Chapter 4: Provisions, Contingent Liabilities and Contingent Assets PDF

# Chapter 4: Provisions, Contingent Liabilities and Contingent Assets ## Related Standard: PAS 37 Provisions, Contingent Liabilities and Contingent Assets ## Learning Objectives 1. Identify the existence of a provision, contingent liability and contingent asset. 2. State the recognition criteria...

# Chapter 4: Provisions, Contingent Liabilities and Contingent Assets ## Related Standard: PAS 37 Provisions, Contingent Liabilities and Contingent Assets ## Learning Objectives 1. Identify the existence of a provision, contingent liability and contingent asset. 2. State the recognition criteria and the available measurement bases for provisions. 3. Determine when a contingent item should be disclosed. ## Provisions A provision is a liability of uncertain timing or amount. Provisions differ from other liabilities because of the uncertainty in the timing of their settlement or on the amount needed to settle them. Unlike other liabilities, provisions must necessarily be estimated. Although some other liabilities are also estimated, their uncertainty is generally much less compared to provisions. Examples of provisions: - Warranty obligations - Estimated liabilities on pending lawsuits - Provisions for environmental damages - Provisions for decommissioning costs of an item of PPE - Obligations caused by an entity's policy to make refunds to customers - Obligations arising from guarantees - Provisions on onerous contracts (e.g., purchase commitment) - Provisions for restructuring costs Provisions are presented in the statement of financial position separately from other types of liabilities. ## Recognition A provision is recognized when all of the following conditions are met: 1. The entity has a present obligation (legal or constructive) resulting from a past event. 2. It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation. 3. The amount of the obligation can be reliably estimated. If any of the conditions is not met, no provision is recognized. ## Present Obligation In rare cases where it is not clear whether there is a present obligation, an entity deems a past event to give rise to a present obligation if available evidence shows that it is more likely than not that a present obligation exists at the end of the reporting period. ## Past Event A past event that creates a present obligation is called an obligating event. An obligating event is one whereby the entity does not have any other recourse but to settle an obligation. This is the case where: 1. The obligation is legally enforceable (legal obligation). 2. The entity's actions (e.g., past practice or published policies) have created valid expectations from others that the entity will discharge the obligation (constructive obligation). Financial statements deal with past or historical information. Therefore, no provision is recognized for future operating costs. Only those obligations arising from past events existing independently of an entity's future actions are recognized as provisions. Thus, possible outflows of resources embodying economic benefits that the entity can avoid by changing its future actions are not recognized as provision. Although an obligation always involve another party to whom the obligation is owed (i.e., obligee), it is not necessary that the identity of the obligee is known - indeed the obligee may be the public at large (e.g., liability for environmental damages). For a constructive obligation to create a valid expectation from others, it is necessary that the commitment must have been communicated to the parties concerned as of the end of the reporting period. ## Probable outflow of resources embodying economic benefits Probable means "more likely than not," i.e., there is a higher chance that the event will cause an outflow of future economic benefits than not. We may think of it as a "51% or more" chance that the outflow will occur. If it is '50:50', then it is not probable because there are equal chances of occurrence and nonoccurrence. A '50:50' chance is "possible" but not "probable." ## Reliable estimate of the obligation Provisions necessarily need to be estimated. If a reliable estimate cannot be made, no provision is recognized. ## Contingent Liabilities In a general sense, all provisions are contingent because they are of uncertain timing or amount. However, PAS 37 uses the term "contingent" to refer to those liabilities and assets that are not recognized because they do not meet all of the recognition criteria. A provision and a contingent liability are differentiated below: | Feature | Provision | Contingent Liability | |---|---|---| | Liability | A liability of an uncertain timing or amount that meets all the following conditions: a present obligation, probable outflow, reliably estimated | A possible obligation whose existence will be confirmed only by the occurrence of one or more uncertain future events not wholly within the control of the entity; or A present obligation but i. it is not probable that it will cause an outflow in its settlement; or ii. its amount cannot be reliably estimated. | Contingent liabilities are disclosed only, except when the possibility of an outflow of resources embodying economic benefits is remote. ## Contingent Assets 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." Contingent assets include claims that an entity is seeking through legal processes where the outcome is uncertain, such as disputed claim for tax refund and disputed insurance claim. Contingent assets are not recognized because they do not meet the asset recognition criteria. Recognizing a contingent asset may result to the recognition of income that may never be realized. Although not recognized, contingent assets are disclosed if the inflow of economic benefits is probable. An asset is not a contingent asset if the realization of income is virtually certain (100% chance of occurrence). In such cases, the asset is appropriately recognized. | Type | Probable | Possible | Remote | |---|---|---|---| | Liability | Recognize and Disclose | Disclose only | Ignore | Ignore | | Asset | Disclose only | Ignore | Ignore | Ignore | ## Illustration 1: Contingent Asset ABC Co. is involved in a tax dispute. ABC Co. is claiming that it has made an overpayment of taxes and is now demanding a refund from the BIR. As of December 31, 20x1, ABC Co.’s attorney is very confident he will win the case in the coming year and recover the tax claim of P10M. What is the entry to recognize the probable receipt of the tax refund? **Answer:** None. Contingent assets are disclosed only when they are deemed probable. If possible or remote, contingent assets are not required to be disclosed. ## Illustration 2: Virtually Certain In 20x1, there was a robbery in one of ABC Co.’s branches. There has been a dispute on the P100M insurance claim that ABC Co. has presented to its insurance provider. On December 31, 20x1, the insurance company approved the payment of 80% of ABC Co.’s claim and notified ABC Co. that the check has been mailed. However, ABC Co. received the check only on January 5, 20x2. What is the entry on December 31, 20x1? **Answer:** | Date | Account | Debit | Credit | |---|---|---|---| | Dec. 31, 20x1 | Claims receivable (100M x 80%) | 80,000,000 | | | Gain on settlement of insurance | | 80,000,000 | The claim is not a contingent asset because it is virtually certain. Therefore, recognition is appropriate. ## Measurement of Provisions Provisions are measured at the best estimate of the amount needed to settle them as at the end of the reporting period. Making the estimate requires management’s judgment, supplemented by experience from similar transactions, and in some cases, reports from independent experts. The estimate also considers events after the reporting period. If the provision being measured involves a large population of items, the obligation is measured at its "expected value." The expected value is computed by weighting all possible outcomes by their associated probabilities. If there is a continuous range of possible outcomes, and each point in that range is as likely as any other, the mid-point of the range is used. | Nature of the outflow | Measurement Basis | |---|---| | General rule (e.g., one-off event) | Best estimate | | Involves a large population of items | Expected Value (Probability Weighted Average) | | Each possible outcome in a range is as likely as any other | Mid-point | ## Recording the Provision Provisions are normally recognized as a debit to expense (or loss) and a credit to an estimated liability account. However, sometimes a provision forms part of the cost of an asset. For example, provisions for restoration and decommissioning costs are capitalized as part of the cost of a PPE. ## Illustration 1: Best Estimate In 20x1, ABC Co. received a court order requiring the cleanup of environmental damages caused by one of ABC’s factory. ABC has no other realistic alternative but to comply with the court order. Other entities have incurred around P15M for similar cleanup; however, ABC’s best estimate of the cost of cleanup is P20M. **Analysis:** 1. **Is there a present obligation arising from past event?** Yes, environmental damages have already been caused. 2. **Is the outflow probable?** Yes, "ABC has no other realistic alternative but to comply with the court order." 3. **Can the outflow be measured reliably?** Yes, the problem indicates a "best estimate" of P20M. **Conclusion:** A provision must be accrued and disclosed in the amount of P20M. **Note:** Before a provision can be recognized, the answer to all the questions in "Steps 1 to 3" must by "yes." If any has a "no" for an answer, no provision is recognized. When a provision is accrued, a disclosure must also be made. **Journal Entry:** | Date | Account | Debit | Credit | |---|---|---|---| | Dec 31, 20x2 | Environmental cleanup costs | 20,000,000 | | | Estimated liability for cleanup costs | | 20,000,000 | ## Illustration 2: Expected Value In 20x1, ABC Co. recalled a product due to a possible defect caused by malfunctioning factory equipment. The products recalled will be repaired free of charge. ABC is uncertain whether all products recalled will have the possible defect. However, the following estimate was made by ABC’s engineers and managerial accountants and approved by the board of directors: | Repair Cost | Probability | |---|---| | 20,000,000 | 5% | | 15,000,000 | 20% | | 10,000,000 | 35% | | 5,000,000 | 40% | | Total | 100% | The expected value of the provision is determined as follows: | Repair Cost | Probability | Expected Value | |---|---|---| | 20,000,000 | 5% | 1,000,000 | | 15,000,000 | 20% | 3,000,000 | | 10,000,000 | 35% | 3,500,000 | | 5,000,000 | 40% | 2,000,000 | | Total | 100% | 9,500,000 | **Journal Entry:** | Date | Account | Debit | Credit | |---|---|---|---| | Dec 31, 20x1 | Repair Costs | 9,500,000 | | | Estimated liability for repair costs | | 9,500,000 | ## Illustration 3: Mid-point In 20x1, a lawsuit was filed against ABC Co. for patent infringement. The plaintiff is claiming P100M in damages. ABC Co.’s legal counsel believes that it is probable that ABC Co. will lose the lawsuit and pay damages of not less than P10M but no more than P100M. The probability of any amount within that range is as likely as any other amount within that range. The plaintiff has offered to settle the lawsuit out of court for P90M but ABC did not agree to the settlement. What amount of provision is reported in ABC Co.’s 20x1 financial statements? **Answer:** P55M [(10M+100M)/2], i.e., the mid-point of the range. **Journal Entry:** | Date | Account | Debit | Credit | |---|---|---|---| | Dec 31, 20x1 | Probable loss on lawsuit | 55,000,000 | | | Estimated liability on pending lawsuit | | 55,000,000 | ## Risk and Uncertainties Estimates take into account risks and uncertainties. The estimates may be increased by a risk adjustment factor to provide an allowance for imprecision inherent in estimates. This, however, does not mean that the entity can make excessive provisions; it cannot deliberately overstate liabilities. ## Present Value If the effect of time value of money is material, the estimate of a provision is discounted to its present value using a pre-tax discount rate. This is usually the case for provisions for restoration and decommissioning costs where cash outflows occur only after a relatively long period of time from the date of initial recognition. ## Illustration 1: Present Value ABC Co., a manufacturer, provides warranties for its products. Under the warranty, ABC Co. undertakes to repair defective products within one year from the date of sale. Based on ABC Co.’s past experience: - 95% of sales require no warranty repairs, while 3% require minor repairs costing 10% of the sale price, and 2% require major repairs costing 90% of the sale price. - 50% of the estimated repair costs are incurred in the year of sale and 50% are incurred in the following year. - The appropriate risk adjustment factor to reflect the uncertainties in estimates is an increment of 6% to the probability-weighted expected cash flows. ABC Co. made total sales of P10M in 20x1. On Dec. 31, 20x1, the cash flows for repair costs in 20x2 are expected to occur on June 30, 20x2. The appropriate present value factor is 0.95238. **Requirement:** Compute for the provision as of Dec. 31, 20x1. **Solution:** **Analysis:** 1. **Is there a present obligation arising from past event?** Yes, products have already been sold. The obligating event for warranties is the act of selling. 2. **is the outflow probable?** Yes, ABC Co. expects, based on past experience, that there will be claims under the warranties. 3. **Can the outflow be measured reliably?** Yes, sufficient information is available to make a reliable estimate. **Conclusion:** A provision must be accrued and disclosed. | Expense | Calculation | Amount | |---|---|---| | Minor repairs | 10M x 3% x 10% | 30,000 | | Major repairs | 10M x 2% x 90% | 180,000 | | Total warranty repair costs for the 20x1 sales | | 210,000 | | Multiply by: Portion to be settled in 20x2 | | 50% | | Warranty repair costs not yet paid as of Dec. 31, 20x1 | | 105,000 | | Multiply by: Risk adjustment (100% +6%) | | 106% | | Total | | 111,300 | | Multiply by: Present value factor | | 0.95238 | | Warranty provision - Dec. 31, 20x1 | | 106,000 | ## Illustration 2.1: Present Value ABC Co. is a defendant in a lawsuit. ABC Co.’s lawyers believe that there is a 30% chance that ABC Co. will win the case and pay no damages. However, if ABC Co. loses, there is a 20% chance that it will pay damages of $200,000 (the amount sought by the plaintiff) and an 80% chance that it will pay damages of P100,000 (the amount that was recently awarded by the same judge in a similar case). Other outcomes are unlikely. A 7% risk adjustment factor to the probability-weighted expected cash flows is considered appropriate to reflect the uncertainties in the cash flow estimates. The court decision is expected to be finalized in December 20x2. The appropriate discount rate is 10%. **Requirement:** Compute for the provision as of Dec. 31, 20x1. **Solution:** | Probability | Amount | Calculation | |---|---|---| | 20% | 40,000 | (200K x 20%) | | 80% | 80,000 | (100K x 80%) | | Total | 120,000 | | | Multiply by: Probability of settlement (100%-30%) | | 70% | | Total | | 84,000 | | Multiply by: Risk adjustment (100%+7%) | | 107% | | Total | | 89,880 | | Multiply by: PV of P1 @10%, n=1 | | 0.909 | | Provision for pending lawsuit - Dec. 31, 20x1 | | 81,571.63 | ## Illustration 2.2: Omission of Required Disclosure Use the facts in Illustration 2.1 above except that in this scenario, because of extremely rare circumstances, disclosure of some of the information required by PAS 37 about the case is expected to prejudice seriously the position of ABC Co. in the dispute. **Requirement:** How should ABC Co. account for the lawsuit ? **Answer:** ABC Co. recognizes the same amount of provision as computed in Illustration 2.1 but discloses the reason why the required information under PAS 37 has not been disclosed. ## Illustration 2.3: Improbable Outflow Use the facts in Illustration 2.1 above except that in this scenario, ABC Co.’s lawyers believe that there is a 60% chance that ABC Co. will win the case and incur no outflow. **Requirement:** How should ABC Co. account for the lawsuit? **Step 1:** Is there a present obligation arising from past event? Yes, ABC Co. is a defendant in a pending lawsuit. **Step 2:** Is the outflow probable? NO, a 40% chance of occurrence (100%-60%) is not probable. **Step 3:** Con the outflow be measured reliably? Yes, sufficient information is available to make a reliable estimate. **Answer:** ABC Co. does not accrue any provision but will disclose only a contingent liability (possible obligation) because not all the recognition criteria are met. ## Future Events Future events may affect the amount needed to settle an obligation. However, future events are considered in estimating a provision only if there is objective evidence that supports their anticipation. For example, the penalty for an environmental damage may be affected by legislation. If a new law that will increase the amount of penalty is expected to be enacted, that new law is anticipated only when it is virtually certain that it will be enacted. Otherwise, it would not be appropriate to anticipate it. ## Expected Disposal of Assets Gains from the expected disposal of assets are not taken into account when measuring a provision. Gains are recognized separately when the disposals occur. ## Reimbursements If another party is expected to reimburse the settlement amount of a provision, a reimbursement asset is recognized if it is virtually certain that the reimbursement will be received. The reimbursement asset is presented in the statement of financial position separately from the provision. However, in the statement of comprehensive income, the expense related to the provision may be presented net of the reimbursement. The amount recognized for the reimbursement should not exceed the amount of the provision. ## Illustration 1: Reimbursement ABC Co is a courier company. During the year, a fire destroyed ABC Co.'s warehouse. ABC Co. estimated that it will probably pay P50M in damages caused to customer-owned goods contained in the warehouse. The contents of the warehouse were insured. The insurer approved the payment of ABC Co.'s insurance claim of P20M. **Journal Entries:** | Date | Account | Debit | Credit | |---|---|---|---| | Dec. 31, 20x1 | Loss on fire | 50,000,000 | | | Estimated Liability on casualty | | 50,000,000 | | Dec. 31, 20x1 | Insurance claims receivable | 20,000,000 | | | Gain on insurance | | 20,000,000 | The reimbursement asset (i.e., the approved insurance claim) is recognized separately from the provision. ## Illustration 2.1: Deductible Clause On January 1, 20x2, an explosion occurred at ABC Co.’s plant causing extensive property damage to area buildings. Although no claims had yet been asserted against ABC Co. as of March 10, 20x2, ABC Co.’s management and counsel concluded that it is likely that claims will be asserted and that it is probable that ABC Co. will be held liable for damages. ABC Co.’s $5,000,000 comprehensive public liability policy has a P250,000 deductible clause, ABC Co. estimates an outflow equal to its net liability on the comprehensive public liability policy. ABC Co.’s financial statements were authorized for issue on March 30, 20x2. **Requirement:** How should ABC Co. report the event above in its December 31, 20x1 financial statements? **Answer:** As a note disclosure only indicating the probable loss of P250,000 (deductible clause). No provision is recognized because there is no present obligation as of Dec. 31, 20x1, i.e., the explosion occurred in 20x2. ## Illustration 2.2: Deductible Clause What if the explosion in Illustration 2.1 above occurred on December 31, 20x1, how should ABC Co. report the event in its December 31, 20x1 financial statements? **Answer:** As a provision of P250,000, i.e., the expected outflow. ## Changes in Provisions Provisions are reviewed at the end of each reporting period and adjusted to reflect the current best estimate. Changes in provisions are accounted for prospectively by accruing an additional amount or by reversing a previously recognized amount. When the provision is discounted, the unwinding (amortization) of the related discount, which increases the carrying amount of the provision, is recognized as interest expense. ## Illustration: Changes in Provisions 20x1: An entity recognizes a provision of P500,000 for probable loss on a pending lawsuit | Date | Account | Debit | Credit | |---|---|---|---| | Dec. 31, 20x1 | Probable loss on lawsuit | 500,000 | | | Estimated liability on pending lawsuit | | 500,000 | 20x2: The lawsuit remains unsettled. The entity reviews its position on the case and revises its estimate of loss to P700,000. | Date | Account | Debit | Credit | |---|---|---|---| | Dec. 31, 20x2 | Probable loss on lawsuit (700K-500K) | 200,000 | | | Estimated liability on pending lawsuit | | 200,000 | 20x3 (Scenario 1): The entity settles the lawsuit for P850,000 | Date | Account | Debit | Credit | |---|---|---|---| | 20x3 | Estimated liability on pending lawsuit | 700,000 | | | Loss on lawsuit | 150,000 | | | Cash | | 850,000 | 20x3 (Scenario 2): The entity settles the lawsuit for P600,000 | Date | Account | Debit | Credit | |---|---|---|---| | 20x3 | Estimated liability on pending lawsuit | 700,000 | | | Cash | | 600,000 | | | Gain on settlement of provision | | 100,000 | 20x3 (Scenario 3): The entity wins the case and pays nothing | Date | Account | Debit | Credit | |---|---|---|---| | 20x3 | Estimated liability on pending lawsuit | 700,000 | | | Gain on reversal of provision | | 700,000 | ## Use of Provisions A provision is used only for the expenditure it was originally intended for. Charging expenditure against a provision that was intended for another purpose is inappropriate as it would confuse the impact of two different events. ## Application of the Recognition and Measurement Rules ### Future Operating Losses No provision is recognized for future operating losses because they do not meet the definition of a liability (i.e., ‘arising from past events’). The expectation of future operating losses may indicate that certain assets may be impaired. Those assets are tested for impairment under PAS 36. ### Onerous Contracts The provision recognized from an onerous contract reflects the least net cost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfill it. ## Illustration: Onerous Contract - Purchase Commitment In 20x1, an entity enters into a three-year, non-cancelable purchase contract whereby the entity obtains the right to purchase up to 60,000 units of a product annually for P25 per unit. The entity guarantees a minimum annual purchase of 15,000 units. On Dec. 31, 20x1, the product becomes obsolete. The entity has 10,000 units on hand, which the entity believes can be sold as scrap for P5 each. **Requirement:** Compute for the loss on purchase commitment to be recognized. **Solution:** | Calculation | Amount | |---|---| | Guaranteed minimum annual purchase (in units) | 15,000 | | Multiply by: Remaining years in the contract (20x2 and 20x3) | 2 | | Total goods to be accepted in the future | 30,000 | | Multiply by: Purchase price less scrap value (P25-P5) | 20 | | Loss on purchase commitment - Dec. 31, 20x1 | 600,000 | **Journal Entry:** | Date | Account | Debit | Credit | |---|---|---|---| | Dec. 31, 20x1 | Loss on purchase commitment | 600,000 | | | Estimated liability on purchase commitment | | 600,000 | **Note:** Loss on purchase commitment is recognized only for guaranteed future purchases. Consequently, impairment loss and not “loss on purchase commitment” is recognized for the 10,000 units on hand on December 31, 20x1. ## Restructuring Restructuring is "a program that is planned and controlled by management, and materially changes either: 1. the scope of a business undertaken by an entity; or 2. the manner in which that business is conducted." **Examples:** 1. Sale or termination of a line of business. 2. Closure of business locations in a country or region or the relocation of business activities from one country or region to another. 3. Changes in management structure, for example, eliminating a layer of management. 4. Fundamental reorganizations that have a material effect on the nature and focus of the entity’s operations. An entity applies the general recognition criteria provided earlier when recognizing provisions for restructuring costs, and in addition, considers the following: ### Sale of Operation A legal obligation exists (and therefore a provision is recognized) only if, at the end of the reporting period, a binding sale agreement is obtained. This is because, until a binding sale agreement is obtained, the entity can still change its mind and may withdraw its plan to sell if it cannot find a purchaser under acceptable terms. If the binding sale agreement is obtained only after the end of the reporting period, no provision is recognized because no present obligation exists at the end of the reporting period. This, however, may be disclosed as a non-adjusting event after the reporting period. ### Closure or Reorganization A constructive obligation exists (and therefore a provision is recognized) only if at the reporting date, the entity has created valid expectations from others that it will discharge certain responsibilities. This would be the case if, at the end of the reporting period, both the following conditions are met: 1. A detailed formal plan for the restructuring is adopted. 2. The plan is announced to those affected by it. A mere board decision to restructure is not enough. No provision is recognized if the detailed plan is adopted or announced after the end of the reporting period. This may also be disclosed as a non-adjusting event after reporting period. ### Measurement of Restructuring Provision A restructuring provision includes only the direct costs that are necessarily entailed with the restructuring. It does not include costs that relate to the ongoing activities of the entity or the future conduct of its business. A restructuring provision excludes the following costs: 1. Retraining or relocating continuing staff. 2. Marketing. 3. Investment in new systems and distribution networks. ### Summary of Restructuring Provisions: | Action | Provision | |---|---| | Sale of operation | Accrue a provision only if a binding sale agreement is obtained on or before the end of reporting period. No provision is recognized if the binding sale agreement is obtained after the reporting period. This is only disclosed as a non-adjusting event after the reporting period. | | Closure or reorganization | Accrue a provision only if a detailed formal plan is adopted and announced publicly on or before the end of reporting period. A board decision is not enough. No provision is recognized if the conditions are met only after the reporting period. This would only be disclosed as a non-adjusting event after the reporting period. | | Restructuring provision on acquisition (merger) | Accrue a provision for terminating employees, closing facilities, and eliminating product lines only if announced at acquisition and, then only if a detailed formal plan is adopted within a short period of time after acquisition (e.g., 3 months). Provisions are not recognized for future operating losses, even in a restructuring. | | Future operating losses | | ## Illustration: Restructuring Provision On December 31, 20x1, ABC Co. adopted a detailed formal plan to close its toys divisions and put up a new division to manufacture warfare weapons. The plan was communicated through a public announcement and all those affected by the closure were informed. ABC Co. estimated the following costs: - Termination benefits of employees terminated as a result of the closure | 1,000,000 | - Costs of retraining and relocating retained employees | 2,000,000 | - Payment for the toys division’s unpaid purchases | 4,000,000 | - New systems and distribution networks for the weapons division | 20,000,000 | - Marketing costs of the weapons division | 6,000,000 | - Expected losses in the first year of operations of the weapons division | 20,000,000 | **Requirement:** Compute for the provision on December 31, 20x1 **Answer:** P1,000,000 - the termination benefits of employees terminated as a result of the closure **Journal Entry:** | Date | Account | Debit | Credit | |---|---|---|---| | Dec. 31, 20x1 | Employee benefits expense | 1,000,000 | | | Provision for restructuring costs | | 1,000,000 | ## Examples of Application of the Recognition Principles 1. An entity engages in transport services. Past experience shows that the entity incurs around P100M a year in car accident lawsuits. Can the entity accrue a year-end provision for car accidents that can happen in the next accounting period? **Answer:** No. There is no present obligation because there is no accident yet (i.e., no past event yet). 2. During the year, a government regulatory body discovers that ABC Co. has caused environmental damages. The government orders ABC Co. to pay a penalty of P100M. Should ABC Co. recognize a provision for the environmental damages? **Answer:** Yes. There is a present obligation because damages have already been caused. The outflow is probable because ABC Co. has no other alternative but to comply with the government order. The outflow can be measured reliably. 3. During the year, a government regulatory body noted that the nature of ABC Co.’s production processes may lead to possible damage to the environment. The government recommends that, in order to operate in the particular way, ABC Co. must fit smoke filters in its factory. The cost of fitting the smoke filters is estimated at P100M. Should ABC recognize a provision for the smoke filters? **Answer:** No. There is no present obligation because damages have not yet been caused (it…may lead to possible damage) and ABC Co. can avoid the future expenditure by its future actions, for example by changing the nature of its production processes. 4. An entity has caused environment damages. Although, currently there are no laws penalizing such acts, the entity has a widely published environmental policy in which it undertakes to rectify all environmental damages that it has caused. The entity has a record of honoring this published policy. The rectification costs can be estimated reliably. Should the entity recognize a provision? **Answer:** Yes. There is a present obligation because damages have already been caused. The present obligation arises from a constructive obligation because the entity has created a valid expectation on others that it will rectify damages. The entity has a record of honoring this expectation; thus, the outflow is probable, and it can be estimated reliably. **Fact Pattern for Next Two Scenarios** During the year, a mining entity acquired a piece of equipment to be used in extracting mineral resources. The law requires the decommissioning (dismantlement) of mining equipment and the restoration of the previous installation site at the end of the equipment’s useful life. 5. **Scenario 1:** As of year-end, the equipment was not yet installed. Should the entity recognize a provision for the decommissioning and restoration costs? **Answer:** No. There is no present obligation because the equipment is not yet installed. The obligation to dismantle arises from installation. A provision will be recognized only when the equipment is installed. 6. **Scenario 2:** It was estimated that of the total decommissioning and restoration costs, 90% pertains to the removal of the equipment and the restoration of damage caused by installing it, while 10% pertains to the extraction of mineral resources. The equipment was installed during the year but no mineral resources have been extracted. The estimated total decommissioning and restoration costs are P100M. Should the entity recognize a provision, and how much? **Answer:** Yes. There is a present obligation because the equipment was already installed. The outflow is probable because it is required by law and the outflow can be measured reliably. The provision is measured at P90M (P100M x 90%). The remaining 10% will be recognized when the mineral resources are extracted. 7. ABC Co. manufactures pharmaceutical products. During the year, a government agency discovered a side-effect caused by a newly introduced product. More than 2,000 patients died with symptoms similar to the discovered side-effect. ABC Co. is the only manufacturer of the product. As of year-end, a lawsuit for P100B has been filed against ABC Co. ABC Co’s legal counsel believes that ABC Co. will probably lose the case and pay an estimated amount of P180B. Should ABC Co. recognize a provision for a loss on the lawsuit? **Answer:** Yes. All the recognition criteria for a provision are met. ABC Co. should recognize a provision for the estimated amount of P80B. 8. ABC Co. manufactures pharmaceutical products. During the year, after a certain new product was introduced, 2,000 patients died. After a series of investigation, authorities discovered that when the new product is used with another product, the patient would transform into a gorilla and dies of eating too much