Relationship between Provisions and Contingent liability

Provision

A provision is a decrease in asset value and should be recognized when a present obligation arises due to a past event. The timing as to when the said obligation arises and the amount is often uncertain. Commonly recorded provisions are, provision for bad debts (debts that cannot be recovered due to insolvency of the debtors) and provision for doubtful debts (debts that are unlikely to be collected due to possible disputes with debtors, issues with payments days etc.) where the organization makes an allowance for the inability to collect funds from their debtors due to nonpayment. Provisions are reviewed at the financial year end to recognize the movements from the last financial year’s provision amount and the over provision or under provision will be charged to the income statement. The usual provision amount for a provision will be decided based on company policy.

Basic accounting treatment for recognizing a provision is,

Expense A\C                              Dr

Provision A\C                            Cr

Contingent Liability

For a contingent liability to be recognized there should be a reasonable estimate of a probable future cash outflow based on a future event. For instance, if there is a pending lawsuit against the organization, a possible cash payment may have to be made in the future in case the organization loses the lawsuit. Either winning or losing the lawsuit is not known at present thus the occurrence of the payment is not guaranteed. The recording of the contingent liability depends on the probability of the occurrence of the event that gives rise to such liability. If a reasonable estimate cannot be made regarding the amount, the contingent liability may not be recorded in the financial statements. Basic accounting treatment for recognizing a contingent liability is,

Cash   A\C                                       Dr

Accrued Liability A\C                   Cr