• University Malaysia Sarawak

• ACCOUNTING 501  Final Revision (A)

Revision
Provision, Contingent liabilities, and Contingent asset
1. Present obligation from a past event
This rule has two parts, first the type of obligation, and second, the requirement for it to
come from a past event (something must have already have happened to create the
obligation).
(a) Type of obligation
The obligation could be a legal or contractual one, arising from a court case or some kind
of contractual arrangement. Most candidates are able to spot this in exams, identifying
the presence of a potential obligation of this type.
The second type of obligation is one called a constructive obligation. This is where a
company establishes an expectation through an established course of past practice.
Example
Rey Co has a published environmental policy. In this, Rey Co explains that they always
replant trees to counter-balance the environmental damage created by their operations.
Rey Co has a consistent history of honoring this policy. During 20X8, Rey Co opened a
new factory, leading to some environmental damage. Rey Co estimates that the damage
will cost $400,000 to restore.
Even if the country has no legal regulations forcing Rey Co to replant trees, Rey Co will
have a constructive obligation because it has created an expectation from its publications,
practice and history.
(b) Past event
The obligation needs to have arisen from a past event, rather than simply something
which may or may not arise in the future.
Example
Rey Co would have to provide for a potential legal case arising from an employee who
was injured at work in 20X8 due to faulty equipment. This is because the event arose in
20X8 which could lead to an obligation.
Rey Co could not provide for any possible claims which may arise from injuries in the
future. That is because there is no past event which has created the obligation. Similarly,
if Rey Co has to pay to install new safety equipment in the factory in 20X9, there is no
present obligation to do this in 20X8, so no provision is required. Rey Co could delay the
work until 20X9, or sell the building.
2. Reliable estimate
In an exam, it is unlikely that there will not be a reliable estimate. Likewise it is unlikely
that an entity will be able to avoid recording a liability when there is an obligation by
claiming there is no way of producing an estimate of the amount. The main rule to follow
is that if the item is a one-off item, the best estimate will be the most likely outcome. If
the item is made up of a number of items, such as a warranty provision for repairing
goods, the expected value should be calculated using the probability of all events
happening.
Example – best estimate
Rey Co has received legal advice that the most likely outcome of the court case from the
employee is that they will lose the case and have to pay $10m. The legal team think there
is an 80% chance of this. They believe there is a 10% chance of having to pay $12m, and
a 10% chance of paying nothing.
In this case, Rey Co would provide $10m, being the most likely outcome. It will not be
uncommon to take the $12m, thinking that the worst-case scenario should be provided for.
Other candidates may calculate an expected value based on the various probabilities.
Example – expected value
Rey Co gives a year’s warranty with all goods sold during the year. Past experience
shows that Rey Co needs to do no repairs on 85% of the goods. On average, 10% need
minor repairs, and 5% need major repairs. Rey Co’s manufacturing manager has
calculated that if minor repairs were needed on all goods it would cost $100,000, and
major repairs on all goods would cost $1m.
Here, the provision would be measured at $60k. The expected cost of minor repairs
would be $10k (10% of $100k) and the expected costs of major repairs are $50k (5% of
$1m). This is because there will not be a one-off payment, so Rey Co should calculate the
estimate of all of the likely repairs.
3. Probable outflow
The final criteria required are that there needs to be a probable outflow of economic
resources. There is no specific list of what % likelihood is required for an outflow to be
probable. A probable outflow simply means that it is more likely than not that the entity
will have to pay money out.
If it appears that there is a possible outflow then no provision is recorded. In this situation,
a contingent liability would be reported. A contingent liability is simply a disclosure note
shown in the notes to the accounts. There is no double entry recorded in respect of this.
Instead, a description of the event should be given to the users with an estimate of the
potential financial effect. In addition to this, the expected timing of when the event
should be resolved should also be included.