CHAPTER 4: PROVISION
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Provision
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An existing liability
o Of uncertain timing or uncertain
amount
Essence
o There is uncertainty of the timing or
amount of future expenditure
Uncertainty
o What distinguishes provision from
other liabilities
Liability definitely exists at the end of the
period
o The amount is indefinite
o The date when the amount is due is
also indefinite
o In some cases
 The payee cannot be
identified or determined
May be equivalent to an:
o Estimated liability or a loss
contingency (accrued)
 Because both
 Probable
 Measurable
o
Past Event
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Recognition of Provision
(Provision shall be recognized as a liability in the financial
statements under the following conditions)
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The entity has a present obligation, legal or
constructive, as a result of a past event
It is probable that an outflow of resources
embodying economic benefits would be
required to settle the obligation
The amount of the obligation can be
measured reliably
Present Obligation
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Legal obligation
o An obligation arising from
 Contract
 Legislation
 Operation of law
Constructive obligation
o An obligation that is derived from
entity’s actions where:
 The entity indicated to other
parties that it will accept
certain responsibilities
By reason of:
 An established
pattern of past
practice
 Published policy
 Sufficiently specific
current statement
 And as a result, the entity
created a valid expectation on
the part of other parties
 That will discharge
those responsibilities
Exists when an entity from an
established pattern of practice or
stated policy
 Has created a valid
expectation that it will accept
certain responsibilities
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Obligating event
o Past event that leads to a present
obligation
o Is an event that creates a legal or
constructive obligation
 Because the entity has no
realistic alternative
 But to settle the obligation
created by the event
o This is the case where:
 Settlement of an obligation
can be enforced by law
 Event creates valid
expectations on the part of
other parties
 That the entity will
discharge the
obligation
Accounting provision
o Cannot be created in anticipation of a
future event
Event must have already occurred
o Which gives rise to a constructive or
legal obligation
Probable outflow of economic benefits
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Considered as probable
o If the event is more likely than not to
occur
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Probability
o more than 50% likely or substantially
more
Possible
o 50% or less likely to occur
Remote
o 10% or less likely to occur
o Very slight occurrence
Reliable Estimate
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Use of estimates
o is an essential part of the preparation
of FS
o does not undermine their reliability
True especially in the case of provision
o Being in its nature, it is uncertain
The standard suggests that by:
o Using a range of possible outcomes
 An entity usually will be able
to make an estimate of the
estimate that is reliable
No reliable estimate = no liability is
recognized
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Other measurement considerations
(The following items are taken into consideration in
recognizing and measuring a provision)
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Amount recognized as a provision
o Should be the best estimate
Best estimate
o Is the amount that an entity would
rationally pay to settle the obligation
 At the end of the reporting
period
 Or to transfer it to a third
party at that time
Where a single obligation is being measured
o The individual most likely outcome
adjusted for the effect of other
possible outcomes may be the best
estimate
When there is a continuous range of possible
outcomes, and each point is as likely as any
other
o The midpoint of the range is used
When provision being measured involves a
large population of items
o The obligation is estimated by:
 Weighting all possible
outcomes by their associated
possibilities
 Such statistical methods of
estimation is
 Expected value
Risks and Uncertainties
Present Value of obligation
Future Events
Expected disposal of assets
Reimbursements
Changes in provision
Use of provision
Future operating losses
Onerous contracts
Risks and Uncertainties
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Measurement of provision
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The amount of provision shall be discounted
o If the effect of the time value of
money is material
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Risks and uncertainties that inevitably
surround events and circumstances
o Shall be taken into account
 In reaching the best estimate
of a provision
Risks
o Described variability of outcome
Risk adjustment
o May increase the amount at which a
liability is measured
As prudence dictates
o Caution is needed in making
judgement under conditions of
uncertainty
 So that income and assets are
not overstated
 Expenses and liabilities are
not understated
Uncertainty
o Does not justify the creation of
excessive provision or a deliberate
overstatement of liabilities
Present Value of Obligation
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When the effect of TVM is material
o The amount of provision is the PV of
the expenditure expected to settle the
liability
Discount rate
o Should be the pre-tax rate
 Reflects the current market
assessment of the TVM
 Also reflects the risk specific
to the liability
o
Future Events
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That affect the amount required to settle an
obligation
o Shall be reflected in the amount of
the provision
 Where there is sufficient
evidence that they will occur
Such future events include
o New legislation
o Changes in technology
Expected disposal of assets
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Gains from expected disposal of asset
o Shall not be taken into account in
measuring a provision
An entity shall recognize a gain on disposal
o at the time of disposition of the assets
Cash inflows from disposal
o Treated separately from the
measurement of provision
Reimbursement
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Should not reflect the risk that cash
flow estimates have already adjusted
When the provision is expected to be
reimbursed by another party
o The reimbursement shall be
recognized when it is virtually certain
 That reimbursement would be
received if the entity settles
the obligation
Shall be treated as a separate asset
Not netted against the estimated liability for
the provision
Amount of reimbursement
o shall not exceed the amount of the
provision
However, in the income statement
o The expense relating to the provision
may be presented net of the
reimbursement
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Use of Provision
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Provisions
o Shall be reviewed at every end of the
reporting period
o Adjusted to reflect the current best
estimate
o Shall be reversed
Provision
o Shall only be used only for
expenditures for which the provision
was originally recognized
A provision of another cannot be used for
another
o If contrary is done it would:
 Distort financial performance
 (possibly) constituting
financial reporting fraud
Future Operating Losses
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Provision
o Shall not be recognized for future
operating losses
Not included as a past event creating a
present obligation has not occurred
However, an expectation of future operating
losses
o May be an indication that certain
assets may be impaired
 Impairment test may be
necessary
Onerous Contract
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Changes in provision
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If no longer probable that an
outflow of economic benefits
would be required to settle
When discounting is used
o The CA of the provision increases each
period
 To reflect the passage of time
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If an entity has an onerous contract
o The present obligation under the
contract shall be recognized and
measured as a provision
Onerous Contract
o A contract in which the unavoidable
costs of meeting the obligation under
the contract
 Exceed the economic benefits
expected to be received
under it
PAS 37 mandates that the unavoidable costs
under a contract
o Represent the least net cost of exiting
from the contract
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Lower amount between
o cost of fulfilling the contract
o compensation or penalty arising from
failure to fulfill the contract
 will be the least cost of exiting
from the contract
Example of Provision
Warranties
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Best estimate of the warranty cost
o Recognized as a provision
 Because there is a clear
constructive obligation arising
from an obligating event
 Sale of a product with
warranty
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Restructuring
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Environmental Contamination
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IF the entity has an environmental policy that
others expect that the entity will clean up any
contamination
o A provision for environmental
damage shall be made
Obligating event
o Contamination of property
 Gives rise to a legal or
constructive obligation
Provision is recognized
o For the best estimate of the cost of
cleaning up the contamination
Decommissioning or Abandonment costs
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When an entity initially purchases an oil field
o It is put under a legal obligation
 To decommission a site at the
end of its life
The costs of abandonment or
decommissioning
o Shall be recognized as a provision
o May be capitalized as cost of oil field
Court Case
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Provision is recognized
o For the best estimate of damages
 Because there is a present
obligation
Guarantee
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When an entity gives a guarantee towards an
entity and that entity filed for bankruptcy
A provision is recognized
o For the best estimate of the
guarantee obligation
 Because there is a legal
obligation arising from the
obligating event
Program that is planned and controlled by
management
Materially changes either
o The scope of a business of an entity
o The manner in which the 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
 Relocation of business
activities
 Relocation of headquarters
from one country to another
o Change in management structure
 Elimination of a layer of
management
 Making all functions
autonomous
o Fundamental reorganization of an
entity
 Has a material and significant
impact on its operations
Provision for Restructuring
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Recognition of the provision for restructuring
o Required because a constructive
obligation may arise
 From the decision to
restructure
A constructive obligation for restructuring
arises when two conditions are present
o The entity has a detailed formal plan
for the restructuring includes the
following:
 The business being
restructured
 The principal location is
affected
 The location, function and
approximate number of
o
employees who will be
compensated for termination
 Date when the plan will be
implemented
 The expenditures to be
undertaken
The entity has raised valid
expectations and announcing the
main features of those affected by it
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Contingent Liability and Provision
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Amount of restructuring provision
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Shall include only direct expenditures arising
from the restructuring
Such expenditures
o Necessarily incurred for the
restructuring
o Not associated with the on-going
activities of the entity
Example:
o Salaries and benefits of employees to
be incurred after operations cease
and are associated with the closing of
operations
 Will be included
Excludes the following expenditures from the
restructuring provision
o Cost of retraining or relocating the
staff
o Marketing or advertising program to
promote the new company image
o Investment in new system and
distribution network
 As they are related to the
future conduct of the
business of the entity
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is a possible obligation that arises from past
event
o whose existence will be confirmed
only by
 the occurrence or
nonoccurrence of one or more
uncertain future event
 not wholly within the
control of the entity
is a present obligation that arises from past
event
o not recognized because it is not
probable
 that an outflow of resources
embodying economic benefits
According to the second definition,
Contingent Liability
o Present obligation
o Either probable or measurable but
not both
Provision
o If both probable and can be measured
reliably
Treatment of Contingent Liability
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Shall not be recognized in the FS
Shall be disclosed only
Required disclosures:
o Brief description of the nature of the
contingent liability
o An estimate of its financial effects
o An indication of the uncertainties that
exist
o Possibility of any reimbursement
If a contingent is remote
o No disclosures necessary
Contingent Asset
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Contingent Liability
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will be required to settle the
obligation
(or) the amount of the
obligation cannot be
measured reliably
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is a possible obligation that arises from past
event
o whose existence will be confirmed
only by
 the occurrence or
nonoccurrence of one or more
uncertain future event
 not wholly within the
control of the entity
shall not be recognized
o because this may result to recognition
of income that may never be realized
However, when the realization of income in
virtually certain
o The related asset is no longer a
contingent asset
o Its recognition is appropriate
Only disclosed when it is probable
The disclosure includes
o A brief description of the contingent
asset
o An estimate of its financial effects
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If a contingent asset is only possible or remote
o No disclosure is required
Decommissioning Liability
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Is an obligation to
o Dismantle
o Remove
o Restore
 An item of PPE as required by
law or contract
Also known as asset retirement obligation
Change in Decommissioning Liability
(Changes in the measurement of an existing
decommissioning liability shall be accounted for as
follows)
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A decrease in the liability is deducted from the
cost of the asset
o If the decrease in liability exceeds the
CA
 The excess is recognized in
profit or loss
An increase in the liability is added to the cost
at the asset
o However, the entity may consider
whether this is an indication that the
CA of an asset may not be fully
recoverable
o If there is such an indication
 Asset shall be tested for
impairment