Provisions and estimates - Events and adjustments before fin...

Learning Outcomes

After reading this article, you will be able to explain the meaning and purpose of provisions and estimates, distinguish provisions from other liabilities, and apply the recognition and measurement criteria. You will also learn how to account for events and adjustments relating to provisions before the final trial balance—essential for the ACCA FA2 exam.

ACCA Maintaining Financial Records (FA2) Syllabus

For ACCA Maintaining Financial Records (FA2), you are required to understand how to identify, record, and report provisions, liabilities, and estimates, and how these adjustments are made before the final trial balance. Focus your revision on:

• The distinction between provisions, accruals, and other liabilities
• The recognition and measurement criteria for provisions (including legal and constructive obligations)
• How to make and record estimates for uncertain liabilities
• Year-end adjustment entries for provisions and related estimates
• The impact of provisions and estimates on profit, assets, and equity
• Reporting provisions in the statement of financial position

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. Which of the following best defines a provision in financial accounting?
   1. A definite liability with fixed timing and amount
   2. An expense that is paid in advance
   3. A liability of uncertain timing or amount
   4. An amount set aside for a future asset acquisition
2. When should a provision be recognised in the financial statements?
   1. When there is a possible obligation only
   2. When there is a present obligation, it is probable that payment will be required, and the amount can be estimated reliably
   3. Whenever management decides it is prudent
   4. Only when cash payment is made

3. True or false? A provision is reported as part of current or non-current liabilities depending on when settlement is expected.

4. Briefly explain why estimates are often necessary when recording provisions before the final trial balance.

Introduction

Year-end financial reporting often involves more than posting routine transactions. Businesses face obligations and potential losses arising from uncertain future events. These situations require judgement to decide whether to record a definite liability, make an estimate, or create a provision. For ACCA FA2, you must be able to distinguish between provisions, accruals, and other liabilities, understand when a provision is needed, and make the correct accounting entries before finalising the trial balance.

This article focuses on recognising and measuring provisions, the criteria for creating them, and the process for adjusting accounting records before the final trial balance is drawn up.

Key Term: provision
A liability of uncertain timing or amount that arises from a present obligation and is recognised in the accounts when certain criteria are met.

Key Term: accounting estimate
A monetary amount determined by judgement under conditions of uncertainty, often used when exact amounts cannot be recorded for year-end adjustments.

What is a Provision?

A provision is a liability where the amount or timing of payment is uncertain. This usually arises from events in the past that create an obligation for the business to transfer resources in the future.

Distinguishing Provisions from Other Liabilities

• Liabilities: Obligations to pay known amounts at known dates (e.g., trade payables, bank loans).
• Accruals: Expenses incurred but not yet invoiced, estimated at period-end.
• Provisions: Amounts set aside to cover probable future outflows due to obligations, but subject to significant uncertainty.

Key Term: liability
A present obligation arising from past events, settlement of which is expected to result in an outflow of resources.

Recognition Criteria for Provisions

A provision must be recognised when:

1. There is a present obligation (legal or constructive) due to a past event,
2. It is probable (more likely than not) that a transfer of economic benefits will be required to settle it,
3. The amount can be estimated reliably.

If any of these are not met, the obligation should not be recorded as a provision—other treatments (such as contingent liabilities or simple disclosure) may be appropriate.

Key Term: constructive obligation
An obligation arising from an entity's actions (such as established patterns or published policies) that creates a valid expectation it will discharge certain responsibilities.

Measurement and Use of Estimates

Provisions are based on the best estimate of the amount required to settle the present obligation at the reporting date. This often involves using judgement, considering historical data, or statistical likelihoods for large populations.

Adjustments must be made using the latest information available before the final trial balance is produced. Significant changes in estimates require revising previous entries.

Worked Example 1.1

A retailer offers a 12-month warranty on all products sold. Based on previous years, 3% of sales usually result in a claim, and sales for the last quarter were $125,000. Should the business record a provision, and at what amount?

Answer:
Yes, the retailer needs to recognise a provision for expected warranty costs. The estimated provision will be 3% of $125,000 = $3,750, as it is probable that outflow will occur and the amount can be reliably estimated.

Year-End Adjustments Before Final Trial Balance

Before preparing the final trial balance, year-end adjustments for provisions and estimates are necessary. The process involves:

• Reviewing all possible obligations arising from past events
• Deciding if recognition criteria are met
• Calculating best estimate amounts
• Recording the required journal entries to adjust or create provisions

Worked Example 1.2

A business is facing a court case where it is probable (but not certain) it will be required to pay damages of $8,000. The legal team advises that the probability of losing is 80%. Should a provision be recognised, and for what amount?

Answer:
A provision should be recorded for $8,000, as it is probable the business will have to pay and the amount can be reliably estimated. Disclose the nature and uncertainty of the obligation in the notes if required.

Accounting Entries for Provisions and Changes in Estimates

To create or adjust a provision at year end:

• Debit: Relevant Expense (statement of profit or loss)
• Credit: Provision (liability, statement of financial position)

If the provision is no longer required or the amount changes:

• For increases: Debit expense, Credit provision
• For decreases: Debit provision, Credit expense

Payment when settled:

• Debit: Provision
• Credit: Cash at bank

Worked Example 1.3

Previous year, a provision of $5,000 was made for possible repairs. At year-end, it's determined only $2,000 is now needed. What is the adjusting entry?

Answer:
Reduce the provision by $3,000. Debit provision $3,000, Credit repairs expense $3,000 (reverses the over-estimate).

Exam Warning

Be careful: Only recognise a provision when all three recognition criteria are met. Do not record "general reserves" for possible future costs unless there is a present obligation. Overprovisioning can overstate liabilities and understate profit.

Revision Tip

Always check supporting evidence—contracts, guarantees, company policies—for possible constructive obligations when reviewing events for provisions.

Summary

Provisions represent uncertain liabilities for which reliable estimates can be made but exact amounts and timing may vary. Recognise a provision only if a present obligation exists, an outflow is probable, and the amount can be estimated. All necessary adjustments for provisions and estimates must be entered before drafting the final trial balance. Correctly handling provisions ensures that the financial statements reflect accurate liabilities and expenses at year end.

Key Point Checklist

This article has covered the following key knowledge points:

• Define a provision and distinguish it from accruals and liabilities
• State the recognition and measurement criteria for provisions
• Explain why estimates are required for many year-end adjustments
• Record accounting entries for creating, increasing, decreasing, or settling provisions
• Understand the impact of provisions on profit and the statement of financial position

Key Terms and Concepts

• provision
• accounting estimate
• liability
• constructive obligation