000 in connection with a lawsuit. The decision is being appealed by the defendant
and it is expected that the appeal process will be completed by the end of 2021. The attorney
believed that it is highly probable that an award will be upheld on appeal but that the
judgment may be reduced by an estimated 40%.
Required: What amount should be reported as receivable on December 31, 2020?
Problem 11: Ant-Man 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.
Page 3
Provisions and Contingent Liabilities 2020
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.
* Costs of P400,000 were expected to be incurred in transferring the 50 employees to their
new work in Manila. The transfer is planned for January 15, 2021.
Required: What amount should be recognized as a warranty provision?
* Four of the five executives who have been retrenched have had their accumulated
entitlements paid, including the three months' wages. However, one remains in order to
complete administrative tasks relating to the closure of Mindanao Branch and the transfer
of staff to Manila. This executive is expected to stay until January 31, 2021. His salary for
January will be P50,000 and his retrenchment package will be P200,000, all of which will be
paid on the day he leaves. He estimates that he would spend 60% of his time administering
the closure of Mindanao Branch, 30% on administering the transfer of staff to Manila, and
the remaining 10% on general administration.
Problem 12: During 2020, Wasp Company is the defendant in a patent infringement
lawsuit. The entity's lawyers believe there is a 30% chance that the court will dismiss the
case and the entity will incur no outflow of economic benefits.
However, if the court rules in favor of the claimant, the lawyers believe that there is a 20%
chance that the entity will be required to pay damages of P200,000 and an 80% chance that
the entity will be required to pay damages of P100,000. Other outcomes are unlikely. The
court is expected to rule in late December 2021. There is no indication that the claimant will
settle out of court.
Required: Prepare journal entry to record the provision for restructuring.
A 7% risk adjustment factor to the probability-weighted expected cash flows is considered
appropriate to reflect the uncertainties in the cash flow estimates.
Problem 13: On January 1, 2020, Hawkeye Company purchased an oil tanker depot at a
cost of P6,000,000. The entity is expected to operate the depot for 5 years after which it is
legally required to dismantle the depot and remove the underground storage tanks.
An appropriate discount rate is 5% per year. The present value of 1 at 5% for one period is
0.95.
The oil tanker dept is depreciated using straight line with no residual value. It is reliably
estimated that the cost of decommissioning the depot will amount to P1,500,000.
Required:
1. What is the amount of undiscounted cash flows for the provision?
2. What is the measurement of the provision for lawsuit on December 31, 2020?
The appropriate discount rate is 10%. The present value of 1 at 10% for 5 periods is 0.62.
Problem 13: Hulk Company decided on November 1, 2020 to restructure the entity's
operations.
* Mindanao Branch would be closed down November 30, 2020 to concentrate on Manila
operations.
On December 31, 2024, after 5 years of operating the depot, the entity paid a demolition
entity to dismantle the depot at a price of P1,700,000.
Required:
1. Prepare journal entries in 2020 in relation to the depot and the decommissioning
liability.
2. Prepare journal entries to record the derecognition of the depot and the settlement
of the decommissioning liability on December 31, 2024.
* 200 employees working in Mindanao Branch would be retrenched on November 30, 2020,
and would be paid accumulated entitlements plus three months' wages.
* The remaining 50 employees working in Mindanao Branch would be transferred to Manila,
which would continue operating.
* Five executives would be retrenched on December 31, 2020, and would be paid their
accumulated entitlements plus three months' wages.
* The retrenched employees have left and their accumulated entitlements have been paid.
However, an amount of P1,500,000, representing a portion of the three months' wages for
the retrenched, has still not been paid.
FEU – IABF
Page 4