Provisions and Contingent Liabilities

The three-part test

A provision is recognised only when all three hold:

• 1.A present obligation arising from a past event — not a future decision still to be made.
• 2.A probable outflow of resources to settle it — more likely than not, not merely conceivable.
• 3.A reliable estimate of the amount, even if not exact.

Fail any one and it is not a provision. It is either nothing at all, or a contingent liability.

A worked case that passes

A customer files a formal legal claim over a delivered batch they allege was defective, seeking damages. Legal counsel assesses payment as more likely than not and estimates a reasonable settlement range.

Test it: present obligation — yes, the delivery already happened. Probable outflow — yes, per counsel. Reliably estimable — yes, a range exists. All three hold, so a provision is recognised: debit Legal Expense, credit Provision for Legal Claims, at the best estimate.

Where “possible” fails

Now change the facts. A competitor faces a lawsuit over a similar product defect. Counsel says a similar claim against your business is merely possible, not probable, and no claim has been filed. Provision?

No. “Possible” is a meaningfully lower bar than “probable”, and the test requires probable. Recognising a provision here would overstate liabilities for something that may never materialise. This is precisely what a contingent liability disclosure exists for.

Disclosed, not recognised

A contingent liability is a possible obligation whose existence will only be confirmed by a future event — or one that is probable but cannot be reliably estimated.

It is not recognised as a liability in the accounts. It is disclosed in the notes, describing the nature of the matter, so a reader knows it exists without the balance sheet carrying a number that is not yet probable or not yet measurable.

Provision or accrual?

Both debit an expense and credit a liability, which is why they get conflated. The difference is the degree of certainty and the kind of underlying event.

• —An accrual covers a routine, recurring obligation with a known or confidently estimable amount — an electricity bill not yet received. Essentially certain in nature.
• —A provision covers something genuinely uncertain in amount, or in whether it occurs at all, typically from a non-routine event — a legal claim, a warranty obligation, a restructuring cost.

The distinction cuts both ways

Recognise every possible future obligation and the balance sheet becomes pessimistic and unreliable, cluttered with speculative liabilities. Disclose nothing and genuinely relevant risk is hidden from anyone reading the accounts.

Applied honestly, the three-part test is what keeps the accounts neither overstated nor silent. It is a test for accuracy, not for caution — and over-providing fails it just as surely as under-providing.

Common mistakes

• —Treating “possible” as satisfying the probable test.
• —Providing for a future operating loss or a decision not yet made — no past event, no obligation.
• —Skipping disclosure entirely once something fails the recognition test.
• —Over-providing in a good year and releasing it in a weak one.
• —Never revisiting a provision as the estimate or the facts change.