International Accounting Standard (IAS) 37, released in July 1999, sets out the criteria and rules for accounting for provisions. Specifically, IAS 37 sets out the rules around recognising, measuring, and disclosing provisions in financial accounts. In today’s article, as part of our accounting tutorial series, we will work through the critical points of this standard to help you better understand provisions and account for them in the financial statements.
Definition of Provisions
So what is a provision? It is a liability of uncertain timing and amount. Ok, so what is a liability then?
A liability is a present obligation arising from past events, and the settlement of this obligation will result in an outflow of economic benefits from an entity. The critical point here is the occurrence of a past event or obligating event that gives rise to an obligation.
So if there’s no past event, then there’s no obligation. However, provisions can still arise with legal or constructive obligations between the firm and third parties.
Legal and Constructive Obligations
The first one is a legal obligation that derives from some contract, legislation, or some other operation of law.
The second one is a constructive obligation, and they arise from a party’s actions, such as established practices or some statement of acceptance of responsibilities.
Under IAS 37, there is no difference between provisions created by legal or constructive obligations concerning their respective accounting treatment. However, identifying the underlying obligation, whether legal or constructive, may help you determine when to recognise a provision.
Accounting for Provisions
A provision must meet all three conditions for us to recognise it in the financial statements. Firstly, whether legal or constructive, there must be a present obligation due to some past event or obligating event.
Secondly, the outflow of economic benefits required to settle the obligation must be probable. The probability of having to pay rather than not having to pay must be more than 50 per cent. When the probability of an event is less than 50 per cent, we refer to its chance of occurrence as “possible”. And these events may come within the disclosers around contingent liabilities.
And thirdly, there must be a reliable estimate of the outflow of economic benefits. In other words, how much is it going to cost to settle the obligation? So if we cannot make a reliable estimate, a provision cannot be recognised.
Provision v Contingent Liability
To help decide whether we should bring a provision to account or contingent liability is disclosed, IAS 37 provides a helpful decision tree that focuses on one question. And that is:
“can you avoid the obligation by some future action?”
If the answer is yes, then we cannot bring a provision to account. For example, when a government introduces new goals, your company must train employees to stay updated. Your company may decide not to continue in business or not to train the personnel. Therefore a present obligation is not in place.
If the answer is no, and the other three criteria above can be met (past event, economic benefits and reliable estimate), then a provision should be accounted for. For example, a warranty you provide for products you are selling. If we run through the three criteria we used in the section above, you can see how a warranty comes under provision guidance.
In attaching the warranty to the goods sold, a potential obligation is created at each sale. Although it is unknown which sales will generate warranty claims, there is a known obligation created.
Outflow of Economic Benefits
A warranty issued does not involve any economic benefits flow, but certainly, there is that potential when a warranty claim is made. This may mean product replacement, repair or other compensation to the purchaser.
Reliable Estimate of Outflow
Of course, perhaps the most difficult part is a reliable estimate of what those costs could be when it comes to warranties. Certainly, this could be more difficult when starting, although trade data would be available for those businesses in well-established industries.
Accounting Entries – Contingent Liability
So far, we have been through what contingency liabilities and provisions are, and in particular with the latter, when these need to be brought to account. Next, we will look at a couple of examples, one for each type of disclosure, to show the type of work involved. First off are contingent liabilities.
A good example of a contingent liability disclosure is one we found in Volkswagen’s 2018 account accounts. Reproduced below is the table from their Note 36:
In the note, they go onto discuss the types of issues arising; for example, in regards to “Other contingent liabilities”, they state:
“The other contingent liabilities primarily comprise potential liabilities arising from matters relating to taxes and customs duties, as well as litigation and proceedings relating to suppliers, dealers, customers, employees and investors. The contingent liabilities recognized in connection with the diesel issue totalled €5.4 billion (previous year: €4.3 billion), of which €3.4 billion (previous year: €3.4 billion) was attributable to investor lawsuits.”
The purpose of the disclosures is to provide the reader with as much information as the company can disclose about future obligations that may arise and what the economic outflows might be.
Accounting Entries – Provisions
Because provisions require some debits and credits, we will focus on them in this section (however, IAS paragraphs 84 and 85 set out the provision note disclosure requirements). In the meantime, we will return to the example company we normally use, ABC Ltd. We will look at three common provisions made in business and often found in accounting exam questions.
Provision for Doubtful Debts
One of the most common forms of provisions is for doubtful debts. Businesses providing any sale on credit, and therefore having trade debtors on their balance sheet will experience delays on payment and, in some instances, no payment by customers. After a period of operation, or perhaps using trade industry data, a business can start to make a reliable estimate on the level of doubtful debts it will experience.
Specific and General Allowances
Now there are two types of allowances made for debts, specific and general. The titles are relatively self-explanatory. Specific allowances relate to specific debts that require a provision. Examples would include the debtor in financial difficulties or a legal dispute between the parties (which may also tie into a contingent liability disclosure for legal proceedings and their associated costs).
General allowances, of course, then relate to the business assessing its debtor books. From trading experience, it will understand what percentage of that balance it will have trouble or fail to collect on.
We’ll work through a general allowance as the debits and credits are the same for specific and general allowance.
General Allowance Provision Example
Set out below is an analysis of ABC’s trade debtors as of July 31. Out of a total of $20,000, $15,000 are within their trade terms and not in arrears. This leaves $5,000 that are now late in payment. These amounts are then split into 30 days tranches, starting with up to 30 days late in payment, all the way up to over 150 days late on a payment. Then for each tranche, ABC maintains historical data on the percentage of the balance it has trouble in collecting. The sum of these two figures provides us with a provision figure we can use for the journal entry.
The journal entry ABC’s accounting team would then prepare is detailed below. We have assumed that ABC already had a provision for trade debtors, but this was only for $1,000. So the journal entry reflects the adjustment required:
$1,315 (new provision figure) – $1,000 (old provision figure) = $315
|July 31||Allowance for Doubtful Debts||315|
|Provision for Doubtful Debts||315|
So the debt to the allowance is an expense and will be reflected in the profit and loss account. At the same time, the credit to the provision account is a contra asset account and is reflected in the balance sheet. An extract from ABC’s accounts is below as an example.
Provision for Depreciation
We already cover the theory behind accounting for depreciation provisions n a couple of other tutorials, so we’ll skip that here. However, the journal entry is worth going over again. Borrowing from one of our previous tutorials on this topic, ABC has new machinery and accounts for $140,000 in depreciation at year-end. So the journal entry required to bring this into the books is:
|March 31||Depreciation – Machinery||140,000|
|Provision for Depreciation – Machinery||140,000|
If you checked out the tutorial we referenced above, you would have noticed that we referred to the “provision for depreciation” as “accumulated depreciation” in that article. Don’t be confused; it means the same thing.
So the debit to depreciation is an expense and is disclosed in the profit and loss statement. While the credit to the provision account, which is a contra asset account, is disclosed in the balance sheet – being netted against the machinery asset account. An extract from the balance sheet is below.
Provision for Warranties
An IAS 37 warranty provision requires the same journal entries as we have already covered above, and like doubtful debts, an analysis of how much the provision should be for. So let’s look at an example with ABC Ltd and how it makes this journal entry.
ABC Ltd has a sideline of selling landscaping machinery and tools to the general public. From its small shop, the line of products covers electric tillers/cultivators. With the brand, it sells it provides a two-year warranty on these units. Over the years, ABC Ltd collects the following data:
- sell on average 150 units per year;
- there is about a 4 per cent warranty claim; and
- each warranty costs approximately $200 in repairs and/or replacement.
So with this information, we can calculate the warranty cost figure:
150 x 4 % x $200 = $1,200
|April 1||Warranties Expense||1,200|
|Provision for Warranties||1,200|
The debit of the entry raises an expense for the anticipated warranty expense for the electric tillers/cultivators over the year. This part of entry shows up in the profit and loss statement. At the same time, the credit creates the provision (liability) for disclosure in the balance sheet.
And warranties brings us to the end of our tutorial, looking at accounting for provisions under IAS 37. If you have any questions, please use the comment section below, the ask a question page or our contact us section.