ACCA Applied Knowledge · Financial Accounting

Provisions and contingencies: formula sheet

Full chapter guide

Key formulas

Recognition test: Provision = present obligation (past event) AND probable outflow AND reliable estimate; All three conditions must be met. Failing any one means no provision.
Meaning of probable: Probable = more likely than not (above 50%); Possible but not probable gives a contingent liability disclosure, not a provision.
Journal to recognise: Dr Expense (profit or loss) / Cr Provision (liability); If the provision is part of an asset's cost, such as decommissioning, the debit goes to the asset instead.
Obligation types: Obligation = legal OR constructive; Constructive needs past practice or a clear statement that creates a valid expectation.
Future operating losses: No provision for future operating losses; There is no past event. Onerous contracts are the exception and are covered separately.
Provision test: Present obligation + probable outflow + reliable estimate = recognise a provision; All three conditions must be met. Probable means more likely than not.
Contingent liability treatment: Possible obligation, or present obligation with payment not probable or not measurable: disclose unless remote. Remote: no disclosure; Never recognise a contingent liability in the statement of financial position.
Contingent asset: probable inflow: Inflow probable but not virtually certain: disclose only, do not recognise; Disclosure is in the notes. No entry in the ledger.
Contingent asset: virtually certain: Inflow virtually certain: recognise as an asset; It is no longer a contingent asset. Example: an insurance claim already agreed by the insurer.
Contingent asset: possible inflow: Inflow only possible: ignore, no disclosure; Do not mention it at all.
Expected value: Expected value = Σ (outcome × probability); Use for a large population of similar items, such as warranty claims. Probabilities must add up to 100%.
Most likely outcome: Best estimate = single most likely amount; Use for a single obligation. Adjust upwards or downwards if other possible outcomes are mostly higher or lower.
Creating a provision: Dr Expense (profit or loss); Cr Provision (liability); Post the full amount in the first year.
Adjusting a provision: Charge or credit to profit or loss = closing provision − opening provision; A positive result is an extra expense. A negative result is a credit, which reduces expenses.
Discounted provision: Present value = future payment ÷ (1 + r)ⁿ; Use when the time value of money is material. Unwinding in later years = opening provision × r, charged as a finance cost.
Provision recognition tests: Present obligation from past event AND outflow probable AND reliable estimate; All three must be met. Otherwise disclose a contingent liability or do nothing.
Warranty provision (expected value): Provision = Units sold × Σ (probability of each outcome × cost per unit); Use expected value for a large population of similar items.
Onerous contract provision: Provision = lower of (unavoidable cost of fulfilling the contract − expected benefits, such as sublet income) and (penalty or compensation for exit); The fulfilment figure is a net cost. Compare it with the cost of getting out and provide the lower.
Restructuring provision: Direct restructuring costs only, once plan is detailed and expectation is raised by year end; Exclude retraining, relocation, marketing and future operating losses.
Double entry for a new provision: Dr Expense (profit or loss) / Cr Provision (liability); For a change in an existing provision, post only the increase or decrease to profit or loss.
Contingent items: Contingent liability: disclose unless remote. Contingent asset: disclose only if inflow probable.; Neither is recognised in the statement of financial position.

Quick revision

A provision is a liability of uncertain timing or amount.
Recognise a provision only if all three hold: present obligation from a past event, probable outflow, reliable estimate.
Probable means more likely than not.
A present obligation can be legal or constructive.
A possible obligation, or a present one that is not probable or not measurable, is a contingent liability: disclose it.
If the chance of outflow is remote, do not disclose.
A contingent asset is disclosed only if an inflow is probable, and recognised only if virtually certain.
Measure at the best estimate: most likely outcome for one item, expected value for many items.
Create a provision by debiting expense and crediting the provision.
In later years, adjust the provision and take only the change to profit or loss.
Restructuring needs a detailed formal plan and a valid expectation in those affected, such as an announcement.
An onerous contract is one where unavoidable costs exceed expected benefits; provide for the loss.
You cannot provide for future operating losses.

Common mistakes

Providing for future operating costs or future losses. Fix: Ask whether a past event has created an obligation now. If the cost can be avoided by future action, there is no provision.
Treating 'possible' as 'probable'. Fix: Probable means more likely than not. Possible gives a contingent liability note only.
Recognising a contingent asset when the inflow is merely probable. Fix: Assets need virtually certain. Probable inflow is disclosure only.
Thinking every probable outflow is a provision. Fix: Check for a present obligation and a reliable estimate as well. If the amount cannot be measured, it is a contingent liability.
Charging the full new provision to profit or loss every year. Fix: Charge only the movement: closing provision minus opening provision.
Using the most likely outcome for a large population of similar items. Fix: Many similar items means expected value. Reserve the most likely outcome for a single obligation.
Providing for a restructuring because the board has decided on it before the year end. Fix: Look for a detailed formal plan and a valid expectation raised in those affected, such as an announcement or the start of implementation. Without that, no provision.
Including retraining, relocation or future operating losses in a restructuring provision. Fix: Include only direct costs that arise from the restructuring and are not related to ongoing activities, such as redundancy payments. Everything else is expensed as incurred.

Exam tips

Write 'all three conditions' in your head every time. Many wrong options pass two out of three.
Watch the date. Events after the reporting date do not create an obligation at the reporting date, although they may give evidence about one.
In multiple response questions, select only the stated number of options and check each against the three tests.
In number entry, give only the amount to recognise. Exclude amounts that are only possible or that relate to future operations.
Know the three outcomes cold: provision, contingent liability disclosure, or nothing.
Learn the asymmetry: liabilities need probable to be recognised, assets need virtually certain.
Read for the exact likelihood word. Probable, possible and remote lead to different answers.
In multiple-response questions, check each statement against the rule separately.