What Are Provisions and Contingent Liabilities?
A provision is a liability of uncertain timing or amount that a company recognizes when it has a present obligation from a past event. A contingent liability is a possible obligation that is too uncertain to recognize, so it's disclosed instead. IAS 37 sets the recognition rules that keep companies from over- or under-stating obligations.
A provision is recognized when an outflow of resources is probable and can be reliably estimated; if not, it's only disclosed as a contingent liability.
- •Present obligation from a past event
- •Probable outflow of resources
- •Amount can be reliably estimated
- •Recognized as a liability on the balance sheet
- •Possible obligation, not yet confirmed
- •Outflow not probable, or cannot be reliably measured
- •Not recognized — disclosed in notes only
- •Reassessed each period for reclassification
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Step-by-step worked examples
A company is being sued and lawyers estimate an 80% chance of losing, with a probable payout of $200,000. How should this be treated?
Outflow is probable (80% chance) and the amount is reliably estimated Recognize a provision of $200,000 Disclose the nature of the obligation in the notes
A company faces a lawsuit with only a 15% chance of loss, estimated at $500,000.
Outflow is not probable (15% < 50%) Do not recognize a provision Disclose as a contingent liability in the notes (unless remote)
A firm has a warranty obligation: 60% probability of claims totaling $50,000.
Probability × Amount = 0.60 × $50,000 = $30,000 Recognize a provision of $30,000 as the best estimate
Flashcards
Quick quiz
Q1.Which condition is NOT required to recognize a provision?
Q2.A lawsuit has a 20% chance of loss. How should it be treated?
Q3.Where are contingent liabilities reported?
Q4.What accounting standard covers provisions?
The full card deck, worked steps and AI-tutor support for “What Are Provisions and Contingent Liabilities?” are in Notek — study by hand before your exam.
Common mistakes
Treating every lawsuit as a provision. — Correct: Only recognize a provision if the outflow is probable (>50%) and reliably estimable.
Recording contingent liabilities on the balance sheet. — Correct: Contingent liabilities are disclosed in notes, not recognized as liabilities.
Ignoring remote possibilities entirely without checking materiality. — Correct: Remote contingent liabilities need no disclosure, but reassess each period as facts change.
Using a single-most-likely outcome always. — Correct: Use the expected value (probability-weighted) when there's a range of possible outcomes.
FAQ
What is a provision in accounting?
A provision is a liability of uncertain timing or amount recognized when a company has a present obligation from a past event that will probably require an outflow of resources.
What is the difference between a provision and a contingent liability?
A provision is recognized as a liability because the outflow is probable and estimable; a contingent liability is only disclosed because it's possible but not probable, or can't be reliably measured.
What are examples of provisions and contingent liabilities?
Warranty provisions, legal claims, restructuring costs, and environmental cleanup obligations are common provisions; pending lawsuits with uncertain outcomes are typical contingent liabilities.
How do you calculate the amount of a provision?
Use the best estimate of the expenditure required to settle the obligation — often the expected value, calculated as probability × estimated outflow, when a range of outcomes exists.