How to Account for Provisions – Practical Questions
Today, let’s be practical.
A couple of weeks ago, I published an article about IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
I received a lot of questions from you, so here I try to give you my answers to the issues that popped out the most frequently.
If there’s any issue you face, share it with us in the comments below. Now, let’s jump right in.
#1: Should we book a provision based on the budget?
We had a budget for advertising services approved for this year with monthly breakdown. Total amount of the budget was CU 130 000, however, until the year-end, we spent only CU 125 000. The bills from advertising company total CU 115 000, with CU 10 000 still unbilled at the year-end.
Can we make a provision for unused budget for advertising services? If yes, in what amount?
Answer to question #1
No, you cannot, unless you have some conditions in the contract with the advertising company about minimum billing per year.
If there are no such conditions, then there’s no past event and neither constructive nor legal obligation for payment was created.
Therefore, no provision based on the budget.
For the services used and not paid, you should make an accrual in the amount of CU 10 000 (unbilled at the year-end).
#2: When should we book a long-term provision (e.g. environmental and removal provision)?
We are constructing a plant (e.g. oilrig, nuclear power plant, etc.) and the local legislation requires us to remove the plant and restore the site at the end of the plant’s useful life.
The estimated useful life of the plant is 30 years and our experts estimate the costs related to its removal and restoring the site at CU 1 000 000, thereof:
- The amount of CU 800 000 relates to the removal of the plant and rectifying damages caused by the construction of the plant;
- The amount of CU 200 000 relate to rectifying the damages caused by the operation of the plant.
When should we book a provision? Should we spread its recognition straight-line over 30 years?
Note: Here, we don’t talk about measurement of this provision, but bear in mind that you should take many factors into account when estimating long-term provision, including time value of money (discounting), inflation, changes in estimates, probabilities, etc.
Answer to question #2
A provision should be recognized when there’s a present obligation as a result of past event.
Therefore, you cannot spread the recognition of this provision straight-line over 30 years, because the corresponding past event – construction of the plant – happens right when the plant is constructed.
What you should do instead:
- A provision for the removal of the plant and rectification of damages caused by its construction of CU 800 000 shall be recognized when the plant is being constructed, as the construction itself gives rise to an obligation to remove it.
This provision is debited or included in the cost of the plant.One practical point: Construction of such a plant can take years. Here, you should NOT recognize a provision at the end of the construction only, but you should gradually recognize the provision over the construction.
The reason is that right after the first works are performed on the site, the past event arose and the obligation was created. Your experts should advise you what cost is associated with the removal of the construction works performed up to the specific reporting date.
- A provision for the rectifying the damages caused by the operation of the plant of CU 200 000 shall be recognized when these damages are caused, i.e. during the plant’s operation.
Similarly as before, you should estimate how many damages you made on the site by the plant’s operation during the particular year and NOT automatically recognize a provision on a straight-line basis.This provision is NOT included in the cost of the plant, but expensed in profit or loss.
#3: What discount rate shall we use for determining the present value of our provision?
How shall we set the discount rate used in arriving at present value of a provision? Our provision will be settled after 30 years and therefore, the small shift in the discount rate can result in huge differences.
Answer to question #3
It’s true that IAS 37 does not give us much guidance about how to set the discount rate. It just says that the discount rate should be:
- Pre-tax rate;
- Reflecting current market assessment of the time value of money; and
- Reflecting the risks specific to the liability.
There are more ways to set the appropriate discount rate and let me offer you just one of them:
- You can take a government bond rate as a basis. This would be a risk-free and pre-tax rate. Make sure you take bonds with the similar maturity as your liability settlement time (e.g. when you expect to settle the liability in 30 years, then you should take bonds with maturity in 30 years).
If there are no such bonds, then you need to take more issues of government bond with various maturity dates, construct a yield curve and extrapolate along the yield curve to get your own discount rate.
- Careful about inflation! Make sure you don’t include inflation twice. In other words:
If you use nominal discount rate (just as it is), then make sure your future cash flows are expressed in the future estimated prices.
If your cash flows are in the current prices (they are not increased by estimated future inflation), then use a real discount rate excluding the effect of inflation.
- Sometimes, it is necessary to adjust the risk-free rates for the risks associated with the liability. Again, there’s no precise guidance in IAS 37 on how to do it.
As a suggested method, you can discount the risk-adjusted cash flow at the risk-free rate first and you get the present value of “A”. Then you can determine what rate will give you the present value of “A” from your future unadjusted cash flow. This will be your risk-adjusted rate.
#4: How should we calculate the amount of a provision for legal case?
We face a legal claim. Our lawyers believe that there’s:
- 70% chance of losing the case and we will have to pay CU 100 000 to settle the claim; and
- 30% of winning the case with zero payment.
Can we recognize a provision of CU 70 000 (CU 100 000*70% + CU 0*30%)?
Answer to question #4
No, this is not the correct approach.
The reason is that in this case, the outcome of the court proceedings will never be CU 70 000 – it will be either CU 100 000, or CU 0.
In other words, the expected value method is NOT appropriate in this case. Here, IAS 37 advises that the provision should measured at the most likely outcome.
As the probability of loss is 70%, this is the most likely outcome and the company would have to pay CU 100 000. Therefore, the provision of CU 100 000 shall be made.
#5: Should we book a provision even if we expect a reimbursement from our insurance company?
We caused a damage amounting to CU 30 000, but we hold an insurance policy covering “the third party liability” and as a result, we expect the insurance company to reimburse the damages. At the end of the reporting period, no reimbursement was made. Should we still recognize a provision and if yes, in what amount?
Answer to question #5
Yes, you should.
The reason is that your liability and your right to its reimbursement are two separate items.
As you have a present obligation as a result of past event, you should definitely make a provision amounting to CU 30 000.
In relation to the reimbursement, if it’s not certain or virtually certain, you should not recognize any asset. You should just disclose the existence of a contingent asset in the notes to the financial statements if it is probable.
If you face any similar issue with the provisions, please let me know in the comments. And if you find this article helpful and useful, share it with your friends. Thank you!
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44 Comments
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Hi everyone,
I would like to seek your help in following inquiry.
We keept the bonus provision in FY 2023, however, actual pay out exceeds the provision, so how should I treat the excess payment of bonus. Should I change the financial statement (events after the reporting period) ?….or book it as bonus expense in FY 2023.
Looking forward for your help
Hi Tandin,
it depends. Is the excess material or not? Have you already closed the accounts of 2023 or not? If it is highly impractical to go back to 2023, and the excess is not material, then just recognize the excess as an expense in 2024. I hope this helps, S.
Hello!
A company has a practice of paying performance base variable allowances every year and accordingly created a provision and expenses adjusted at the year end. The excess provision is considered as an income in the subsequent year and passed the reversal entry through the profit and loss account.
However, some proponents suggests that it has to be routed through changes in equity rather than in the statement of comprehensive income. Kindly share your expert opinion please?
Hi SIlvia, Do discount rates used for provision calculation should be revisited frequently and adjust the present values or the assumptions took on initial recognition holds good. especially when the interest rates turns out to be negative.
i have fallen inlove with this lectures, i come back every day
God bless you
A company has initiated legal proceedings against its customer / client as the customer did not approve certain value of works done in a construction contract. The contract works is completed and customer is unwilling to certify that portion and hence legal claim is initiated. Should the company make provision against legal expenses at inception when a suit is filed or account this as and when legal service is provided by the legal consultant
Hi Silvia,
is it acceptable to book provision for leave as a reversing journal, such that for every month you post the actual amount of the provision and not the movement as the previous month’s journal would have reversed at the beginning of the month.
Yes, that’s just a technicality with the same result (in most cases).
Hello Silvia,
Example: A motor vehicle which is worth USD500 (Manufacturer price) and when the vehicle come to my country, we have the option to pay to the government its duty amount (50% of the manufacturer price) when the vehicle is sold (In the meantime it is stored in a bonded area). If a client have duty free benefits from government, then this 50% is not paid. If at the end of the reporting period, I have stock of vehicles which have duty not yet paid, should I provisioned the duty amount in the cost of the stock which will be paid in the future based on an average? (With consideration that there may be the possibility that a duty free client may buy this same vehicle) Or no provision is required?
Thanks Silvia
Hi Avish, interesting question. I assume that the motor vehicles in question are in fact your inventories and you are a distributor. So, now the question is: is that duty your obligation or the obligation of a client? Having that said, if you never sell the vehicle (hypothetically), will you as a dealer have to pay the duty? I am trying to find out here what the obligating past event is – mere import through borders? Actually starting to use the vehicle? It can be that this is not your obligation, but the obligation of your client and in this case, no provision is necessary. I really cannot conclude from your description.
Hi.j). A class action against the company has been instituted by employees of the company. They claim that the dust in the factories made them suffer from TB. A total of $6 000 000 is being claimed. The company’s attorney advise the company that the case could go either way. Total legal cost payable should the company lose, amount to $8 200 000.Do we treat this as a legal obligation or not…if yes how do we record it in the books
Hello
In an instance where a provision has been overprovided in a previous financial year (Debit Expense, Credit Provision) and needs to be reversed in a subsequent financial year, will the reversal be booked to the same Expense line where it was originally recognised or will it go under Other Income.
Thanks
Hello
If you were estimating a future restoration provision, do you believe any future overheads associated with the restoration works should be included in the provision. I’m thinking not since these are arguably not incremental and would be incurred anyways ? Or of you can demonstrate they are directly attributable this would suffice ?
Hi! I just want to ask if these 2 situations should have an accrued provisions? Why or why not?
Western Oil Company had several contingent liabilities on December 31, 2020. The auditor obtained the following brief description of each liability.
1. In May 2020, Zarraga bought action against the company for polluting the Zarraga River with its waste products.
It is probable that Zarraga will be successful but the amount of damages Western Oil Company might have to pay should not exceed P1,500,000
2. A personal injury liability suit for P500,000 was brought against Western Oil Company in December 2020.
The management and legal counsel of Western Oil Company concluded that it is not probable that Western Oil Company will be responsible for damages and that P200,000 is the best estimate of the damages.
Seems like homework from school…. please study and work on yourself 🙂
Hi
I am subsidiary company building a utility plant. Provision to dismantle is recognised at discounted method. However the amount to dismantle will be reimbursed by parent company as per contract. So we are recording receivables as right to receive exist. But there is a huge gap between receivables and provision due to provision being recorded at discounted value. Can we by any chance record discounted receivables given it is just reimbursment at end of life of project and it is not revenue?
How to allocate the dismantling cost for each year?? After first year calculation, should it mention as finance cost and provision or should add that particular amount with asset cost and provision ???? Could you explain how we have to allocate each year?
Can you help me with this issue
A company has a short term loan that will mature in 6 months’ time. The company’s common practice is to settle the liability before the maturity date. In that sense can I say that the timing and amount are uncertain. So can I recognize “provision for interest” as per IAS 37???
No, this is not a provision for interest. If you apply effective interest rate method for the loan, then you should know exactly how much interest you should recognize in profit or loss at the reporting date.
Hi Silvia,
Thanks a lot for your explanation of the above mentioned issues. It’ll be very helpful to me if you give your comment on the following issue:
A company has special medical allowance for an employee USD 12000 for 12 months which has to be paid on the basis of actual expense incurred (reimbursement of expense). If not incurred, no allowance is to be paid. But past history shows in every month an amount of USD 800 minimum is required to pay for the medial treatment to this employee. Amount may vary in every month. Is it required for the company to recognise provision for this allowance monthly? If any, then How?
Hello Silvia,
If a company owns a closed factory site which it wants to sell, however there is some contamination in the soil which is not required by the law to be removed since contamination is not severe. However in order to be able to sell the land the company decides it is best to remove the contamination before selling since otherwise the land could not be sold. Let’s assume the cleaning costs 1 million and the estimated sales price after decontamination is only 0.9 million. Can the company book a provision for 1 million?
Hi Siliva,
Appreciate your hard work to clarify many doubts. Would appreciate if you can clarify this too:
I have Raw material which is converted into a semi-finished stage and found not fit and sent for rework. Now the rework can be used within 1 year after which it will be expired. Normally we use it and there is no expiry. In this case, do we need to make a provision even if we have reached 9 months and we are confident that we will use all before it expires?
Hi Naseer,
this question is not about provisions under IAS 37, but about valuation adjustments for inventories under IAS 2. If it’s not yet expired and you have past experience of no expiries, then why making a valuation adjustment? 🙂 S.
Hi Silivia,
Great explanation. Thank you. Just to ask, When should we start to discount the provision. I presume that it would be wrong to discount in year. Is that correct or could you provide more light on this?
Henry, you need to start discounting the provision right when you book it – if you assume that you will incur the related costs after more than 12 months after the reporting period. Then each year you need to book the interest (unwind the discount). S.
Dear Silvia,
I have a question with respect to valuation allowance and provision for liquidated damages.
As per IFRS we create valuation allowance against customer receivables based on customer credit rating. So if a customer credit rating is poor, more valuation allowance is created and vice versa.
In a particular situation, we have found that customer has withheld some part of receivable against a liquidated damage that customer claims from us due to some contract breach. We have also created a provision based on estimate for this liquidated damage.
The question is, should valuation allowance be created against that part of receivable which customer has withheld? since we already have 100% provision in terms of liquidated damages ?
Please advise.
Thank you
Hello Silvia,
A company enters into a long term contract (say five years) for purchase of inventory. At the end of the current year, the market price of the inventory decreased by 25%.
Under IAS 37, do we need to recognize loss in the current year itself for the loss that may arise in the coming four years or only disclosure is required in financials?
Thank you.
Dear Abdul,
You would need to recognize a provision for onerous contract, but I don’t think this contract can be seen as onerous under IAS 37 (the contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it). It depends on whether the fact that you buy more expensive than at the market would put you to a loss (e.g. you would need to decrease sales prices of your products as a result of decreased input prices). If that’s not the case, then there’s no reason to recognize a provision, because you would not make any loss.
You do not make any provision just because you buy 25% than the market. S.
Hi Silvia,
Thank you so much for your notes, it is really helpful.
For the second example, could you please kindly explain why the CU 800K should be capitalised as part of assets?
Kind Regards,
Jing
Question 2: “This provision is debited or included in the cost of the plant.”
So you should:
Dr PPE CU 800K
Cr Provision CU 800K
… and depreciate the 800K in line with the life of the plant?
Also, when you say “this provision is debited”, what do you mean as the alternative to capitalazing the provision? What is the double-entry for this?
Thanks.
FB
Hi Frodo,
the entry is correct. When I say “the provision is debited”, it is the same as saying “capitalizing the provision”. Also, you do not depreciate 800K separately, but within the cost of the plant. Hope this helps!
Galadriel
Great Explanation.
Hi, in below senecio can we make provision on monthly basis for future certain expenditure ie
1.quartelly /annual agreed audit fees to be paid to auditors on completion of quarter / year end assignment .
Hi Silvia,
First thanx a lot for ur article regarding IAS 37. I have a doubt.
In the example 2, at the construction stage, shall the Liabelity / Provision be the present value of the obligation? (800,000)
If so, then the changes in the Present value shall account as interest cost?
In the same example,at the inception of the contract can we identify a certain value for the provision to be made for operation (200,000) because it changes due to conditions exists in operating time.( in the Example it says total provision is 1,000 where 800 & 200. My dough with 200 & can we say by accumulating these two as 1000)?
Regards.
Hi Chinthaka,
of course, the provision has to be at its present value as it will be settled in more than 12 months after the reporting period – but that’s what I wrote somewhere up there – that here, we don’t care about the measurement now – only the method of recognition. Measurement of long-term provisions is a big topic itself.
When you recognise the provision at the present value, then you book interest cost on it each year (it’s called “unwinding the discount”).
Your second question – you should not accumulate these 2, because they are recognised in a different way as written above. And of course, each year the provision amount should be updated.
S.
Hi,
Could you clarify the unwinding the discount more?
When you discount the provision to the present value, you need to charge interest on it each year to bring it to the actual estimate in the future – that’s called unwinding the discount. S.
Hi Silvia,
In the second example, it mention that ” A provision for the removal of the plant and rectification of damages caused by its construction of CU 800 000 shall be recognized when the plant is being constructed, as the construction itself gives rise to an obligation to remove it.”
Here a think the word shall be not provision but Liability. Because the time & amount is certain. If those two (Time & Amount) uncertain we call it as provision. here the liability to be occur after 30 years & the amount is CU 800,000.
What is opinion regarding thiz ?
Regards. 🙂
No, I beg to disagree. The reason is that CU 800 000 is an estimate by the expert and not the liability. The liability is when you have an invoice – so the exact amount and timing of payment is known (there’s usually stated how much and when you should pay). But here, each year conditions change, timing may change, so calling it a liability is wrong. How do you know, for example, that you will have to pay exactly 800 000 and not 800 010? Also, who is the counterpart of this “liability”? To whom are you going to pay? These things are NOT certain at the time of making provision, that’s why it is not the liability. S.
How to allocate the dismantling cost for each year?? After first year calculation, should it mention as finance cost and pfovision or should add that patyicular amount with asset cost and provision ???? Could you explain how we have to allocate each year?
Hi Silvia
Great Article.
Questions 2/3
Assuming the construction took 4 years(and this was known from the start), and an equal portion of plant and rectification of damages caused by its construction of CU 800 000 was advised by the experts each year, would the computation of liability of CU 200,000 per year be discounted to 34,33, etc years respectively?
Regards
Yes, that’s right. Once you book a provision, you need to update it’s amount each year. Try to look at it as at 4 separate provisions – 200 000 for each year. S.
Hi
But in this instance, when discounting a provision of 200,000 per year, for 4 years, for 34-31 years respectively, the amount booked is way different from 200,000.
Toyin,
yes, it’s right, but that’s what I have written up there in the article. I wrote that we do not care about measurement (=how much), but about recognition itself (=when). I talk about measurement in a detail in my IFRS Kit. S.