Provisions or contingent liabilities?
When a client's possible obligation becomes a provision in its statements and when it is only disclosed as a contingent liability, with client examples.
By Achekam · · 4 min read · For Accountants & audit firms in South Africa, Nigeria, Kenya
A former employee has taken the client to the labour court. A customer says a product failed and wants compensation. The client signed a lease on premises it no longer uses. Each is a possible cost hanging over the year end. The preparer's question is whether it goes into the figures as a provision, into the notes as a contingent liability, or nowhere.
Small-company statements often get this wrong in both directions: real obligations left out because "nothing has been decided", and vague worries booked as provisions to smooth profit. This article sets out the tests, works through common client examples, and covers recording the judgement and posting the entry.
The recognition test for a provision
A provision is a liability of uncertain timing or amount. It is recognised only when all three conditions hold at the reporting date:
- A present obligation exists as a result of a past event. It can be legal, from a contract or legislation, or constructive, from the entity's established practice or public statements that have created a valid expectation in others.
- An outflow is probable, meaning more likely than not.
- A reliable estimate of the amount can be made.
The amount recognised is the best estimate of what it would take to settle the obligation at the reporting date. Future operating losses are never provided for. The rules sit in IAS 37 under full IFRS and in the provisions and contingencies section of IFRS for SMEs; the IFRS Foundation's summary of IAS 37 explains how provisions, contingent liabilities and contingent assets are defined and accounted for, and what must be disclosed about them.
Contingent liabilities, and when nothing is disclosed
A contingent liability is either a possible obligation whose existence will be 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 cannot be measured reliably.
Contingent liabilities are disclosed, not recognised: a brief description, an estimate of the financial effect where practicable, the uncertainties, and the possibility of any reimbursement. Where the possibility of an outflow is remote, nothing is disclosed at all.
| Situation at year end | Treatment |
|---|---|
| Present obligation, outflow probable, reliable estimate | Recognise a provision |
| Present obligation, outflow probable, no reliable estimate (rare) | Disclose a contingent liability |
| Possible obligation, or outflow not probable but not remote | Disclose a contingent liability |
| Outflow remote | Neither recognise nor disclose |
Client examples: claims, warranties, onerous contracts
Legal claims. A dismissed employee's claim in the labour court. If the client's attorney says the claim is likely to succeed and can estimate the settlement, provide. If the attorney thinks the client has a good defence but cannot rule out losing, disclose. Get the attorney's view in writing; legal letters on litigation and claims explains how.
Warranties. A manufacturer that repairs faulty products under warranty has a present obligation for goods already sold. Even before any individual claim arrives, experience usually makes an outflow probable for the class of products as a whole. Provide on the basis of that experience, and revisit the estimate each year.
Onerous contracts. A contract where the unavoidable costs of meeting the obligation exceed the benefits expected from it. Vacated premises are the classic example, although where the lease is already on the balance sheet the question becomes impairment of the right-of-use asset, plus any related costs outside the lease.
What is not a provision. Planned repairs, future losses, a general cushion for bad times, or a restructuring the directors are considering but have neither announced nor started.
Recording the judgement and consulting on hard cases
Provisions are estimates built on judgement, and the file should show the reasoning. For each matter: the facts, the analysis of the obligation, the probability assessment and where it came from, and the estimate and how it was reached.
The facts usually come from the client and its advisers. Staff can create, send and track requests to clients for documents, answers and confirmations in Achekam's RFI console, which leaves a record of what was asked and what came back.
Where the team is unsure, consult. Achekam lets staff take a technical consultation on an engagement from question to conclusion and closure, and record a difference of opinion with each party's position, escalation and resolution. A borderline claim is a good candidate.
On wording: where AI is set up, narrative text in the draft is labelled "AI draft - review before issue". Contingent liability wording has to describe the specific matter without prejudicing the client's position in a dispute, so it is not a place for generic text.
Posting the year-end entry and reversing it if it was wrong
When a provision is needed and the client's ledger does not hold it, staff can post a year-end adjusting entry in Achekam. The Studio's notes take their figures from the mapped trial balance, so the provision flows into the note, which should show the opening balance, additions, amounts used, unused amounts reversed and the closing balance. Facts the trial balance cannot hold, such as the nature of the obligation and its expected timing, are left as "[to be completed]".
If the entry turns out to be wrong before the statements are issued, for example because the claim settles for a different amount, it is reversed with a record of who and why, never deleted. A settlement after year end is itself an adjusting event, covered in events after the reporting period.
Whatever the outcome this year, revisit every provision and contingent liability at the next year end. Matters that were possible become probable, and claims that seemed certain quietly go away.
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
