What is a Provision?
A provision is a liability of uncertain timing or amount. It's recognized on the balance sheet when three criteria are met.
Three Recognition Criteria (All Must Be Met)
- Present obligation: The entity has a legal or constructive obligation as a result of a past event
- Probable outflow: Probable that resources will flow out to settle the obligation
- Reliable estimate: A reliable estimate can be made of the amount
Key difference: If any criterion is NOT met, the item is a contingent liability (disclosed in notes, not recognized).
The "Probable" Test: Key Judgment
IFRS 37 defines "probable" as more likely than not (>50%). This is a judgment call auditors heavily challenge.
Examples: Probable vs Not Probable
| Scenario | Probable? | Accounting |
|---|---|---|
| Product warranty: 60% of customers claim warranty | Yes (>50%) | Recognize provision |
| Legal lawsuit: 40% chance of loss based on precedent | No (<50%) | Disclose as contingent liability |
| Environmental cleanup: Regulation now requires remediation | Yes (obligation exists) | Recognize provision |
| Possible patent claim: Legal team unsure of merit | Unclear (judgment) | Disclose as contingent; auditors push to clarify likelihood |
Measurement: Present Value & Expected Value
Measure a provision at the expected value of the obligation, discounted to present value.
Two Methods (Use Whichever Better Predicts the Outcome)
- Expected value: Probability-weighted average of all possible outcomes
- Most likely amount: If only two outcomes and one is much more likely
Present Value Adjustment
If settlement is >1 year away, discount the provision using a pre-tax rate that reflects the time value of money and specific risks.
Measurement Example: Warranty Provision
Sold 10,000 products with 2-year warranty (cost to fix per unit = £50).
Historical claim rate: Year 1 = 20%, Year 2 = 10% (total 30%)
Expected claims: 3,000 units × £50 = £150,000
Timing of payouts:
— Year 1: 2,000 units × £50 = £100,000 (no discounting needed)
— Year 2: 1,000 units × £50 = £50,000 (discount at 5% = £47,619)
Total provision: £100,000 + £47,619 = £147,619
Warranty Obligations
A provision is typically required for warranty claims, measured as the expected cost based on historical claim rates.
Legal Claims & Contingent Liabilities
If a lawsuit is unlikely to succeed (<50% probability), it's a contingent liability (disclosed in notes, not recognized). If probable (>50%), recognize a provision at estimated settlement amount.
Worked Example: Environmental Cleanup
Scenario: Manufacturing plant contaminated soil. Regulator requires cleanup by 2028. Estimated cost: £2m.
- Present obligation? YES (regulation imposed, company responsible)
- Probable outflow? YES (obligation is certain)
- Reliable estimate? YES (external contractors quoted £2m)
- Discount to present value: £2m due 3 years from now; discount at 4% = £1,776,970
- Provision balance (31 Dec 2025): £1,776,970
- Unwinding of discount (31 Dec 2026): Add interest back: £1,776,970 × 4% = £71,079 (expense)
Audit Red Flags
Red Flag 1: Under-Provisioning
Finding: Company has pending litigation with 60% probability of £5m loss, but made no provision (claiming "unlikely").
Auditor action: At 60% probability (>50%), recognize provision of £5m × 60% = £3m.
Red Flag 2: Over-Provisioning
Finding: Warranty provision assumes 50% claim rate, but actual historical rate is 15%.
Auditor action: Reduce provision to actual expected rate; release the excess to profit.
Red Flag 3: Absent Discount
Finding: £10m environmental provision, due in 5 years, but not discounted.
Auditor action: Apply present value discount (5% = £7.8m); adjust provision and finance cost.
Real-Life Case Study: Provision, Contingent Liability, or Nothing?
Scenario. A company faces three matters at year end: (1) a warranty on products sold, (2) a lawsuit it will probably lose (est. £600k), and (3) a lawsuit it will probably win.
- Warranty: present obligation, probable outflow, reliably estimable → provision.
- Likely-lose lawsuit: probable outflow → provision £600k.
- Likely-win lawsuit: possible only → contingent liability, disclose only.
Takeaway. The dividing line is "probable" (recognise) vs "possible" (disclose) vs "remote" (ignore). A present obligation from a past event plus a probable, measurable outflow is what turns a risk into a booked provision, mere existence of a claim is not enough.
Illustrative composite scenario for educational purposes. Figures are indicative and do not represent any specific company.