BATANGAS STATE UNIVERSITY

The National Engineering University

Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and International
Hospitality Management

INTERMEDIATE ACCOUNTING II
BS Management Accounting
1st Semester, AY 2024 - 2025
Reference: Conrado Valix, et.al

PROVISION
A provision is an existing liability of uncertain timing or uncertain amount. The essence of a provision is
that there is uncertainty about the timing or amount of the future expenditure.

Actually, a provision may be the equivalent of an estimated liability or a loss contingency that is accrued
because it is both probable and measurable.

Recognition of Provision
PAS 37, paragraph 14, provides that a provision shall be recognized as a liability in the financial
statements under the following conditions:
a. The entity has a present obligation, legal or constructive, as a result of a past event.
b. It is probable that an outflow of resources embodying economic benefits would be required to
settle the obligation.
c. The amount of the obligation can be measured reliably.

For a provision to qualify for recognition there must be not only a present obligation but also a probable
outflow of resources embodying economic benefits to settle the obligation. An outflow of resources is
regarded as probable if the event is more likely than not to occur. As a rule of thumb, probable means
more than 50% likely or substantially more. Possible means 50% or less likely to occur. Remote means
10% or less likely to occur or very slight occurrence.

Where no reliable estimate can be made, no liability is recognized.

Measurement of Provision
Where a single obligation is being measured, the individual most likely outcome adjusted for the effect
of other possible outcomes may be the best estimate.

Where there is a continuous range of possible outcomes and each point in that range is as likely as any
other, the midpoint of the range is used.

Where the provision being measured involves a large population of items, the obligation is estimated by
"weighting" all possible outcomes by their associated possibilities. The name for this statistical method of
estimation "expected value".

Illustration 1
An entity sells goods with a warranty under which customers are covered for the cost of repairs of any
manufacturing defects that become apparent within 6 months after purchase.

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 BATANGAS STATE UNIVERSITY
The National Engineering University
Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and International
Hospitality Management

If minor defects are detected in all products sold, repair costs would be about P 1,000,000. If major
defects are detected in all products sold, repair costs of 5,000,000 would result.
The entity's past experience and future expectations indicate that 75% of the goods sold will have no
defects, 20% will have minor defects and 5% will have major defects.

The expected value is computed as:

Illustration 2
An entity is a defendant in a patent infringement suit. The lawyers believe that there is a 60% chance that
the court will not dismiss the case and the entity will incur an outflow of future economic benefits. If the
court rules against the entity and in favor of the claimant, the lawyers believe that there is a 30% chance
the entity will be required to pay damages of P4,000,000 and a 70% chance that the damages will be
P2,000,000.

A 10% risk adjustment factor to the probabilities of the expected cash flows is considered appropriate to
reflect the uncertainties in the cash flow estimate.

RISKS AND UNCERTAINTIES

Risk describes variability of outcome. A risk adjustment may increase the amount at which a liability is
measured. As prudence dictates, caution is needed in making judgment under conditions of uncertainty
so that income and assets are not overstated, or expenses and liabilities are understated.

PRESENT VALUE OF OBLIGATION

Where the effect of the time value of money is material, the amount of provision shall be the present
value expenditure expected to settle the obligation.

The discount rate should be a pretax rate that reflects the current market assessment of the time value of
money and the risk specific to the liability. The discount rate should not reflect the risk for which cash
flow estimates have already been adjusted.

FUTURE EVENTS
Future events that affect the amount required to settle an obligation shall be reflected in the amount of a
provision where there is sufficient evidence that they will occur.

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 BATANGAS STATE UNIVERSITY
The National Engineering University
Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and International
Hospitality Management

EXPECTED DISPOSAL OF ASSET

Gain from expected disposal of asset shall not be taken into account in measuring a provision. Instead,
an entity shall recognize gain on disposal at the time of the disposition of the asset. In other words,
any cash inflows from disposal are treated separately from the measurement of the provision.

REIMBURSEMENTS
Where some or all of the expenditure required settling a provision is expected to be reimbursed by
another party, the reimbursement shall be recognized when it is virtually certain that reimbursement
would be received if the entity settles the obligation.

The reimbursement shall be treated as a separate asset and not netted against the estimated
liability for the provision. The amount of reimbursement shall not exceed the amount of the
provision.

CHANGES IN PROVISION
Provisions shall be reviewed at every end of the reporting period and adjusted to reflect the current best
estimate. The provision shall be reversed if it is no longer probable that an outflow of economic benefits
would be required to settle the obligation. Where discounting is used, the carrying amount of the
provision increases each period to reflect the passage of time.

USE OF PROVISION
Future operating losses provision shall not be recognized for future operating losses. In other words, a
provision for operating losses is not recognized because a past event creating present obligation has not
occurred.

ONEROUS CONTRACT
If an entity has an onerous contract, the present obligation under the contract shall be recognized and
measured as provision.

An onerous contract is a contract in which the unavoidable costs of meeting the obligation under the
contract exceed economic benefits expected to be received under it. PAS 37, paragraph 68, mandates that
the unavoidable costs under a contract represent the least net cost of exiting from the contract.
The lower amount between the cost of fulfilling the contract and the compensation or penalty arising
from failure to fulfil the contract is the least cost of exiting from the contract.

Examples of provision
1. Warranty - The best estimate of the warranty cost is recognized as a provision because there is
clear constructive obligation arising from an obligating event which is the sale of the product
with warranty.
2. Environmental contamination —- If an entity has an environmental policy such that other
parties would expect the entity to clean up any contamination, or if the entity has broken current
environmental legislation then a provision for environmental damage shall be made. The
obligating évent is the contamination of the property which gives rise to constructive or legal
obligation. A provision is recognized for the best estimate of the cost of cleaning up the
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 BATANGAS STATE UNIVERSITY
The National Engineering University
Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and International
Hospitality Management

contamination.
3. Decommissioning or abandonment cost — When an oil entity initially purchases an oil field} it
is put under a legal obligation to decommission the site at the end of its life. The cost of
abandonment or decommissioning shall be recognized as a provision and may be capitalized as
cost of the oil field.

4. Court case — After a wedding in the current year, ten people died possibly as a result of food
poisoning from products sold by the entity. Legal proceedings are started seeking damages from
the entity. When the entity prepares the financial statements for the current year, the lawyers
advise that owing to the developments in the case, it is probable that the entity would be found
liable. A provision is recognized for the best estimate of the damages because there is a present
obligation

5. Guarantee - In the current year, an entity gives a guarantee of certain borrowings of another
entity. During the year, the financial condition of the borrower deteriorates and at year-end, the
borrower files a petition for bankruptcy. A provision is recognized for the best estimate of the
guarantee obligation because there is legal obligation arising from the obligating event which is
the guarantee.

RESTRUCTURING
PAS 37, paragraph 10, defines restructuring as a program planned and controlled by management and
materially changes either the scope of a business of an entity or the manner in which that business is
conducted. Events that may qualify as restructuring include:
a. Sale or termination of a line of business
b. Closure of business location in a region or relocation of business activities from one location
to another or relocation of headquarters from one country to another.
c. Change in management structure, such as elimination of a layer of management or making
all functional units autonomous.
d. Fundamental reorganization of an entity that has a material and significant impact on its
operations.

Provision for Restructuring

Recognition of the provision for restructuring is required because a constructive obligation may arise
from the decision to restructure.

A constructive obligation for restructuring arises when two conditions are present:
1.The entity has a detailed formal plan for the restructuring which includes the following:
a. The business being restructured.
b. The principal location affected.
c. The location, function and approximate number of employees who will be compensated
for terminating their employment.
d. Date when the plan will be implemented.
e. The expenditures that will be undertaken.

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 BATANGAS STATE UNIVERSITY
The National Engineering University
Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and International
Hospitality Management

2. The entity has raised valid expectation in the minds of those affected that the entity will carry
out the restructuring by starting to implement the plan and announcing the main features to those
affected by it.

Amount of Restructuring Provision

A restructuring provision shall include only direct expenditures arising from the restructuring.Such
expenditures are necessarily incurred in connection with the restructuring and not associated with the
ongoing activities of the entity.

For example, salaries and benefits of employees to be incurred after operations cease and that are
associated with the closure of the operations shall be included in the amount of the restructuring provision.
PAS 37, paragraph 81, specifically excludes the following expenditures from the restructuring provision:
a. Cost of retraining or relocating continuing staff
b. Marketing or advertising program to promote the new company image.
c. Investment in new system and distribution network.

CONTINGENT LIABILITY
PAS 37, paragraph 10, defines a contingent liability in two ways:
1. A contingent liability is a possible obligation that arises from past event and whose existence
will be confirmed only by the occurrence or nonoccurrence of one or more Uncertain future
events not wholly within the control of the entity.
2. A contingent liability is a present obligation that arises from past event but is not recognized

because it is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation or the amount of the obligation cannot be measured reliably.

Contingent liability and provision

The second definition states that a contingent liability is a present obligation. However, the present
obligation is either probable or measurable but not both to be considered a contingent liability.
If the present obligation is probable and the amount can be measured reliably, the obligation is not a
contingent liability but shall be recognized as a provision.

Treatment of contingent liability

A contingent liability shall not be recognized in the financial statements but shall be disclosed only. The
required disclosures are:
a. Brief description of the nature of the contingent liability.
b. An estimate of its financial effects.
c. An indication of the uncertainties that exist.
d.Possibility of any reimbursement.

If a contingent liability is remote, no disclosure is necessary.

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 BATANGAS STATE UNIVERSITY
The National Engineering University
Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and International
Hospitality Management

CONTINGENT ASSET
A contingent asset is a possible asset that arises from past event and whose existence will be confirmed
only by the occurrence or non occurrence of one or more uncertain future events not wholly within the
control of the entity.

A contingent asset shall not be recognized because this may result to recognition of income that may
never be realized. However, when the realization of income is virtually certain, the related asset is no
longer contingent asset and its recognition is appropriate.

A contingent asset is only disclosed when it is probable. The disclosure includes a brief description of the
contingent asset and an estimate of its financial effects.

If a contingent asset is only possible or remote, no disclosure is required.

DECOMMISSIONING LIABILITY
A decommissioning liability is an obligation to dismantle, remove and restore an item of property, plant
and equipment as required by law or contract. A decommissioning liability is also called asset retirement
obligation.

Illustration
On January 1, 2022, an entity engaged in extracting natural gas and oil constructed a drilling platform
for P25,000,000 and is required by Philippine law to remove and dismantle the platform at the end of its
useful life of 10 years.

The straight line method is used in depreciating the drilling platform. The entity had estimated that such
decommissioning will cost P5,000,000. Based on a 12% discount rate, the present value of 1 for 10 years
is 0.322.

What are the journal entries for 2022 and 2023?

Settlement of decommissioning liability

On December 31, 2031, after 10 years, the entity contracted with another entity to dismantle and remove
the drilling platform for P 5,500,000.

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 BATANGAS STATE UNIVERSITY
The National Engineering University
Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and International
Hospitality Management

Change in decommissioning liability

Under IFRIC 1, changes in the measurement of an existing decommissioning liability shall be accounted
for in the following manner:
1. A decrease in the liability is deducted from the cost of the asset. If the decrease in liability
exceeds the carrying amount of the liability, the excess is recognized in profit or loss.
2. An increase in liability is added to the cost at the asset. However, the entity shall consider
whether this is an indication that the carrying amount of the asset may not be fully recoverable.

If there is such an indication, the asset should be tested for impairment.

Illustration
On January 1, 2022, the plant of Seaoil Company is 10 years old. The cost of the plant was12,000,000
with accumulated depreciation of P 4,000,000.
The plant had a useful life of 30 years and was depreciated using the straight line with no residual value.
Because of the unwinding discount of 6% over 10 years, the decommissioning liability had grown from
P 1,000,000 to 1,790,000

On January 1, 2022, the discount rate has not changed. However, the entity had estimated that as a result
of technological advances, the present value of the decommissioning liability had decreased by
P800,000.

What are the journal entries for 2022?

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 BATANGAS STATE UNIVERSITY
The National Engineering University
Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and International
Hospitality Management

EXERCISES
1. During 2022, Odyssey Company is the defendant in a patent infringement lawsuit. The entity's
lawyers believed there is a 30% chance that the court will dismiss the case and the entity will
incur no outflow of economic benefits.

However, if the court rules in favor of the claimant, the lawyers believed that there is a 20%
chance that the entity will be required to pay damages of P200,000 and an 80% chance that the
entity will be required to pay damages of P 100,000. Other outcomes are unlikely.

The court is expected to rule in late December 2023. There is no indication that the claimant will
settle out of court.

A 7% risk adjustment factor to the probability-weighted expected cash flows is considered

appropriate to reflect the uncertainties in the cash flow estimates. An appropriate discount rate is
5% per year. The present value of 1 at ‘5% for one period is 0.95.

What amount should be recognized as undiscounted cash flows for the provision?

What amount should be reported as provision for lawsuit on December 31, 2022?
2. During 2022, Beal Company became involved in a tax dispute with the BIR. On December 31,
2022, the entity's tax advisor believed that an unfavorable outcome was probable and the best
estimate of additional tax was P 500,000 but could be as much as P650,000.

After the 2022 financial statements were issued, the entity received and accepted a BIR
settlement offer of P550,000.

What amount of accrued liability should be reported on December 31, 2022?

3. At year-end, Mich Company was a defendant in a pending lawsuit. In the opinion of the entity's
attorney, it is probable that Mich Company will have to pay P 500,000 and it is reasonably
possible that Mich Company will have to pay P 600,000 as a result of this lawsuit.

What should be reported in year-end financial statements?

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 BATANGAS STATE UNIVERSITY
The National Engineering University
Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and International
Hospitality Management

MULTIPLE CHOICES
1. Which is the correct definition of a provision?
a. A possible obligation arising from past events
b. A liability of uncertain timing or uncertain amount
c. A liability which cannot be easily measured
d. An obligation to transfer funds to an entity

2. A provision shall be recognized when

a. An entity has a present obligation as a result of a past event.
b. It is probable that an outflow of resources embodying economic benefits will be required to
settle the obligation.
c. The amount of the obligation can be measured reliably.
d. d. All of these are required for the recognition of a provision liability.

3. A legal obligation is an obligation that is derived from all of the following, except
a. Legislation
b. A contract
c. Other operation of law
d. An established pattern of practice

4. An entity has an established pattern of practice or stated policy that has created valid expectation
that it will accept certain financial responsibility.
a. Constructive obligation
b. Legal obligation
c. Onerous obligation
d. Possible obligation

5. It is an event that creates a legal or constructive obligation because the entity has no other
realistic alternative but to settle the obligation.
a. Obligating event
b. Past event
c. Subsequent event
d. Current event

6. An outflow of resources embodying economic benefits is regarded as probable when

a. The probability that the event will occur is greater than the probability that the event will not
occur.
b. The probability that the event will not occur is greater than the probability that the event will
occur.
c. The probability that the event will occur is the same as the probability that the event will not
occur.
d. The probability that the event will occur is 90% likely.

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 BATANGAS STATE UNIVERSITY
The National Engineering University
Rizal Avenue Extension, Batangas City
College of Accountancy, Business Economics and International
Hospitality Management

7. Where there is a continuous range of possible outcomes, and each point in that range is as likely
as any other, the range to be used is the
a. Minimum
b. Maxim um
c. Midpoint
d. Summation of the minimum and maximum

8. When the provision involves a large population of items, the estimate of the amount
a. Reflects the weighting of all possible outcomes by their associated probabilities.
b. Is determined as the individual most likely outcome.
c. May be the individual most likely outcome adjusted for the effect of other possible outcomes.
d. Midpoint of the possible outcomes.

9. When the provision arises from a single obligation, the estimate of the amount
a. Reflects the weighting of all possible outcomes by their associated probabilities.
b. Is determined as the individual most likely outcome.
c. Is the-individual most likely outcome adjusted for the effect of other possible outcomes.
d. Midpoint of the possible outcomes.

10. The present value in a range of possible outcomes all discounted using the same rate would be
a. The most-likely outcome
b. The maximum outcome
c. The minimum outcome
d. The sum of probability-weighted present value

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