## **Learning Outcomes**

After reading this article, you will be able to explain the criteria for recognising provisions, identify contingent liabilities and contingent assets, and describe the measurement and disclosure requirements under IAS 37. You will be able to distinguish provisions from accruals and explain their audit implications. You will also learn what constitutes a related party and the auditor’s responsibilities for related party disclosures.

## **ACCA Audit and Assurance (AA) Syllabus**

For ACCA Audit and Assurance (AA), you are required to understand how provisions, contingent liabilities/assets, and related party disclosures affect the financial statements, and how auditors should audit and report on them. Focus your revision on:

- The definition and distinction between provisions, accruals, contingent liabilities, and contingent assets under IAS 37.
- The criteria for recognising a provision and the rules for measurement and disclosure.
- Identification of contingent liabilities and contingent assets, and when/if they are recognised or only disclosed.
- Typical examples of provisions and contingencies (e.g., warranties, pending legal claims, restructuring, guarantees).
- Assessment and audit procedures for provisions and contingencies, including sufficient, appropriate evidence.
- The concept of a related party and typical transactions subject to disclosure.
- The auditor’s responsibilities for related party transactions, including procedures for identification and assessing disclosure adequacy.

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. According to IAS 37, when can a provision be recognised in the financial statements?
2. What is the difference between a provision and a contingent liability? Provide an example of each.
3. When should a contingent asset be recognised or disclosed?
4. List three examples of related party transactions that should be disclosed.
5. What audit procedures should you perform to assess the reasonableness of a provision for warranties?

## **Introduction**

Provisions and contingencies are key to achieving a true and fair view in financial reporting. IAS 37 sets out clear rules about when an entity must recognise provisions, and when obligations remain off balance sheet as contingent liabilities or contingent assets. Related party transactions have separate but closely linked disclosure requirements due to their effect on transparency in the financial statements.
Failure to apply the appropriate recognition criteria and provide the required disclosures can lead to material misstatements and audit reporting issues.

> **Key Term: provision**
> A liability of uncertain timing or amount, recognised when there is a present (legal or constructive) obligation as a result of a past event, it is probable that an outflow of economic resources will be required, and a reliable estimate can be made.
>
> **Key Term: contingent liability**
> A possible obligation from past events, confirmed only by uncertain future events outside the entity’s control, or a present obligation that is not recognised because an outflow is not probable, or the amount cannot be estimated reliably.
>
> **Key Term: contingent asset**
> A possible asset arising from past events, whose existence will be confirmed only by the occurrence or non-occurrence of uncertain future events outside the entity’s control.
>
> **Key Term: related party**
> A person or entity related to the reporting entity through control, joint control, significant influence, or kinship, where transactions may not occur on arm’s length terms.

## Recognition Criteria for Provisions

A provision is recognised only when:

- There is a present obligation (legal or constructive) from a past event,
- It is probable that an outflow of economic benefits will be needed to settle the obligation,
- The amount can be estimated reliably.

All three criteria must be met. If not, no provision is recognised—though disclosure may still be necessary.

> **Key Term: constructive obligation**
> An obligation arising from an entity’s actions, established by past practice or public statements, creating a valid expectation among other parties that it will discharge certain responsibilities.

### **Worked Example 1.1**

**A manufacturing company provides a one-year warranty on products sold. Claims typically arise in the year after sale. At year-end, there are no warranty claims yet, but based on historical experience, management estimates \$100,000 of possible payments. Can a provision be recognised?**

> **Answer:** Yes. The sale of goods with warranty creates a present obligation. It is probable customers will claim, and historical data gives a reliable estimate. A provision should be recognised for the best estimate of the expected cost.

## Measurement of Provisions

The provision should represent the best estimate of the expenditure required to settle the present obligation at the reporting date. This involves management judgement—supported by past experience, expert reports, or other evidence.

If time value of money is material (e.g., long-term environmental costs), the provision should be discounted to present value.

Include only costs needed to settle the obligation—not future operating losses or costs for continuing activities.

### **Worked Example 1.2**

**A company has a self-insured environmental restoration obligation expected to cost \$500,000 in five years. The discount rate is 4%. What amount should be recognised today?**

> **Answer:** \$500,000 should be discounted to present value using 4%. The provision recognised equals \$500,000/(1.04^5) ≈ \$411,000.

### **Exam Warning – Misclassification**

Misclassifying provisions and accruals is a common exam mistake. Only provisions require a present obligation with uncertainty in amount or timing. Routine payables/accruals (e.g., electricity bills for services received) are not provisions.

## Contingent Liabilities and Assets

If an obligation exists but is not probable, or the amount cannot be estimated reliably, disclose as a contingent liability—do not recognise it. Examples include possible legal claims or guarantees where payment is not probable.

For contingent assets (possible assets from events not wholly under the entity's control), do not recognise them. Disclose if an inflow is probable. Only when the inflow is virtually certain can it be recognised as an asset.

### **Worked Example 1.3**

**A company is being sued for damages of \$2 million. Legal opinion at year-end states payment is possible but not probable. Should a provision or contingent liability be recognised?**

> **Answer:** No provision should be recognised, but a contingent liability should be disclosed in the notes, as payment is possible but not probable.
>
> **Key Term: best estimate**
> The amount that an entity would rationally pay to settle the obligation at the end of the reporting period or to transfer it to a third party.

## Disclosures Required (IAS 37)

Entities must provide clear disclosures about:

- Each class of provision: opening balance, additions, used amounts, reversals, closing balance, brief description and uncertainties.
- For each contingent liability: a description, estimate of financial effect, uncertainties, and possible reimbursements.
- Contingent assets: only if inflow of resources is probable, with nature and estimate disclosed.

Failure to disclose can result in material audit reporting implications.

### **Revision Tip**

Prepare a summary table distinguishing between: (a) provision, (b) contingent liability, (c) contingent asset, (d) accrual—focus on present obligation, probability, and measurement.

|             | Provision                   | Contingent Liability                    | Contingent Asset                         | Accrual                  |
| ----------- | --------------------------- | --------------------------------------- | ---------------------------------------- | ------------------------ |
| Obligation  | Present, legal/constructive | Possible, or present but not probable   | Possible, not controlled                 | Present, routine/service |
| Probability | Probable outflow            | Possible outflow                        | Possible/probable inflow                 | Virtually certain        |
| Measurement | Reliable estimate           | Not reliably measurable or not probable | Not recognised/disclosed unless probable | Fixed or matched amount  |
| Recognition | Recognise                   | Disclose (unless remote)                | Disclose if probable inflow              | Recognise                |

## Provisions for Restructuring and Other Examples

Provisions can only be made for restructuring if there is a detailed formal plan and valid expectation raised (i.e., announcement to those affected or start of implementation). Recognise only direct costs of restructuring (e.g., staff redundancy payouts, contract termination penalties). Do not include costs for ongoing activities.

Other typical examples:

- Warranties
- Onerous contracts (where unavoidable cost > benefit)
- Legal claims (if probable and amount can be estimated)
- Guarantees (if probable outflow)

Future operating losses are never provided for in advance.

### **Worked Example 1.4**

**A company’s board approves restructuring and tells staff. The plan is to close a business segment, lay off employees, and terminate lease agreements. Should a provision be recognised?**

> **Answer:** Yes, if a detailed plan exists and affected parties are informed, creating a constructive obligation. Only direct costs (e.g., redundancy payments, contract break fees) are included in the provision, not costs for reorganisation of ongoing activities.

## Related Party Transactions

IAS 24 defines related parties and requires disclosure of material transactions, balances, and relationships—so users can assess risks from transactions not at arm’s length.

Auditors must obtain sufficient appropriate evidence that related party relationships and transactions are identified and disclosed. Audit procedures include:

- Enquiring of management and those charged with governance
- Reviewing board minutes and contracts
- Examining accounting records for unusual transactions
- Testing year-end balances and material transactions for completeness and accuracy of disclosure

Examples of related party transactions to disclose:

- Sales or purchases of goods or services
- Loans to or from related parties
- Guarantees
- Arrangements with directors/key management or their close family

> **Key Term: arm’s length transaction**
> A transaction carried out between unrelated parties, each acting in their own best interest.

## Audit Procedures for Provisions, Contingencies, and Related Parties

- Obtain a detailed schedule of all provisions, contingencies, and related party transactions.
- Understand management’s basis for the provision—review calculations, supporting contracts, legal correspondence, and post-year-end events.
- Assess reasonableness of assumptions and judgements.
- Obtain written representation confirming completeness of disclosures and accuracy of estimates.
- Evaluate whether all required notes have been made, including uncertainties and estimation bases.
- For related parties, corroborate disclosures by reviewing accounting records, bank statements, and other external documents.

### **Worked Example 1.5**

**As an auditor, you see a provision for restructuring. What evidence will you seek?**

> **Answer:** Examine the board-approved formal plan, evidence of announcements to affected staff, redundancy estimates, calculations, and post-year-end payments. Inspect for completeness of included direct costs only.

### **Exam Warning – Audit Opinion**

If a client fails to provide adequate evidence for a provision or does not disclose a material contingent liability or related party matter, you should consider whether a modified audit opinion is necessary.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Define provisions, contingent liabilities, and contingent assets, explaining recognition and disclosure under IAS 37.
- Identify the required criteria for recognising a provision in financial statements.
- Distinguish provisions from accruals, and explain the treatment of future operating losses and restructuring costs.
- Outline typical examples and audit procedures for provisions, contingencies, and related party transactions.
- Specify required disclosures for provisions, contingencies, and related parties under IAS 37 and IAS 24.
- State the possible audit reporting consequences for missing or misstated provisions, contingencies, or related party disclosures.

## **Key Terms and Concepts**

- provision
- contingent liability
- contingent asset
- related party
- constructive obligation
- best estimate
- arm’s length transaction

Provisions, contingencies, and related parties - Recognition, measurement, and disclosure (IAS 37)