PROVISIONS, CONTINGENT

LIABILITIES, CONTINGENT
ASSETS
IAS-37
 The requirements of IAS 37 are applicable to recognition and
measurement of all provisions, contingent liabilities, and contingent
assets except
 (a) Those resulting from executory contracts, other than onerous
contracts
 (b) Those covered by other Standards
 Executory contract. A contract under which neither party (to the
contract) has performed its obligations or both the parties (to the
contract) have performed their obligations partially to an equal extent.
 Onerous contract. A contract in which the unavoidable costs of
meeting the obligations under the contract exceed the economic benefit
expected to be received under the contract.
Onerous Contract
 Although executory contracts are outside the general purview of IAS 37,
it is required to recognize a provision under an executory contract that is
“onerous.” An onerous contract that is covered under IAS 37 is an
executory contract where the unavoidable costs exceed the benefits
expected.
 An onerous contract is an agreement that an entity cannot get out of
legally even though it has signed another parallel agreement under
which it is able to undertake the same activities at a better price.
 As it is locked into the existing agreement, it would need to incur costs
under both contracts but derive economic benefits from only one of
them. The next example explains this better.
 An entity is bound under the terms of a franchise agreement for a local
brand that it has marketed for years. Based on market survey and a
cost-benefit study, the entity decided to stop marketing the local brand
and entered into a new agreement to market an international brand.
Although the entity does not derive any economic benefit from the
franchise agreement for the local brand, there is an obligation to pay a
lump-sum amount to the franchiser under the noncancellable franchise
agreement for a period of two more years. Thus the entity would need to
make a provision for the commitment under the franchise agreement
(since it is an onerous contract).
 XYZ Inc. is getting ready to move its factory from its existing location to a new industrial free zone
specially created by the government for manufacturers. To avail itself of the preferential licensing
offered by the local governmental authorities as a reward for moving into the free trade zone and the
savings in costs that would ensue (since there are no duties or taxes in the free trade zone), XYZ
Inc. has to move into the new location before the end of the year. The lease on its present location is
non-cancelable and is for another two years from year-end. The obligation under the lease is the
annual rent of $100,000.
Required:
Advise XYZ Inc. what amount, if any, it needs to provide at year-end toward this lease obligation.
 The lease agreement is an executory onerous contract because after moving to the
new location, XYZ Inc. would derive no economic benefits from the existing
factory building but would still need to pay rent under the agreement since the
lease is non-cancelable.
 Based on the annual lease obligation under the lease agreement, the total amount
needed to be provided at year-end is the present value of the total commitment
under the lease = PV of [$100,000 × 2 (years)].
 Provision. A liability of uncertain timing or amount.
 Liability. A present obligation of an entity arising from past events, the
settlement of which is expected to result in an outflow of resources
embodying economic benefits.
 Contingent liability.
 (a) A possible obligation arising from past events whose existence will
be confirmed only by the occurrence or nonoccurrence of one or more
uncertain future events that are not completely within the control of the
entity.
 (b) A present obligation that arises from past events but is not
recognized because either it is not possible to measure the amount of
the obligation with sufficient reliability or it is not probable that an
outflow of resources will be required to settle the obligation
Contingent asset. A possible asset arising from past events and whose
existence will be confirmed only by the occurrence or nonoccurrence of one
or more uncertain future events that are not completely within the control
of the entity.
 PROVISION

Provisions should be recognized if, and only if, all of these conditions are
met:
(a) An entity has a present obligation resulting from a past event;
(b) It is probable that an outflow of resources embodying economic
benefits would be required to settle the obligation;
(c) A reliable estimate can be made of the amount of the obligation.

Not all obligations would make it incumbent upon an entity to

recognize a provision. Only present obligations resulting for a past
obligating event give rise to a provision.
An obligation could either be a legal obligation or a constructive obligation.
 A legal obligation is an obligation that could-
(a) Be contractual; or
(b) Arise due to a legislation; or
(c) Result from other operation of law.
 A constructive obligation, however, is an obligation that results from an
entity’s actions where-
(a) By an established pattern of past practice, published policies, or
sufficiently specific current statement, the entity has indicated to other
(third) parties that it will accept certain responsibilities; and
(b) As a result, the entity has created a valid expectation in the minds of
those parties that it will discharge those responsibilities.
 Facts

 Excellent Inc. is an oil entity that is exploring oil off the shores of Excessoil Islands. It
has employed oil exploration experts from around the globe. Despite all efforts, there
is a major oil spill that has grabbed the attention of the media. Environmentalists are
protesting and the entity has engaged lawyers to advise it about legal repercussions.
In the past, other oil entities have had to settle with the environmentalists, paying
huge amounts in out-of-court settlements. The legal counsel of Excellent Inc. has
advised it that there is no law that would require it to pay anything for the oil spill;
the parliament of Excessoil Islands is currently considering such legislation, but that
legislation would probably take another year to be finalized as of the date of the oil
spill. However, in its television advertisements and promotional brochures, Excellent
Inc. often has clearly stated that it is very conscious of its responsibilities toward the
environment and will make good any losses that may result from its exploration. This
policy has been widely publicized, and the chief executive officer has acknowledged
this policy in official meetings when members of the public raised questions to him
on this issue.

 Does the above give rise to an obligating event that requires Excellent Inc. to make a
provision for the cost of making good the oil spill?
 Present obligation-as a result of a past obligating event.
 past obligating event- oil spill.
 Obligation-constructive obligation since the company, with its advertised
policy and public statements, has created an expectation in the minds of
the public at large that it will honor its environmental obligations.
 An outflow of resources embodying economic benefits in settlement
Probable.
 A provision should be recognized for the best estimate of the cost to
clean up the oil spill.
 The amount to be recognized as a provision is the best estimate of the
expenditure required to settle the present obligation at the balance
sheet date.
 While a reliable estimate is usually possible, in rare circumstances, it
may not be possible to obtain a reliable estimate. In such case liability is
to be disclosed as a contingent liability.
Car dealership also owns a workshop that it uses for servicing cars under warranty. In preparing its financial
statements, the car dealership needs to ascertain the provision of warranty that it would be required to provide
at year-end. The entity’s past experience with warranty claims is
 • 60% of cars sold in a year have zero defects.
 • 25% of cars sold in a year have normal defects.
 • 15% of cars sold in a year have significant defects.
 The cost of rectifying a “normal defect” in a car is $10,000. The cost of rectifying a “significant defect” in
a car is $30,000.

Compute the amount of “provision for warranty” needed at year-end.

 Solution:
 The expected value of the provision for warranty needed at year-end is:
 (60% × 0) + (25% × $10,000) + (15% × $30,000) = $7,000.
Future Operating Losses

 It is not permissible to recognize a provision for future operating losses,

because they do not meet the criteria for recognition of a provision.
 As future losses are not present obligations arising from past obligating
events and could be avoided by a future action of the entity.
Disclosures:

 For each class of provision, an entity should disclose

• The carrying amount at the beginning and the end of the period
• Additional provisions made in the period, including increases to existing
provisions
• Amounts utilized during the period
• Unused amounts reversed during the period
• The increase during the period in the discounted amount arising from the
passage of time and the effect of any change in the discount rate
 An entity should also disclose, for each class of provision
 • A brief description of the nature of the obligation and the expected
timing of any resulting outflows of economic benefits.
 • An indication about the uncertainties about the amount and timing of
those outflows (and, where necessary, major assumptions made
concerning future events).
 • The amount of any expected reimbursement, stating the amount of
any asset that has been recognized for that expected reimbursement.
 In order to recognize a provision (and record it on the books as opposed
to only disclosing it in footnotes), certain conditions (as discussed
earlier) need to be satisfied.
 However, when one of the prescribed conditions is not satisfied, then a
provision cannot be recognized. It is then a contingent liability and
needs to be disclosed in footnotes, unless the probability of the outflow
 embodying economic benefits is remote (in which case it does not even
have to be disclosed).
Contingent liability

Contingent liability is a possible obligation arising from past events, the

outcome of which will be confirmed only on the occurrence or
nonoccurrence of one or more uncertain future events.
 Unless the possibility of any outflow is remote, for each class of
contingent liability an entity should disclose at the balance sheet date a
brief description of the nature of the contingent liability.
• An estimate of its financial effect;
• An indication of the uncertainties relating to the amount or timing of
any outflow; and
• The possibility of any reimbursement.
 Once recognized as a contingent liability, an entity should continually
assess the probability of the outflow of the future economic benefits
relating to that contingent liability.
 If the probability of the outflow of the future economic benefits changes
to more likely than not, then the contingent liability may develop into an
actual liability and would need to be recognized as a provision.
Amazon Inc. has been sued for following three alleged infringements of law: Legal counsel is
of the opinion that not all the legal cases are tenable in law and has communicated to Amazon
Inc. this assessment of the three lawsuits
 Unauthorized use of a trademark; the claim is for $100 million. Lawsuit 1: The chances of
this lawsuit are remote
 Nonpayment of end-of-service severance pay and gratuity to 5,000 employees who were
terminated without Amazon Inc. giving any reason; the class action lawsuit is claiming $3
million. It is probable that Amazon Inc. would have to pay the displaced employees, but
the best estimate of the amount that would be payable if the plaintiff succeeds against the
entity is $2 million.

 Unlawful environmental damage for dumping waste in the river near its factory;
environmentalists are claiming unspecified damages as cleanup costs.There is no current
law that would compel the entity to pay for such damages. There may be a case for
constructive obligation, but the amount of damages cannot be estimated with any
reliability.
 Required
What should be the provision that Amazon Inc. should recognize or the contingent liability
that it should disclose in each of the lawsuits, based on the assessments of its legal counsel?
CONTINGENT ASSETS (Possible
Assets)
 Contingent assets are possible assets that arise from a past event and
whose existence is confirmed only by the occurrence or nonoccurrence
of one or more uncertain future events not wholly within the control of
the entity.
A Singapore-based shipping company lost an entire shipload of cargo
valued at $5 million on a voyage to Australia. It is, however, covered by an
insurance policy. According to the report of the surveyor the amount is
collectible, subject to the deductible clause (i.e., 10% of the claim) in the
insurance policy. Before year-end, the shipping company received a letter
from the insurance company that a check was in the mail for 90% of the
claim. The international freight forwarding company that entrusted the
shipping company with the delivery of the cargo overseas has filed a
lawsuit for $5 million, claiming the value of the cargo that was lost on high
seas, and also consequential damages of $2 million resulting from the
delay.
According to the legal counsel of the shipping company, it is probable that
the shipping company would have to pay the $5 million, but it is a remote
possibility that it would have to pay the additional $2 million claimed by
the international freight forwarding company, since this loss was
specifically excluded in the freight forwarding contract.
 What provision or disclosure would the shipping company need to make
at year-end?
 The shipping company would need to recognize a contingent asset of
$4.5 million (the amount that is virtually certain of collection).
 Also it would need to make a provision for $5 million toward the claim of
the international freight forwarding company.
 Because the probability of the claim of $2 million is remote, no provision
or disclosure would be needed for that.
Reporting Uncertainty
Contingent liability - Potential liability that may become
an actual liability in the future.

Three levels of probability:

 Probable
 Reasonably possible
 Remote

LO 2
Reporting Uncertainty

Probability Accounting

Probable Accrue

Reasonably
Footnote
Possible

Remote Ignore

LO 2
Product Warranties
Promise made by a seller to a buyer to make good on a
deficiency of quantity, quality, or performance in a product.

Estimated cost of honoring product warranty contracts

should be recognized as an expense in the period in which
the sale occurs.

LO 2
Illustration: Denson Manufacturing Company sells 10,000
washers and dryers at an average price of $600 each. The
selling price includes a one-year warranty on parts. Denson
expects that 500 units (5%) will be defective and that warranty
repair costs will average $80 per unit. In 2017, the company
honors warranty contracts on 300 units, at a total cost of
$24,000. At December 31, compute the estimated warranty
liability.

Illustration 11-3
Computation of estimated
product warranty liability

LO 2
Illustration: Denson Manufacturing Company sells 10,000
washers and dryers at an average price of $600 each. The
selling price includes a one-year warranty on parts. Denson
expects that 500 units (5%) will be defective and that warranty
repair costs will average $80 per unit. In 2017, the company
honors warranty contracts on 300 units, at a total cost of
$24,000. On December 31, compute the estimated warranty
liability. Make the required adjusting entry.

Warranty Expense 40,000

Provision for Warranty Liability 40,000

LO 2
Illustration: Prepare the entry to record the repair costs
incurred in 2017 to honor warranty contracts on 2017 sales.

Provision for Warranty Liability 24,000

Repair Parts 24,000

Assume that the company replaces 20 defective units in

January 2018, at an average cost of $80 in parts and labor.

Provision for Warranty Liability 1,600

Repair Parts 1,600

LO 2
16000

LO 2
Restructuring

 To provide guidance on this contentious issue, IAS 37 provides these

examples of events that may qualify as restructuring:
• Sale or termination of a line of business
• Closure of business locations in a region or relocation of business
activities from one location to another
• Changes in management structure, such as elimination of a layer of
management
• Fundamental reorganization of the entity such that it has a material
and significant impact on its operations.
 A restructuring provision should include only direct expenditures arising
from the restructuring, which are necessarily entailed by the
restructuring and not associated with the ongoing activities of the entity.