As you go through CPA Canada PEP and CFE technical review, you may notice the terms “provision” and “contingent liability”, specifically in your IFRS review (ASPE does not use the term provision).

Many candidates find it challenging to understand the relationship between provision vs. contingent liability, and how to effectively address these issues in CPA cases. In this blog, I’ll provide you simplified explanations to ensure you are assessing the correct criteria.

Liabilities

Before we differentiate provisions and contingent liabilities, let’s review the definition of liability. Under IAS 37, liabilities are defined as present obligations to a company that arise from past events, where the settlement is expected to result in an outflow of the company’s resources (i.e. cash).

Let’s look at an example of liability. Let’s say Company ABC got a loan of $50,000 from the bank that’s due in January of 202X. This is a present obligation, because the company has agreed to pay it back. This arose from the past event when the company signed the agreement to accept the loan. When the company pays back, there will be an outflow of cash.

Provisions

A provision is a liability that is uncertain in timing or amount. In our earlier example, Company ABC had to pay back $50,000 loan in January 202X. This was a liability, not provision, because both the timing (Jan. 202X) and amount ($50,000) were certain. 

Now, let’s say Company ABC sells its products with warranty. The amount of warranty claims and when they will be claimed are uncertain, thus this is a provision.

Provision is recognized when it meets all 3 criteria below:

• Present obligation for outflow of cash as a result of a past event
• Probable that it’ll have to settle the provision
• Amount can be reliably measured 

Let’s look at the details of each:

• An obligation exists when the company has no alternative to settling the obligation other than being enforced by the law.
• Probable means “more likely than not”. This means more than 50% probable.
• Provision is measured at the best estimate. In the case where there is a large possibility of outcomes, it’s estimated using the expected value method. When there is a range of possible outcomes and each point is just as likely as the other, midpoint of the range is used.

Under IFRS, a provision is required to be reviewed at the end of every reporting period. If the provision criteria is no longer met, it should be reversed.

Some examples of provisions include: 

• Warranty obligation
• Policy to make refunds to customers
• Onerous contracts
• Construction obligations to clean up land. 

These examples create an unavoidable outflow of resources and often require historical knowledge to record the estimated amount (i.e. warranty claim %).

For example, Company ABC sells dishwashers, each included with a legal warranty period of 2 years. Throughout these 2 years, Company ABC is required to remove all defects that existed at the time of the sale. It’s given that this is not a separate performance obligation. Based on historical evidence, Company ABC estimates $30K costs of repairs in the first year, and $10K in the second year. 

Let’s check if the 3 provision criteria are met:

• Present obligation for outflow of cash as a result of a past event
  • MET: Sale has occurred in the past and the company is obliged to fulfill the warranty.
• Probable that it’ll have to settle the provision
  • MET: This is unavoidable because the warranty agreement is in place.
• Amount can be reliably measured. 
  • MET: The company has historical knowledge that it needs to settle $30K in first year, $10K in the second year (Note: An item can be both “measurable” and “uncertain.” Measurable means that we can estimate the amounts (such as in this example), but the timing and the exact amounts may be “uncertain”).

Because Company ABC has an unavoidable obligation of uncertain timing/amount, this is a provision. (Note that this is also a liability because remember provision is a type of liability.)

Contingent liability

Simply put, if outflow is not probable, the entry is a contingent liability.

Contingent liabilities are possible (not present) obligations that will be confirmed by future uncertain events. Provision is of uncertain timing/amount, but it will happen (unavoidable), while contingent liability may or may not happen (avoidable).

The recognition criteria for contingent liability are as follows:

• Possible obligation that arises from past events
• Existence will be confirmed by occurrence or non-occurrence of uncertain future events not wholly in the control of the entity

Then discuss:

• Probable
• Measurable

While provisions are recorded in F/S, contingent liability is not recorded but disclosed, outlining the nature of the events, financial impact estimates, etc. If the probability of outflow is remote, the contingency doesn’t need to be disclosed.

For example, let’s say there is a pending investigation against Company ABC for possible health concerns at one of its facilities. Company ABC’s legal team believes the probability of being found in violation is likely low as the complaint is said to have come for a disgruntled former employee. No estimate of the amount is provided.

Let’s check if the 3 provision criteria are met:

• Present obligation for outflow of cash as a result of a past event
  • NOT MET: It’s a possible obligation, not present
• Probable that it’ll have to settle the provision
  • NOT MET: The lawyers believe that there is a low chance
• Amount can be reliably measured 
  • NOT MET: The amount is unknown

Because outflow of resources is not probable and no estimate is given, this is not a provision.  So let’s check the contingent liability criteria:

• Possible obligation that arises from past events
  • MET: It is a possible obligation as a result of a past health concern
• Existence will be confirmed by occurrence or non-occurrence of uncertain future events not wholly in the control of the entity
  • MET:  The payout for the lawsuit may or may not happen.
• Probable
  • NOT MET: There is low chance, per lawyers
• Measurable
  • NOT MET: The amount is unknown.

Therefore, this is contingent liability that should be disclosed.

Test Your Knowledge: Practical Example

For example, Company ABC has been engaged in a lawsuit where a customer had fallen on company property in January. As of April, it is unclear whether the Company will be required to pay settlement or not. << At this point, it represents a contingent liability (avoidable, may or may not happen).

As of June, Company ABC has been found guilty of the lawsuit against them, but it has not yet been determined if they will have to pay $50,000 or $150,000 and when. This will be determined at the next court date in July. << At this point, it represents a provision (unavoidable, will happen). If the amount or timing were known at this point, it would be classified as a liability.

Decision Tree

Below is a decision tree to help you understand and analyze this standard in CPA cases:

ASPE Differences

For review of contingencies under ASPE, check out ASPE 3290. Under ASPE, the following differences exist:

• The term contingent liability is used opposed to the term provision. 
• Contingent liability is to be recognized when the probability of an outflow is likely instead of probable.
• Instead of taking the best estimate or range for measurement, use the minimum amount.
• No requirement to review contingent liabilities at the end of each reporting period.

Overall, the key difference to keep in mind when reviewing an AO, is to remember that provisions are unavoidable and will happen, but the timing and amounts are uncertain. Contingent liability may or may not happen. Be sure to integrate case facts when assessing these criteria to achieve depth!

If you need support along the way, get in touch with our professional CPA coaching team.