Some obligations are certain in amount and date, such as a supplier invoice. Others are real but uncertain: a warranty that may or may not be claimed, a court case that may or may not be lost, a factory closure that has been planned but not yet carried out.
International Accounting Standard (IAS) 37 sets the rules for when such items are recorded as liabilities, when they are only mentioned in the notes, and when they are ignored. It also covers the mirror image, possible gains, which are treated more cautiously.
This topic builds on accrued expenses, because a provision is a liability whose amount or timing is less certain than an accrual. It also sits beside the allowance for doubtful debts, which is not an IAS 37 item. Most exam questions ask for a warranty calculation, a journal, or the right treatment of a lawsuit. The next topic starts the preparation of full financial statements.
In 30 seconds
A Provision is a liability of uncertain timing or amount. Recognise it only if there is a Present obligation (legal or constructive) from a Past event, an outflow is Probable (more likely than not). A Reliable estimate can be made. Measure it at the Best estimate: Dr Expense, Cr Provision. A Contingent liability is never recognised: disclose it unless the outflow is remote.
A Contingent asset is never recognised: disclose it only if the inflow is probable, and recognise the asset once the gain is virtually certain. No provision for future operating losses. Provide for onerous contracts. Provide for a restructuring only after a detailed formal plan has been announced or begun.
What a provision is
A provision is a liability of uncertain timing or amount (IAS 37, paragraph 10). It differs from a trade payable, where the goods have been received and invoiced, and from an accrual, where the goods or services have been received but not yet invoiced or agreed, and the uncertainty is much smaller (paragraph 11). Provisions are reported separately from payables, and they need more judgement.
A provision is recognised only when all three conditions are met (paragraph 14):
- The entity has a Present obligation, legal or constructive, as a result of a Past event.
- An outflow of economic benefits is Probable, which means more likely than not (paragraph 23).
- A Reliable estimate of the amount can be made.
If any condition fails, no provision is recognised. A Legal obligation comes from a contract, legislation or other operation of law, such as a warranty or a duty to clean up unlawful pollution.
A Constructive obligation comes from the entity’s own conduct, such as an established pattern of past practice, a published policy or a specific statement, which creates a valid expectation in others that it will accept the responsibility (paragraph 10). Past refund practice and a regular redundancy payment policy are examples.
The obligation must exist independently of the entity’s future actions, so no provision is made for costs that can be avoided, such as fitting new equipment to meet a future standard (paragraph 19).
Measuring and recording a provision
The amount recognised is the Best estimate of the expenditure needed to settle the obligation at the reporting date (paragraph 36). For a single obligation the most likely outcome is usually used. For a large population of similar items, such as warranties, the provision is the Expected value, which weights each possible outcome by its probability (paragraphs 39 and 40).
Provisions are reviewed at each reporting date and adjusted, and reversed if an outflow is no longer probable (paragraph 59). A provision may only be used for the expenditure it was created for (paragraph 61).
| Event | Debit | Credit |
|---|---|---|
| Provision first made | Expense (for example warranty expense) | Provision |
| Provision increased | Expense | Provision |
| Provision reduced | Provision | Expense |
| Provision used | Provision | Cash or payables |
A provision is a liability on the statement of financial position, current if it will be settled within 12 months, as warranty claims usually are, and non-current if later, as with long-term site restoration.
Example. Ajii Ltd gives a 12-month warranty and sold goods worth ₦998,000,000 on credit. Its policy is a provision of 5% of revenue, and rectifying claims costs 60% of the sale price. A provision of ₦15,200,000 is already in the books.
- Required provision.
998,000,000 × 5% × 60% = ₦29,940,000. - The additional charge is 29,940,000 − 15,200,000 = ₦14,740,000: Dr Warranty (administration) expense 14,740,000, Cr Provision for warranty 14,740,000.
- The full ₦29,940,000 appears as a current liability.
Three special cases
| Case | Treatment | Reference |
|---|---|---|
| Future operating losses | No provision. They are not a present obligation. The expectation may be a sign that assets are impaired. | Paragraphs 63 to 65 |
| Onerous contract | Provide when the unavoidable costs of the contract exceed the benefits. The provision is the lower of the cost of fulfilling it and the compensation or penalty for not fulfilling it. | Paragraphs 66 and 68 |
| Restructuring | Provide only when there is a detailed formal plan and the entity has raised a valid expectation in those affected by starting the plan or announcing its main features. | Paragraph 72 |
Restructuring example. ABC Ltd announced a plan on 31 December 2024 with redundancy payments of ₦8,000,000 and lease termination penalties of ₦4,000,000. Both are direct costs of the plan, so the provision is ₦12,000,000: Dr Restructuring expense 12,000,000, Cr Provision for restructuring 12,000,000. Its warranty provision is 300,000,000 × 4% × 50% = ₦6,000,000, so total provisions are ₦18,000,000.
A restructuring provision includes only direct expenditure that the plan necessarily entails and that does not relate to continuing activities, so it excludes retraining continuing staff, marketing and new systems (paragraphs 80 and 81).
Reimbursements. If an insurer or supplier is expected to repay some of the cost, the reimbursement is recognised only when it is virtually certain. It is a separate asset, capped at the amount of the provision, and is not netted against the provision. The expense in profit or loss may be shown net (paragraphs 53 and 54).
Contingent liabilities and contingent assets
A contingent liability is a possible obligation whose existence depends on uncertain future events outside the entity’s control, or a present obligation that is not recognised because an outflow is not probable or the amount cannot be measured reliably (paragraph 10). It is not recognised, but it is disclosed unless the possibility of an outflow is remote (paragraphs 27 and 28).
It is assessed continually, and if an outflow becomes probable it is recognised as a provision in that period (paragraph 30).
A contingent asset is a possible asset arising from past events, confirmed only by uncertain future events outside the entity’s control, such as a claim being pursued in court. It is not recognised, because that could record income that is never realised. It is disclosed if an inflow is probable, and the asset is recognised only when the gain is virtually certain (paragraphs 31 to 35).
Examples. A customer sues for ₦100,000 and the lawyers judge a loss remote: no provision and no disclosure. A company pays out on a tax assessment it disputes and expects a refund: the refund stays a contingent asset, disclosed if probable, until the dispute is won.
A company that polluted a river with no law against it may still have a constructive obligation if it has publicly accepted responsibility or public pressure leaves it no realistic alternative. Then it provides if the cost can be estimated (paragraph 21).
Disclosure
| Item | What is disclosed | Reference |
|---|---|---|
| Each class of provision | Opening and closing amounts, additions, amounts used, unused amounts reversed, and the unwinding of any discount. Also the nature of the obligation and expected timing, the uncertainties, and any expected reimbursement. | Paragraphs 84 and 85 |
| Contingent liability (unless remote) | Its nature and, where practicable, the estimated financial effect, the uncertainties and the possibility of reimbursement. | Paragraph 86 |
| Contingent asset (if probable) | Its nature and, where practicable, the estimated financial effect. If not practicable, say so. | Paragraphs 89 and 91 |
The ideas in more depth
Background (IAS 37). A reliable estimate can be made in all but extremely rare cases (paragraph 25), so “we cannot estimate it” is seldom a valid reason to avoid a provision. Where the time value of money is material the provision is the present value of the expected outflows, using a pre-tax discount rate. The yearly unwinding is a borrowing cost (paragraphs 45 to 47 and 60).
Gains from expected asset disposals are not taken into account (paragraph 51). Items such as depreciation and the allowance for doubtful debts are adjustments to the carrying amounts of assets, so they are outside IAS 37 (paragraph 7).
A point to watch. Some illustrations suggest disclosing a remote claim, but a remote item is not disclosed. Follow the rule: remote means no disclosure (paragraph 28). Exam questions also say “provisions are to be made for audit fees and directors’ fees”. Treat these as ordinary expenses with a credit to a provision or accrued expense.
Sources: IAS 37 Provisions, Contingent Liabilities and Contingent Assets, paragraphs 7, 10, 11, 14, 19, 21, 23, 25, 27 to 36, 39, 40, 45 to 47, 51, 53, 54, 59 to 61, 63, 66, 68, 72, 80, 81 and 84 to 91.
Worked example: Bida Appliances Ltd
Scenario. Bida Appliances Ltd has a 31 December year end. (1) It sold appliances worth ₦400,000,000 with a 12-month warranty. Experience is that 5% of sales are claimed, costing 40% of the sale price. The provision account holds ₦5,000,000. (2) A customer is suing for ₦20,000,000. Lawyers say a loss is more likely than not, with a best estimate of ₦12,000,000. The insurer will virtually certainly repay ₦9,000,000.
(3) Bida is claiming ₦6,000,000 from a supplier, and success is probable but not virtually certain. (4) Another customer claims ₦50,000,000 and the lawyers say a loss is possible. (5) On 20 December the board decided to close a branch, but nothing was announced or started until 15 January. Required: the treatment of each item.
- Warranty.
Provision = 400,000,000 × 5% × 40% = ₦8,000,000.
Existing balance 5,000,000, so increase by 3,000,000: Dr Warranty expense 3,000,000, Cr Provision 3,000,000. - Lawsuit. Present obligation more likely than not, so provide ₦12,000,000: Dr Legal expense 12,000,000, Cr Provision 12,000,000. Recognise the reimbursement as a separate asset of ₦9,000,000: Dr Reimbursement receivable 9,000,000, Cr Legal expense 9,000,000. The net charge is 3,000,000.
- Supplier claim. Probable but not virtually certain: a Contingent asset. Disclose it in the notes and do not recognise it.
- Second claim. A loss is only possible: a Contingent liability. No provision. Disclose its nature and the ₦50,000,000 financial effect.
- Branch closure. The decision was not announced or started before the year end, so there is no constructive obligation and No provision (paragraph 75). If material, disclose it as an event after the reporting period.
- Result.
Provisions on the statement of financial position: warranty 8,000,000 + legal 12,000,000 = ₦20,000,000 as current liabilities, with the ₦9,000,000 reimbursement as a separate current asset.
The charge in profit or loss is 3,000,000 + 12,000,000 − 9,000,000 = ₦6,000,000.
Common mistakes in the exam
- Providing for a possible loss. A provision needs the outflow to be probable.
- Disclosing a remote contingent liability.
- Recognising a contingent asset, or income, before the gain is virtually certain.
- Providing for future operating losses or for costs that can be avoided.
- Charging the whole provision to profit instead of only the increase over the existing balance.
- Netting an insurance reimbursement against the provision on the statement of financial position instead of showing a separate asset.
- Making a restructuring provision because the board has decided, when nothing has yet been announced or begun.
- Treating the allowance for doubtful debts as an IAS 37 provision.
Quick revision
- Provision = present obligation from a past event + probable outflow + reliable estimate.
- Journal: Dr Expense, Cr Provision. Only the increase goes to profit.
- Single obligation: most likely outcome. Many similar items: expected value.
- Contingent liability: disclose unless remote. Contingent asset: disclose if probable, recognise when virtually certain.
- No provision for future operating losses. Provide for onerous contracts. Restructuring needs a detailed plan and valid expectation.
- Reimbursement: separate asset, only when virtually certain.
Practice questions
These are original questions in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one first.
Section A style: multiple choice
Question 1. A provision is a liability of:
- Uncertain timing or amount
- Certain timing and certain amount
- A known amount payable on a fixed date
- A possible obligation not yet confirmed
Show the answer
A. IAS 37, paragraph 10, defines a provision as a liability of uncertain timing or amount.
Question 2. Which is NOT a condition for recognising a provision?
- The outflow is virtually certain
- A present obligation from a past event
- A probable outflow of economic benefits
- A reliable estimate of the amount
Show the answer
A. Probable is enough for a provision. Virtually certain is the test for recognising a contingent asset or a reimbursement.
Question 3. In IAS 37, “probable” means:
- Certain
- Possible but unlikely
- At least 90% likely
- More likely than not
Show the answer
D. Paragraph 23 treats an event as probable if it is more likely than not to occur.
Question 4. Lawyers judge that the chance of losing a court claim is remote. The treatment is:
- Recognise a provision
- Disclose a contingent liability
- No provision and no disclosure
- Disclose a contingent asset
Show the answer
C. A contingent liability is disclosed unless the outflow is remote (paragraph 28).
Question 5. Sales are ₦500,000,000. Past experience is that 4% of sales are claimed under warranty and each claim costs 50% of the sale price. The warranty provision is:
- ₦20,000,000
- ₦25,000,000
- ₦2,000,000
- ₦10,000,000
Show the answer
D. 500,000,000 × 4% × 50% = 10,000,000.
Question 6. A warranty provision of ₦29,940,000 is required and the books hold ₦15,200,000. The charge to profit or loss is:
- ₦14,740,000
- ₦29,940,000
- ₦15,200,000
- ₦45,140,000
Show the answer
A. Only the increase is charged: 29,940,000 − 15,200,000 = 14,740,000.
Question 7. An entity expects to make an operating loss of ₦8,000,000 next year. It should:
- Provide in full
- Provide for half
- Make no provision, and consider whether assets are impaired
- Disclose a contingent liability
Show the answer
C. Future operating losses are not a present obligation (paragraph 63).
Question 8. On 20 December the board decides to close a depot. Nothing is announced or started before the 31 December year end. At 31 December:
- A full provision is made
- No provision is made
- A provision is made for redundancy only
- A contingent asset is disclosed
Show the answer
B. A board decision alone creates no constructive obligation (paragraph 75).
Question 9. A provision of ₦10,000,000 is made and an insurer will virtually certainly repay ₦4,000,000. The statement of financial position shows:
- A net provision of ₦6,000,000 only
- A provision of ₦10,000,000 and a separate asset of ₦4,000,000
- A provision of ₦4,000,000 only
- A note about the reimbursement only
Show the answer
B. The reimbursement is a separate asset and is not netted (paragraph 53).
Question 10. A claim of ₦5,000,000 against a supplier is probable to succeed but not virtually certain. The treatment is:
- Recognise the asset
- Recognise the income
- Ignore it
- Disclose as a contingent asset
Show the answer
D. A contingent asset is disclosed when the inflow is probable and recognised only when virtually certain.
Section B style: written questions
Question 11 (10 marks). (a) State the three conditions for recognising a provision under IAS 37. (3 marks) (b) Explain the difference between a provision and a contingent liability. (4 marks) (c) Explain how a contingent asset is treated. (3 marks)
Question 12 (20 marks). Okitipupa Foods Ltd has a 30 June year end. (1) Sales were ₦600,000,000 with a 12-month warranty. Experience is that 6% of sales are claimed at 45% of the sale price. The provision account holds ₦14,000,000. (2) A customer is suing for ₦30,000,000. A loss is more likely than not, the best estimate is ₦18,000,000, and the insurer will virtually certainly repay ₦10,000,000. (3) The company is claiming ₦7,000,000 from a supplier and success is probable but not virtually certain.
(4) On 28 June the board decided to close a factory, and the employees were told on 15 July. (5) Another claim of ₦9,000,000 has been made and the lawyers judge a loss remote.
(a) Calculate the warranty provision and give the journal. (5 marks) (b) Explain and show the treatment of the lawsuit and the reimbursement. (5 marks) (c) State the treatment of items (3), (4) and (5). (6 marks) (d) State the provisions and the reimbursement shown on the statement of financial position. (4 marks)
A further written question
Question 13 (10 marks). (a) A company sells goods with a warranty. It expects that 70% of goods will have no defects, 20% will have minor defects that would cost ₦2,000,000 if all goods were affected, and 10% will have major defects that would cost ₦8,000,000 if all goods were affected. Calculate the expected value of the warranty provision.
(4 marks) (b) A contract to supply goods for ₦6,000,000 will cost ₦7,500,000 to fulfil, and the company would pay a penalty of ₦1,200,000 to cancel it. State the provision and explain why. (6 marks)
Model answers
Show the model answer to Question 11
(a) A present obligation, legal or constructive, from a past event. A probable outflow of economic benefits to settle it. A reliable estimate of the amount. (b) A provision is a present obligation that meets all three conditions, so it is recognised as a liability.
A contingent liability is either a possible obligation that depends on uncertain future events outside the entity’s control, or a present obligation that is not recognised because an outflow is not probable or the amount cannot be measured reliably. It is not recognised, but it is disclosed unless the outflow is remote. If an outflow later becomes probable it is recognised as a provision.
(c) A contingent asset is a possible asset confirmed only by uncertain future events. It is not recognised, to avoid recognising income that may never be realised. It is disclosed if an inflow is probable, and the asset is recognised when the gain is virtually certain.
Show the model answer to Question 12
(a)
- Provision = 600,000,000 × 6% × 45% = ₦16,200,000.
- Opening balance 14,000,000, so the increase is 2,200,000: Dr Warranty expense 2,200,000, Cr Provision for warranty 2,200,000.
(b) A loss is more likely than not, so there is a probable outflow and a reliable estimate: provide ₦18,000,000 (Dr Legal expense 18,000,000, Cr Provision 18,000,000). The insurer’s repayment is virtually certain, so recognise a separate asset of ₦10,000,000 (Dr Reimbursement receivable 10,000,000, Cr Legal expense 10,000,000). The net charge is 8,000,000.
(c) Item (3): a contingent asset, disclosed because the inflow is probable and not recognised. Item (4): no provision at 30 June, because the employees were told only after the year end and nothing was started, so there was no constructive obligation. It is disclosed as an event after the reporting period if material. Item (5): a remote contingent liability, so no provision and no disclosure.
(d)
- Provisions.
warranty 16,200,000 + legal 18,000,000 = ₦34,200,000. - The reimbursement of ₦10,000,000 is shown separately as an asset and is not netted against the provision.
Show the model answer to Question 13
(a) Expected value = (70% × nil) + (20% × 2,000,000) + (10% × 8,000,000) = 0 + 400,000 + 800,000 = ₦1,200,000. (b) The contract is onerous, because the unavoidable costs exceed the benefits. If the company fulfils it, it loses 7,500,000 − 6,000,000 = 1,500,000. If it cancels, it pays a penalty of 1,200,000. The unavoidable cost is the lower of the two, so the provision is ₦1,200,000 (Dr Loss on onerous contract 1,200,000, Cr Provision 1,200,000).
Pathfinder on Provisions, contingent liabilities and contingent assets (IAS 37)
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
From the previous syllabus. Asks for the term for a present obligation arising from past events whose settlement is expected to result in an outflow of resources. The answer is a liability, which is the base definition for a provision.
Revise first: What a provision is
From the previous syllabus. Company final accounts questions that state that provisions are to be made for directors’ fees of ₦6,000,000 and audit fees of ₦2,500,000. You charge them as expenses and credit a provision or accrued expense.
Revise first: The ideas in more depth
Provisions, contingent liabilities and contingent assets are new syllabus items and no past diet asks for them directly. Expect items on the recognition conditions, a warranty provision calculation, and whether a given claim is provided for, disclosed or ignored. Check Section A of every diet you practise.
Revise first: Contingent liabilities and contingent assets
Source: ICAN Pathfinder, Financial Accounting. Diets covered: November Diet, 2014, November Diet, 2015, November Diet, 2021 and November Diet, 2022. Provisions, contingent liabilities and contingent assets are new syllabus items and no past diet asks for them directly. Diets before November 2014, and November Diet, 2024 onwards, are not covered here.
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