Which provision is NOT a requirement
Funds put aside by a company to cover anticipated losses in the future Show
What are Provisions?Provisions represent funds put aside by a company to cover anticipated losses in the future. In other words, provision is a liability of uncertain timing and amount. Provisions are listed on a company’s balance sheet under the liabilities section. Summary
Example of a ProvisionAn example of a provision is a product warranty or an income tax liability. Consider a manufacturer that offers a warranty to a customer for one of its products. The product warranty is a term in a contract, specifying the conditions under which the manufacturer will compensate for any good that is defective without any additional cost to the buyer. That said, it falls under the definition of provision because the warranty is a possible future liability of uncertain time and amount. How to Recognize ProvisionsBusinesses cannot simply record a provision whenever they see fit. The following criteria must be met in order to recognize a provision from the perspective of the International Financial Reporting Standards (IFRS):
Provisions are not recognized for operational costs, which are expenses that need to be incurred by an entity to operate in the future. How to Record ProvisionsThe recording of provisions occurs when a company files an expense in the income statement and, consequently, records a liability on the balance sheet. Typically, provisions are recorded as bad debt, sales allowances, or inventory obsolescence. They appear on the company’s balance sheet under the current liabilities section of the liabilities account. What is a Loan Loss Provision?A loan loss provision is defined as an expense set aside by a company as an allowance for any unpaid debt meaning loan repayments that are due and are not paid for by a borrower. The loan loss provision covers a number of factors in regards to potential loan losses, such as bad debt (loans), defaults of the customers, and any loan terms being renegotiated with a borrower that will provide a lender with lower than previously estimated debt repayment amounts. How Does a Loan Loss Provision Work?Lending institutions, such as banks, generate a substantial portion of revenue from the interest paid by borrowers. Lenders initiate loans to a variety of clients. They include:
Since the 2008 Global Financial Crisis, lending regulations for banks were restricted in order to attract higher credit quality borrowers with high capital liquidity. Despite such regulatory improvements, banks still need to take into account loan defaults and the expenses for loan origination. Loan loss provisions serve as a standardized accounting adjustment made to a bank’s loan loss reserves appearing in the lender’s financial statements. They incorporate any change in potential loss projections from the bank’s lending products due to client defaults. Additional ResourcesThank you for reading CFI’s guide on Provisions. To keep advancing your career, the additional resources below will be useful:
For some ACCA candidates, specific IFRS® standards are more favoured than others. IAS® 37, Provisions, Contingent Liabilities and Contingent Assets appears to be less popular than other standards because, usually, answers to Financial Reporting (FR) questions require a balanced discussion of whether criteria are met, as opposed to calculating numbers. However, IAS 37 is often a key standard in FR exams and candidates must be prepared to demonstrate application of the criteria. This article will consider the aims of the standard, followed by the key specific criteria which must be met for a provision to be recognised. Finally, it will examine some specific issues which are often assessed in relation to the standard. The definition of a provision is key to the standard. A provision is a liability of uncertain timing or amount, meaning that there is some question over either how much will be paid or when this will be paid. Before the introduction of IAS 37, these uncertainties may have been exploited by companies trying to ‘smooth profits’ in order to achieve the results that their various stakeholders wanted. For example, we will now consider a fictional company known as Rey Co. At the start of the year, Rey Co sets a profit target of $10m for the year ended 31 December 20X8. The chief accountant of Rey Co has reviewed the profit to date and realises they are likely to achieve profits of $13m. The accountant knows that if Rey Co reports a profit of $13m, directors will not get any more of a bonus than if they reported $10m. He also knows that the profit target will be set at $14m next year. To avoid this, the accountant may be tempted to make some provisions for potential future expenses of $3m, with the impact of making the profit seem lower in the current year. As the double entry for a provision is to debit an expense and credit the liability, this would potentially reduce profit to $10m. Then in the next year, the chief accountant could reverse this provision, by debiting the liability and crediting the statement of profit or loss. This is effectively an attempt to move $3m profit from the current year into the next financial year. Clearly this is not good for the users of the financial statements, as they would have been given a false impression of the performance of the business. This is where IAS 37 is used to ensure that companies report only those provisions that meet certain criteria. IAS 37 stipulates the criteria for provisions which must be met for a provision to be recognised so that companies are prevented from manipulating profits. According to IAS 37, three criteria are required to be met before a provision can be recognised. These are:
These criteria will now be examined in further detail to see how they can be applied in practice. 1. Present obligation from a past eventThis rule has two parts, first the type of obligation, and second, the requirement for it to arise from a past event (ie something must already have happened to create the obligation). (a) Type of obligation Alternatively, the obligation could be constructive. This is where a company establishes an expectation through an established course of past practice. EXAMPLE Even if the country that Rey Co operates in has no legal regulations forcing them to replant trees, Rey Co will have a constructive obligation because it has created an expectation from its publications, practice and history. (b) Past event EXAMPLE If the lawyers had advised Rey Co that they would not be held liable for the employee’s injury, there would be no obligation as a result of a past event and therefore no provision would be recognised. The matter would potentially require disclosure as a contingent liability. Contingent liabilities will be explained further below. Similarly, Rey Co would not provide for any possible claims which may arise from injuries in the future. That is because there is no past event which has created an obligation and any possible claims could be avoided by implementing new safety measures or selling the factory. 2. Reliable estimateIn an exam, it is unlikely that it will not be possible to make a reliable estimate of a provision. Likewise, it is unlikely that an entity will be able to avoid recording a liability when there is an obligation by claiming there is no way of producing an estimate of the amount. The main rule to follow is that where a single obligation is being measured, the best estimate will be the most likely outcome. If the provision being measured involves a large number of items, such as a warranty provision for repairing goods, the expected value should be calculated using the probability of all possible outcomes. EXAMPLE – best estimate In this case, Rey Co would provide $10m, being the most likely outcome. It is not uncommon for candidates to incorrectly take the $12m, thinking that the worst-case scenario should be provided for. Other candidates may calculate an expected value based on the various probabilities which also would not be appropriate in these circumstances. EXAMPLE
– expected value Here, the provision would be measured at $60k. The expected cost of minor repairs would be $10k (10% of $100k) and the expected costs of major repairs is $50k (5% of $1m). This is because there will not be a one-off payment, so Rey Co should calculate the estimate of all likely repairs. 3. Probable outflowThe final criteria required is that there needs to be a probable outflow of economic resources. There is no specific guidance of what percentage likelihood is required for an outflow to be probable. A probable outflow simply means that it is more likely than not that the entity will have to pay money. If it appears that there is a possible outflow then no provision is recorded. In this situation, a contingent liability would be reported. A contingent liability is simply a disclosure note shown in the notes to the accounts. There is no double entry recorded in respect of this. Instead, a description of the event should be given to the users with an estimate of the potential financial effect. In addition to this, the expected timing of when the event should be resolved should also be included. Similar to the concept of a contingent liability is the concept of a contingent asset. A contingent asset is a possible asset that arises from past events 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. Like a contingent liability, a contingent asset is simply disclosed rather than a double entry being recorded. Again, a description of the event should be recorded in addition to any potential amount. The key difference is that a contingent asset is only disclosed if there is a probable future inflow, rather than a possible one. The table below shows the treatment for an entity depending on the likelihood of an item happening. It can be seen here that Rey Co could only recognise an asset from a potential inflow if the realisation of income is virtually certain. EXAMPLE –
Likelihood In this case, Rey Co would include a provision for the $10m legal provision in liabilities. Even though there is a similar likelihood that Rey Co would win the counterclaim, this is a probable inflow and therefore only a contingent asset can be recorded. This will be disclosed in the notes to the financial statements rather than being recorded as an asset in the statement of financial position. Whilst this seems inconsistent, this demonstrates the asymmetry of prudence in this standard, that losses will be recorded earlier than potential gains. Other issues within provisions1. The time value of money EXAMPLE On 31 December 20X8, Rey Co should record the provision at $10m/1.10, which is $9.09m. This should be debited to the statement of profit or loss, with a liability of $9.09m recorded. By 31 December 20X9, when Rey Co is required to make the payment, the liability should be showing at $10m, not $9.09m. Therefore, the liability is increased by 10% over the year, giving an increase of $910k which would be recorded in finance costs. 2. Restructuring costs The second issue for consideration is which costs should be included within the provision. These costs should exclude any costs associated with any continuing activities. Therefore, any provision should only include items such as redundancy costs and closure costs. Ongoing costs such as the costs of relocating staff should be excluded from the provision and should instead be expensed as they are incurred. 3. Onerous contracts 4. Decommissioning costs associated
with assets EXAMPLE Here, Rey Co would capitalise the $170m as part of property, plant and equipment. As only $150m has been paid, this amount would be credited to cash, with a $20m provision set up. Over the useful life of the asset, the $170m will be depreciated. In addition to this, the discount on the provision will be unwound and debited to finance costs. Consequently, the provision will increase each year until it becomes $20m at the end of the asset’s 25-year useful life. 5. Future operating losses SummaryIn summary, IAS 37 is a key standard for FR candidates. Candidates are required to learn the three key criteria for a provision, as they are likely to have to explain these in an exam. Careful attention must also be paid to the calculations involved in the recording of a provision, particularly those around long-term provisions and including them at present value. If candidates are able to do this, then provisions can be an area where they can score highly in the FR exam. Written by a member of the Financial Reporting examining team Which of these provisions is not required in life insurance policies?Which of these provisions is NOT required in life insurance policies? Extended Term. All of these provisions must be included in life insurance policies EXCEPT Extended Term.
What is a trustee group policy?Trustee Group Life Insurance — a master group life insurance policy issued to a trustee for two or more employers in the same industry, for two or more unions, or for joint employer-union funds for the benefit of the employees or members.
What type of life insurance are credit policies issued as?What type of life insurance is credit policies issued as? Credit life insurance policies are most commonly issued as whole life insurance policies. However, they can also be issued as term life insurance policies.
What kind of life policy either pays the face?Endowment insurance provides for the payment of the face amount to your beneficiary if death occurs within a specific period of time such as twenty years, or, if at the end of the specific period you are still alive, for the payment of the face amount to you.
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