ACCA Applied Knowledge · Financial Accounting

Provisions and Contingencies for ACCA Financial Accounting

A provision is a liability of uncertain timing or amount. Under IAS 37 you recognise it only if there is a present obligation from a past event, an outflow is probable, and you can estimate it reliably. Otherwise disclose a contingent liability, or ignore it if remote. Contingent assets are disclosed only when an inflow is probable.

What this chapter covers

This chapter covers IAS 37 Provisions, Contingent Liabilities and Contingent Assets. It answers one question: when must a business record a liability that is uncertain, and when should it only mention it in the notes?

You will learn three outcomes for any uncertain item: recognise it in the statements, disclose it in the notes, or do nothing. You will also learn how to measure a provision using the best estimate, and how to book the entry. The main cases are warranties, restructuring and onerous contracts.

The chapter links to the rest of the paper. Provisions create expenses and liabilities, so they affect the statement of profit or loss and the statement of financial position. They also connect to events after the reporting period, where new information can change a provision, and to accounts preparation questions in Section B. In Section A, expect short objective test questions that ask you to classify an item.

Provisions are a favourite for objective test questions because the decision rules are short and the traps are clear. A student who knows the three tests and the three outcomes can answer classification questions fast, and the same logic helps with number entry questions on the amount to record. It also helps in the longer accounts preparation question, where a provision adjustment is a common step. The chapter is compact, so effort here pays back well.

Provisions and contingencies: topics in the order to study them

1IAS 37 Provisions: Recognition CriteriaStart here because every other topic uses the three recognition tests: present obligation, probable outflow, reliable estimate.
2Contingent Liabilities and Contingent AssetsNext, learn what happens when a test fails, since this decides between disclosure and no action.
3Measuring Provisions and Accounting EntriesOnce you can decide whether to recognise an item, learn how much to record and how to post and adjust it.
4Specific Provisions: Warranties, Restructuring and Onerous ContractsFinish with the common cases, which apply all the earlier rules and appear often in questions.

How to prepare Provisions and contingencies

Treat this chapter as a decision process first and a calculation topic second. Practise the decision until it is automatic, then add the numbers.

Learn the three recognition tests in your own words and write them from memory: present obligation from a past event, probable outflow, reliable estimate.
Memorise the outcomes. Provision: recognise. Possible obligation or improbable outflow: disclose as a contingent liability. Remote: nothing. Contingent asset: disclose only if an inflow is probable; recognise only when virtually certain.
Practise measurement. Use the best estimate. For a single obligation use the most likely outcome. For a large population of items use the expected value, which weights each outcome by its probability.
Practise the entries. Debit expense, credit provision when you create it. For later years, post only the increase or decrease in the provision to profit or loss.
Work through warranties, restructuring and onerous contracts, and note what makes each one qualify, such as a detailed formal plan announced for restructuring.
Do timed multiple choice, multiple response and number entry questions. For each wrong answer, name which of the three tests you misjudged.

Common mistakes in Provisions and contingencies

Providing for a future expense because the business intends to spend money, such as planned repairs or future losses.
Fix: Ask what past event created an obligation. If the business could avoid the cost by its future actions, do not provide.
Mixing up a provision and a contingent liability.
Fix: Check the tests. If an outflow is probable and measurable with a present obligation, it is a provision. If not, it is a contingent liability for disclosure only.
Recognising a contingent asset because the gain looks likely.
Fix: Remember the asymmetry. Disclose a probable inflow. Recognise only when it is virtually certain.
Charging the full provision to profit or loss again each year.
Fix: Compare the new required provision with the old balance and post only the difference, as an expense if it rises or a credit if it falls.
Using the most likely outcome for a large population of items, such as warranty claims.
Fix: For many similar items, calculate the expected value by multiplying each outcome by its probability and adding the results.
Providing for restructuring before it is committed.
Fix: Look for a detailed formal plan and a valid expectation in those affected, such as an announcement or start of implementation, before the year end.

Last-day revision: Provisions and contingencies

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.

Provisions and contingencies practice questions

Provisions and contingencies in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Provisions and contingencies: frequently asked questions

What are the three conditions for recognising a provision under IAS 37?

There must be a present obligation from a past event, an outflow of economic benefits must be probable, and the amount must be reliably estimable. If any one fails, you do not recognise a provision. You may need to disclose a contingent liability instead.

What is the difference between a provision and a contingent liability?

A provision is recognised in the statement of financial position because the obligation exists, the outflow is probable and the amount can be estimated. A contingent liability is a possible obligation, or a present one that fails the other tests, and is only disclosed in the notes. If the chance of outflow is remote, you do not disclose it.

How do I measure a provision in the exam?

Use the best estimate of the cost to settle the obligation. For one item, take the most likely outcome. For a large group of similar items, use the expected value by weighting each outcome by its probability. Read the question to see which one it expects.

Can I recognise a contingent asset?

Not unless the inflow is virtually certain, at which point it is no longer a contingent asset. If an inflow is only probable, disclose it in the notes. If it is merely possible, do nothing.