Both provisions and contingent liabilities and also contingent assets are governed by “IAS 37: Provisions, Contingent Liabilities and Contingent Assets”. The objective of creating provisions and contingent liabilities is in line with Prudence concept in accounting where assets and liabilities should be matched against incomes and expenses for a given financial year. This practice is done to ensure that the year-end financial statements are presented in a realistic manner where assets are not overvalued and liabilities are not undervalued. The key difference between a provision and a contingent liability is that provision is accounted for at present as a result of a past event whereas a contingent liability is recorded at present to account for a possible future outflow of funds.
What is a Provision?
A provision is a decrease in asset value and should be recognized when a present obligation arises due to a past event. The timing as to when the said obligation arises and the amount is often uncertain. Commonly recorded provisions are, provision for bad debts (debts that cannot be recovered due to insolvency of the debtors) and provision for doubtful debts (debts that are unlikely to be collected due to possible disputes with debtors, issues with payments days etc.) where the organization makes an allowance for the inability to collect funds from their debtors due to nonpayment. Provisions are reviewed at the financial year end to recognize the movements from the last financial year’s provision amount and the over provision or under provision will be charged to the income statement. The usual provision amount for a provision will be decided based on company policy. For example, a company may have a policy is to make an allowance of 4% of debtors for bad and doubtful debts. In that case, if the total debtors amount to $ 10000 the allowance will be $400.
Basic accounting treatment for recognizing a provision is,
Expense A\\C Dr
Provision A\\C Cr
What is a Contingent Liability?
For a contingent liability to be recognized there should be a reasonable estimate of a probable future cash outflow based on a future event. For instance, if there is a pending lawsuit against the organization, a possible cash payment may have to be made in the future in case the organization loses the lawsuit. Either winning or losing the lawsuit is not known at present thus the occurrence of the payment is not guaranteed. The recording of the contingent liability depends on the probability of the occurrence of the event that gives rise to such liability. If a reasonable estimate cannot be made regarding the amount, the contingent liability may not be recorded in the financial statements. Basic accounting treatment for recognizing a contingent liability is,
Cash A\\C Dr
Accrued Liability A\\C Cr
If the cash outflow takes place in the future then the above entry reverses.
What is the difference between Provision and Contingent Liability?
Provision vs Contingent Liability |
|
| Provision is accounted for at present as a result of a past event. | Contingent liability is recorded at present to account for a possible future outflow of funds. |
| Occurrence | |
| The occurrence of provisions is certain. | The occurrence of contingent liability is conditional. |
| Estimate | |
| The amount of provision is largely not certain. | A reasonable estimate can be made for the amount of payment. |
| Inclusion in Statement of Financial Position | |
| Provision is recorded as a decrease in assets in Statement of financial position. | Contingent liability is recorded as an increase in liabilities in Statement of financial position |
| Inclusion in Income statement | |
| Increase or decrease of provisions is recorded in the Income statement. | Contingent liability is not recorded in the Income statement. |
Image Courtesy:
“Do you know what causes bad debt?” by StepChange MoneyAware (CC BY 2.0) via Flickr
“1680905” (Public Domain) via Pixabay
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