Is there a need to differentiate between Contingent Liabilities and Provisions?
When does a company stop treating an item as a contingent liability, and start treating it as a provision?
The goal of IAS 37 and Ind AS on Provisions, Contingent Liabilities and Contingent Assets, is to ensure that Contingent Assets, Contingent Liabilities and Provisions, all the three are recognized and measured appropriately.
We already read the definition of Contingent Assets and Contingent Liabilities in our previous post. To read them again click here
Here in this post, We shall try to understand provisions, the relationship between a contingent liability and a provision and also how a provision is different from a contingent liability.
Definition of a Provision: A provision is a liability of uncertain timing or amount.
If you notice the difference between the definition of a contingent liability and a provision, the definition of a contingent liability says, a contingent liability is a liability which may arise due to the happening or non-happening of a future event. Whereas, from the definition of provision it is understood clearly that the existence of liability is almost certain, but it is the amount of such liability or the timing of the liability which is not certain. Hence the accountant creates a liability, but he calls it a provision, because the exact amount of liability is unknown.
[Note: Although the exact amount of liability is unknown, for a provision to be made, a reliable estimate of such liability should be made possible. If the liability cannot be estimated reliably, then it is still treated as a contingent liability and no provision is created].
DISCLOSURE OF CONTINGENT LIABILITY
Here, a contingent liability is disclosed only when there is a possibility that the liability will arise in the future. It is not recognized when the possibility is remote.
The disclosure of a Contingent Liability is made in the notes to the Financial Statements of a Company.
RECOGNITION OF A PROVISION
Usually, a company stops classifying an item as a contingent liability and creates a provision for such liability, when it becomes an obligation and probable outflow of economic benefits for the contingent liability becomes probable.
Read more about Recognition and Measurement of a Provision
The following chart clearly distinguishes between a contingent liability and a provision.
Taking the same example as in the previous post, let us assume that it is now probable that Finger Foods Pvt Ltd has to pay Rs.7 Lakhs for the claim as compensation. Finger Foods would now create a provision for Rs.7 Lakhs.
To read on more about criteria for recognition of provisions click here
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