The right techniques for estimating provisions on your balance sheet

The right techniques for estimating provisions on your balance sheet. FILE PHOTO | SHUTTERSTOCK

By AKINYEMI AWODUMILA More by this Author

According to the International Accounting Standard (IAS) 37, a provision is a liability

of uncertain timing and amount. Examples include provisions for pending litigation, environmental/climate-related provisions, provisions for planned restructuring or sale of business and warranty provisions for goods sold.

Due to their degree of uncertainty, provisions differ from other types of liabilities that organisations hold on their balance sheets, such as trade payables and accruals.

The first involves determining the amount of liability an organisation will pay, and the second is determining the timing or when an organisation will pay the liability.

Therefore, three conditions are necessary before organisations can recognise provisions on the balance sheet. Firstly, they must have a present obligation arising either from a legal or constructive obligation.

Secondly, they must have assessed the outflow of resources to be more likely than not to occur.

Thirdly, a reliable estimate of the provision can be made.

This exercise might not always be straightforward and would require organisations to exercise judgment when assessing each of the three criteria to decide when to recognise provisions on the balance sheet.

Once a provision has met the recognition criteria, the following exercise measures or determines the correct estimate for the provision.

An organisation should measure a provision at the best estimate of the expenditure required to settle the present obligation at the balance sheet date.

The two main estimating techniques are the single most likely outcome approach and the weighted average of all the possible outcomes approach.

The single most likely outcome approach is well suited for estimating provision liabilities with binary outcomes, for example, where a pending litigation outcome results in either a loss with a specific amount to be paid by the organisation or a win with no payment.

The weighted average of all the possible outcomes approach is suited for multiple outcomes, such as when pending litigation could result in various amounts paid by the organisation.

Organisations should apply the right approach when estimating to improve the reliability and accuracy of the amounts included in the financial statements. They should also consider the impact of future events when measuring provisions.