In India the term ‘provision’ is used to refer to a liability and also to refer to a ‘valuation allowance’. Valuation allowance is neither an asset nor a liability. It refers to reduction of an asset or a liability. Most common examples of valuation allowance are ‘provision for doubtful debts’ and ‘provision for depreciation’. In this article we shall use the term provision to refer to a liability, which is not a financial instrument. Examples of provision are provision for product warranty, provision for dismantling an item of property, plant and equipment, provision for environment restoration, provision for a liability arising from a law suit and provision for income tax.
Provision is an obligation present at the balance sheet date. It arises from a past event. For example, an obligation for product warranty arises from the sale of the product. An obligation for dismantling of an item of PP&E arises on installation of the item. Provision is a liability the amount of which is uncertain. The timing when economic resource will flow out of the entity to settle the provision is also uncertain. Those uncertainties surrounding a provision make it difficult to estimate the liability with any degree of precision.
Best estimate
The present accounting position is that a provision should be measured at an amount which represents the best estimate of the management. The extant accounting standard (IAS 37) does not provide much guidance on how to arrive at the best estimate. IASB has now taken a view that the concept of best estimate is quite vague. Different entities use different methods to arrive at the best estimate. This impairs the comparability. Therefore, IASB has issued a draft amendment to IAS 37, which deals with accounting for provision. In the following paragraphs, we shall discuss those guidelines.
The proposed revision requires an entity should measure a provision at the amount that it would rationally pay at the end of the reporting period to be relieved of the present obligation. The amount that an entity would rationally pay to be relieved of an obligation is the lowest of: (a) the present value of the resources required to fulfil the obligation, (b) the amount that the entity would have to pay to cancel the obligation; and (c) the amount that the entity would have to pay to transfer the obligation to a third party. In most situations, an entity measures provisions at the present value of the resources required to fulfil the obligation. Presented value is calculated by discounting expected value (probability-weighted amount) of resource outflows.
Estimation of the outflow
If the obligation will be fulfilled by making payments to the counterparty, the relevant outflows include: (a) payments to the counterparty; and (b) associated costs, such as external legal fees or the costs of an in-house legal department attributable to that obligation. An example of such an obligation is a disputed claim by a customer. Some types of obligation are fulfilled by undertaking a service at a future date. Examples of such services are environment restoration, servicing the product warranty and dismantling of an item of PP&E.
The relevant outflows for such obligations are the amounts that the entity would rationally pay a contractor at the future date to undertake the service on its behalf. If there is a market for a service, the amount is the price that the entity estimates a contractor would charge at the future date to undertake the service on the entity’s behalf. If there is not a market for the service, the entity estimates the amount it would charge another party at the future date to undertake the service. The estimates shall include the costs the entity expects to incur and the margin it would require to undertake the service for the other party. In estimating the outflow of economic resources, an entity need to take into account the possible future developments (e.g. technological developments and change in the competitive environment) in the market for those services.
Conclusion
The proposed amendment will reduce arbitrariness in selecting the method for the measurement of the provision. But, it will not reduce the subjectivity. Therefore, the auditor should verify carefully the evidence which is relied on by the management in measuring the provision. It should also verify the assumptions and bases for estimating the probabilities and the discounting rate.