Chapter 34 SMEs Provisions and Contingencies

QUESTION
1.
2.
3.
4.

Define a provision
Explain the recognition of a provision
Explain the initial measurement of a provision
Explain the measurement when the provision involves a large
population of items
5. Explain the measurement when the provision arises from a single
obligation
6. Explain the measurement when there is a continuous range of
possible outcome and each point in that range is as likely as any
other
7. Explain the treatment of reimbursement of a provision
8. Explain the subsequent measurement of a provision
9. Define a contingent liability
10.
What is the treatment of contingent liability
11.
What are the disclosure about the contingent liability
12.
Define a contingent asset
13.
What are the disclosures about contingent asset?
14.
What is the treatment of contingent asset?
15.
What is prejudicial disclosure in relation to a provision?

Problem 34-1 Multiple choice (IFRS)

1. A provision is
a. A liability of uncertain timing or amount
b. A possible obligation as a result of past event that is of uncertain timing or
amount
c. An adjustment to the carrying amount of asset
d. A liability of certain timing or amount
2. An SME shall recognize a provision in when
a. The entity has a present obligation as a result of a past event
b. It is probable that the entity will be required to transfer economic benefits
in settlement
c. The amount of the obligation can be estimated reliably
d. All of these are required in recognizing a provision
3. When the provision involves a large population of items, the
estimate of the amount
a. Shall reflect the weighing of all possible outcomes by their associated
probabilities
b. Is determined as the individual most likely outcome

c. May be the individual most likely outcome adjusted for the effect of other
possible outcome
d. Is the midpoint of the possible outcomes
4. When the provision arises from a single obligation, the estimate of
the amount
a. Shall reflect the weighting of all possible outcomes by their associated
probabilities
b. Is determined as the individual most likely outcome
c. Is the individual most likely outcome adjusted for the effect of other
possible outcomes
d. Is the midpoint of the possible outcomes.
Problem 34-2 Multiple choice (IAA)
1. Which of the following terms is associated with recognizing a
provision?
a.
b.
c.
d.

Possible
Likely
Remote
Probable

2. Provisions are accrued because the likelihood of an unfavorable

outcome is
a.
b.
c.
d.

Virtually certain
Greater than 50%
At least 75%
Possible

3. No single amount within a range is a better estimate than any other

amount. What is the amount of accrual?
a.
b.
c.
d.

Zero
The midpoint of the range
The minimum of the range
The maximum of the range

4. What condition is necessary to recognize an environmental liability?

a. The entity has an existing legal obligation and can reasonably estimate
the amount of the liability
b. The entity can reasonably estimate the liability
c. The entity has an existing legal obligation
d. The obligating event has occurs
5. Which is not considered when evaluating whether to record a
liability for pending litigation?

a.
b.
c.
d.

Time period of the underlying cause of action

The type of litigation involved
The probability of an unfavorable outcome
The ability to make a reasonable estimate

6. A contingent liability
a. Definitely exists as a liability but the amount and due date are
indeterminable
b. Is accrued even though not reasonably estimated
c. Is the result of a loss contingency
d. Is not recognize in the financial statements
7. Which of the following is not a contingent liability?
a.
b.
c.
d.

A
A
A
A

possible but uncertain obligation

present obligation that is not probable but measurable
present obligation that is probable but not measurable
liability of uncertain timing or amount

8. Which of the following is the proper way to report a probable

contingent asset?
a.
b.
c.
d.

As an asset
As deferred revenue
As a disclosure only
No disclosure or no accrual

9. Contingent assets need not be disclosed when considered

a.
b.
c.
d.

Virtually certain
Probable
Likely
Possible

10.
Which is the proper way to report a contingent asset, receipt
of which is virtually certain?
a.
b.
c.
d.

As an asset
As unearned revenue
As a disclosure only
No disclosure or no accrual

Problem 34-3 (IFRS)

An SME gives warranties at the time of sale to purchasers of its product.
Under the terms of the sale, the SME undertakers to make good, by repair

or replacement, manufacturing defects that becomes apparent within one

year from the date of sale.
On the basis of experience, it is probable that there will be some claims
under the warranties.
Sales of P 10,000,000 were made evenly throughout 2014. The
expenditures for warranty repairs and replacement for the products sold
in 2014 are expected to be made 50% in 2014 and 50% in 2015.
The 2015 outflows of economic benefits related to the warranty will take
place on June 30, 2015.
Experience indicates that 95% of products sold require no warranty
repairs, 3% of products sold required minor repairs costing 10% of the
sale price, and 2% of products sold require major repairs or replacement
costing 90% of sale price.
The appropriate discount factor for cash flows expected to occur on June
30, 2015 is 0.95238.
Furthermore, an appropriate risk adjustment factor to reflect the
uncertainties in the cash flow estimates is an increment of 6% to the
probability weighted expected cash flows.

What is the warranty provision on December 31, 2014?

a.
b.
c.
d.

210,000
222,600
111,300
106,000

Problem 34-4 (IFRS)

During 2014, An SME is the defendant in a patent infringement lawsuit.
The entitys lawyers believe there is a 30% chance that the court will
dismiss the case and the entity will incur no outflow of economic benefits.
However, if the court rules in favor of the claimant, the lawyers believes
that there is a 20% chance that the entity will be required to pay damages
of P200,000 and an 80% chance that the entity will be required to pay
damages of P100,000. Other outcomes are unlikely. The court is expected
to rule in late December 2015. There is no indication that the claimant will
settle out of court. A 7% risk adjustment factor to the probability
weighted expected cash flows is considered appropriate to reflect the
uncertainties in the cash flow estimates. An appropriate discount rate is
5% per year. The PV of 1 at 5% for one period is .95. On December 31,
2014, what is the measurement if the provision for lawsuit?

a.
b.
c.
d.

100,000
84,000
89,880
85,386

Problem 34-5 (IFRS)

An SME gives warranties at the time of sale to purchasers of its product.
Under the terms of the sale. SME undertakes to make good, by repair or
replacement, manufacturing defects that become apparent within one
year from the date of sale. On the basis of experience, it is probable that
there will be some claims under the warranties.
On December 31, 2014, SME appropriately recognized P50,000 warranty
provision. SME incurred and charged P140,000 against the warranty
provision in 2015. Out of the provision of P140,000, an amount of P80,000
is related to warranties for sale made in 2015.
The increase during 2015 in the discounted amount recognized as a
provision on December 31, 2014 arising from the passage of time is
P2,000.
On December 31, 2015, SME estimated that it would incur expenditures in
2016 to meet the warranty obligations on December 31, 2015 as follows:
5% probability of P400,000
20% probability of P200,000
50% probability of P80,000
25% probability of P20,000
Assume for simplicity that the 2016 cash flows for warranty repairs and
replacements take place on June 30, 2016.
An appropriate discount rate is 10% per annum. The PV of 1 at 10% for
one year is 0.91 and the PV of 1 at 10% for 6 months uncertainties in the
cash flow estimates is an increment of 8% to the probability weighted
expected cash flows.
SME is also the defendant in a breach of patent lawsuit. Its lawyers
believe there is a 70% chance that the court will not dismiss the case and
the entity will incur outflow of benefits.
If the court rules in favor of the claimant, the lawyers believe that there is
a 60% chance that the entity will pay damages of P2,000,000 and a 40%
chance that the entity will be required to pay damages of P1,000,000,
Other amounts of damages are unlikely.

The court is expected to rule in late December 2016. There is no indication

that the claimant will settle out of court.
A 7% risk adjustment factor to the cash flows is considered appropriate to
reflect the uncertainties in the cash flow estimates.
REQUIRED:
Prepare the journal entries to record the provision in the records of SME
for 2014 and 2015.