Provisions, Contingencies, and Financing Structure

Learning objectives

By the end of this chapter, you should be able to:

• Explain when provisions are recognised and how they are measured and presented in the financial statements.
• Distinguish provisions from contingent liabilities and contingent assets, and apply appropriate note disclosure.
• Record movements in provisions using journal entries, including settlement and year-end remeasurement.
• Explain the difference between equity finance and borrowed finance and their impact on profit or loss and the statement of financial position.
• Record share issues (including rights and bonus issues) and explain the effect on share capital, share premium, and reserves.
• Account for dividends and finance costs, including the timing of recognition and classification.

Overview & key concepts

This chapter covers two areas that are commonly tested together in scenario questions because both affect liabilities, equity, and profit or loss: (1) uncertain obligations and potential assets (provisions and contingencies) and (2) how a business is funded (financing structure).

Provisions

A provision is a recognised liability where the timing, the amount, or both are uncertain. Recognition is only appropriate when there is a present obligation at the reporting date arising from a past event that will probably require an outflow of economic resources and can be estimated reliably.

One point is essential: the obligation must arise from a past event (the obligating event) and exist at the reporting date.

What “probable” means

In this chapter, “probable” means “more likely than not”, i.e. a likelihood greater than 50%. Using this definition consistently helps you separate recognition (provision) from disclosure (contingency).

Probable supports disclosure (for assets) or recognition (for provisions); virtually certain is the threshold for recognising an asset that was previously contingent.

Contingent liabilities

A contingent liability is either:

• a possible obligation arising from a past event (it depends on uncertain future events), or
• a present obligation arising from a past event that is not recognised because an outflow is not probable or the amount cannot be measured reliably.

Contingent liabilities are not recorded in the ledger. They are generally disclosed in the notes unless the chance of payment is remote.

Contingent assets

A contingent asset is a potential asset arising from a past event, confirmed only by uncertain future events. It is not recognised until the inflow becomes virtually certain. If the inflow is probable (more likely than not), it is disclosed if material and sufficiently reliable to describe without overstating the outcome.

Core theory and frameworks

Provisions: when to recognise one

Start with the obligating event. Something has already happened by the reporting date that leaves the business with a duty it cannot realistically avoid (because of law, contract terms, or a well-established pattern of behaviour that creates valid expectations). If that duty exists at the reporting date, then apply two practical tests:

1. Is an outflow of economic resources probable (more likely than not)?
2. Can the obligation be measured with a sufficiently reliable estimate?

If the duty is only possible, or if a present duty exists but either the outflow is not probable or measurement is not sufficiently reliable, the item is normally dealt with by note disclosure rather than recognition.

Measuring a provision: most reasonable estimate at the reporting date

A provision is measured using the most reasonable estimate, at the reporting date, of what it will take to settle the obligation (or transfer it to another party). The method used should match the nature of the uncertainty:

• Large populations of similar items (e.g. warranties): probability-weighted estimates (expected values) often provide the most faithful measure.
• Single obligations (e.g. one lawsuit): the most likely outcome may be an appropriate starting point, but where there are multiple plausible outcomes, a probability-weighted estimate may still be needed.

What matters is that the measurement reflects the obligation as at the reporting date and is not deliberately biased high or low.

Discounting and unwinding

If the timing of settlement is expected to be later and the time value of money is material, the provision is discounted to present value.

As time passes, the discounted amount increases because the settlement date is closer. That increase is shown as a finance cost, and it increases the provision balance (it is not a separate liability).

Onerous contracts

A contract is onerous when unavoidable costs exceed the expected economic benefits. The provision reflects the cheapest unavoidable route:

• fulfil the contract using costs that relate directly to meeting the contract, or
• exit the contract and pay the cancellation or penalty costs.

Fulfilment cost should include only costs that relate directly to the contract (not general overheads unless they are directly attributable).

If the contract is linked to specific assets, consider whether those assets are impaired as well (topic-dependent).

Contingent liabilities and contingent assets: disclosure focus

A note disclosure should help a reader understand:

• what the uncertainty is and what could trigger a cash flow,
• the likely direction of impact (outflow or inflow), and
• where practicable, the possible scale and timing.

If a sensible estimate cannot be made, the note should say so and explain why. Potential reimbursements should be described separately and cautiously.

Financing structure: equity vs borrowed finance

Equity finance raises funds by issuing shares. Borrowed finance raises funds through interest-bearing obligations such as loans and debentures. These are accounted for very differently:

• Equity finance increases equity and does not create interest expense.
• Borrowed finance creates a liability and finance costs recognised on an accrual basis. Principal is split between current and non-current based on the repayment date.

Journal entries: exam patterns to know

Provisions

Initial recognition (e.g. warranty, onerous contract):

• Dr Expense (profit or loss)
• Cr Provision (liability)

Settlement:

• Dr Provision
• Cr Cash / Payables

Year-end remeasurement:

• Increase required: Dr Expense, Cr Provision
• Decrease required: Dr Provision, Cr Expense

A provision is used only for the purpose for which it was originally recognised.

Share issues for cash

• Dr Cash (proceeds)
• Cr Share capital (nominal value)
• Cr Share premium (excess over nominal, if any)

Bonus issues (no cash)

• Dr Reserves (eligible reserves)
• Cr Share capital (nominal value)

Dividends

Recognise a dividend only when it is authorised such that it is no longer at the entity’s discretion at the reporting date.

In many jurisdictions, final dividends typically remain at shareholders’ discretion until approved.

If recognised:

• Dr Retained earnings
• Cr Dividends payable

When paid:

• Dr Dividends payable
• Cr Cash

Dividends proposed after the reporting date are not recognised at the reporting date (but may be disclosed if material).

Finance costs (interest)

Accrual of unpaid interest:

• Dr Finance cost
• Cr Interest payable / Accrued expenses

Payment:

• Dr Interest payable / Accrued expenses
• Cr Cash

Worked example

Narrative scenario

Ridgeway Tools manufactures and sells tools. The year end is 31 December 20X5. The following matters arise:

1. Warranty claims are expected from past sales.
2. A lawsuit is pending; the outcome is uncertain.
3. The company issues 40,000 ordinary shares at £1.60 each. Nominal value is £1 per share.
4. A dividend of £7,500 is authorised before year-end such that it is no longer at the entity’s discretion.
5. Finance costs of £2,400 are accrued but unpaid at year-end.
6. A rights issue offers 1 new share for every 4 shares held at £1.50 per share (nominal value £1).
7. A bonus issue of 1-for-4 is made.
8. A supplier dispute could lead to compensation receivable.
9. An unavoidable contract is loss-making (onerous).
10. A further dividend is proposed after year-end but not authorised before year-end.

Assume Ridgeway Tools had 200,000 ordinary shares in issue at the start of the year (nominal value £1 each). Share transactions occur in this order: cash share issue, then rights issue, then bonus issue.

Required

• Calculate and record the warranty provision.
• Explain the disclosure treatment for the lawsuit.
• Record the share issue and share premium.
• Record the dividend (if recognised) and accrued finance costs.
• Calculate and record the rights issue and bonus issue.
• Explain the disclosure treatment for the supplier dispute.
• Record the provision for the onerous contract.
• Explain the year-end treatment for the proposed (not authorised) dividend.

Solution

1) Provision for warranty claims

The warranty relates to past sales (the obligating event) and creates a present obligation at the reporting date if the business cannot realistically avoid valid claims arising from those sales. Measurement requires an estimate of expected claims based on:

• past claim rates,
• the volume and type of goods sold, and
• expected repair/replacement cost.

Assume the most reasonable estimate of expected warranty claims at 31 December 20X5 is £12,000.

Journal entry (recognition):

• Dr Warranty expense (profit or loss) £12,000
• Cr Provision – warranties £12,000

Accounting equation impact:

• Liabilities increase £12,000
• Equity decreases £12,000 (via expense)

2) Lawsuit: contingent liability (disclosure)

To decide between a provision and a contingent liability, you would need:

• an assessment of whether a payment is more likely than not, and
• a reasonable estimate (or range) of the expected settlement and timing.

Assume the outcome is possible rather than probable. Therefore no provision is recognised. A note disclosure is appropriate (unless the chance of payment is remote). The note should explain:

• what the claim relates to and what could trigger payment, and
• where practicable, the possible scale and timing of any outflow (or state that it cannot be measured reliably).

No journal entry is recorded.

3) Cash share issue: 40,000 shares at £1.60 (nominal £1)

Proceeds formula:
40,000 × £1.60 = £64,000

Nominal share capital:
40,000 × £1.00 = £40,000

Share premium:
£64,000 − £40,000 = £24,000

Journal entry:

• Dr Cash £64,000
• Cr Share capital £40,000
• Cr Share premium £24,000

Shares in issue after this transaction:
200,000 + 40,000 = 240,000 shares

4) Dividend and finance costs at year-end

Dividend authorised before year-end

Because the dividend is authorised before year-end such that the entity cannot avoid payment at 31 December 20X5, it is recognised as a liability.

Journal entry:

• Dr Retained earnings £7,500
• Cr Dividends payable £7,500

Finance costs accrued but unpaid

Journal entry:

• Dr Finance cost £2,400
• Cr Interest payable (or accrued expenses) £2,400

5) Rights issue: 1 new for every 4 shares held at £1.50 (nominal £1)

Rights issue is based on shares held at the time of the offer. Using the sequence given, shares in issue before the rights issue are 240,000.

New shares:
240,000 ÷ 4 = 60,000 shares

Cash proceeds:
60,000 × £1.50 = £90,000

Nominal share capital:
60,000 × £1.00 = £60,000

Share premium:
£90,000 − £60,000 = £30,000

Journal entry:

• Dr Cash £90,000
• Cr Share capital £60,000
• Cr Share premium £30,000

Shares in issue after rights issue:
240,000 + 60,000 = 300,000 shares

Exam note: this chapter focuses on journal entries and statement impacts. Share valuation effects (such as theoretical ex-rights price) are addressed separately where required.

6) Bonus issue: 1-for-4

Bonus shares are based on shares in issue immediately before the bonus issue: 300,000.

Bonus shares:
300,000 ÷ 4 = 75,000 shares

Increase in share capital at nominal value:
75,000 × £1.00 = £75,000

Journal entry (funded from retained earnings or other eligible reserves):

• Dr Retained earnings (or eligible reserves) £75,000
• Cr Share capital £75,000

Shares in issue after bonus issue:
300,000 + 75,000 = 375,000 shares

7) Supplier dispute: contingent asset (disclosure)

To decide between disclosure and recognition, you would need:

• the likelihood of success,
• the range or estimated amount of compensation, and
• expected timing of settlement.

If the inflow is probable (more likely than not) but not virtually certain, no asset is recognised. A note disclosure is made if material and sufficiently reliable to describe without presenting the inflow as assured. If the inflow later becomes virtually certain, an asset (such as a receivable) is recognised at that point.

No journal entry is recorded.

8) Onerous contract: provision

To measure an onerous contract provision, you need:

• the direct costs to fulfil the contract,
• the costs to exit (penalties/compensation), and
• confirmation the contract cannot be avoided.

Assume:

• cost to fulfil (directly attributable): £18,000
• cost to exit (penalty): £14,000

The provision reflects the cheaper unavoidable route, so £14,000.

Journal entry:

• Dr Onerous contract expense £14,000
• Cr Provision – onerous contract £14,000

9) Proposed dividend after year-end (not authorised before year-end)

A dividend proposed after the reporting date does not create an obligation at 31 December 20X5 if it is not authorised such that it is beyond the entity’s discretion at that date. Therefore:

• no liability is recognised at year-end, and
• it is disclosed after the reporting date if material.

No journal entry is recorded at year-end.

Interpretation of the results

• Warranty and onerous contract provisions recognise present obligations from past events, reducing profit and increasing liabilities.
• The lawsuit is treated as a contingency and handled by disclosure, avoiding overstatement of liabilities when payment is not probable.
• The cash share issue and rights issue increase cash and equity; the split between share capital (nominal) and share premium (excess) must be shown.
• The bonus issue transfers amounts within equity from reserves to share capital; total equity and cash do not change.
• The authorised dividend (where it is no longer at the entity’s discretion at the reporting date) reduces retained earnings and creates a payable until paid.
• Accrued interest ensures finance costs are matched to the period, with a payable recognised if unpaid.

Common pitfalls and misunderstandings

• Recognising a provision without a past obligating event: forecasts of future costs do not create present obligations.
• Treating “possible” outflows as provisions: if payment is not probable, recognition is usually inappropriate.
• Recording contingent liabilities or contingent assets in the ledger: contingencies are typically disclosed, not recognised.
• Overstating contingent assets: disclosure must be cautious and should not present inflows as assured.
• Measuring provisions using vague “buffers”: estimates should be supportable, not deliberately biased.
• Forgetting to remeasure provisions at each reporting date: update to the latest estimate.
• Using provisions for a different purpose: provisions are used only for the obligation they were recognised for.
• Miscounting shares for rights/bonus issues: state the share base used and keep the transaction sequence consistent.
• Posting share issues without separating nominal value and premium: share capital is recorded at nominal value.
• Recognising a proposed dividend as a liability when it is still within discretion at the reporting date.

Summary

Provisions recognise present obligations from past events where payment is probable (more likely than not) and a reliable estimate can be made. Contingent liabilities and contingent assets are generally not recognised but may require note disclosure when the uncertainty is relevant to understanding the financial statements.

Financing structure affects both the statement of financial position and profit or loss. Equity finance increases share capital and reserves, while borrowed finance creates liabilities and finance costs recognised on an accrual basis. Correct journals for share issues, rights issues, bonus issues, dividends, and interest accruals are core exam skills.

FAQ

What is the difference between a provision and a contingent liability?

A provision is recognised when an obligation exists at the reporting date because of a past event, payment is probable (more likely than not), and a reliable estimate can be made. A contingent liability is not recognised because the obligation is only possible, or because payment is not probable, or because the amount cannot be measured reliably. Contingent liabilities are generally disclosed unless the chance of payment is remote.

How are share issues recorded in financial statements?

Cash proceeds are debited to cash. Share capital is credited for the nominal value of shares issued, and any excess proceeds are credited to share premium. This records the increase in equity and explains how much funding came from nominal capital versus additional paid-in amounts.

When should a contingent asset be recognised?

A contingent asset is not recognised until the inflow becomes virtually certain. If the inflow is probable, it is disclosed if material and sufficiently reliable to describe, but it is presented cautiously and not as guaranteed income.

What is the impact of finance costs on financial statements?

Finance costs reduce profit for the period they relate to. If interest is unpaid at the reporting date, a corresponding liability is recognised as interest payable (or accrued expenses), ensuring the statement of financial position reflects the obligation.

How are dividends recorded in financial statements?

A dividend is recognised only when it is authorised such that, at the reporting date, the entity no longer has the discretion to avoid payment. In many jurisdictions, final dividends typically remain at shareholders’ discretion until approved. If recognised, retained earnings are debited and dividends payable credited. Dividends proposed after the reporting date are not recognised at the reporting date but may be disclosed if material.

What are the key considerations for recognising a provision?

Identify the past obligating event and confirm a present obligation exists at the reporting date. Then assess whether an outflow is probable (more likely than not) and whether the amount can be estimated reliably. Measure using the most reasonable estimate at the reporting date and remeasure at each reporting date.

How do rights issues and bonus issues differ?

A rights issue raises new cash and increases share capital and (where applicable) share premium. A bonus issue raises no cash; it capitalises reserves into share capital, increasing the number of shares while leaving total equity unchanged.

Summary (Recap)

This chapter explained how uncertain obligations and potential assets are handled in financial statements and how financing choices flow through equity, liabilities, and profit or loss. Provisions are recognised for present obligations from past events when outflows are probable (more likely than not) and measurable by a reliable estimate. Contingent items are generally disclosed rather than recognised. The chapter also set out core journals for share issues, rights issues, bonus issues, dividends, and finance costs, and highlighted common exam pitfalls.

Glossary

Provision

A recognised liability with uncertainty over timing or amount, recorded for a present obligation from a past event when an outflow is probable (more likely than not) and a reliable estimate can be made.

Probable

More likely than not, i.e. likelihood greater than 50%.

Virtually certain

So close to certainty that recognising the related asset is appropriate; this is the threshold for recognising an asset that was previously treated as contingent.

Contingent liability

A possible obligation arising from a past event, or a present obligation arising from a past event not recognised because an outflow is not probable or cannot be measured reliably; generally disclosed unless remote.

Contingent asset

A potential asset dependent on uncertain future events; not recognised until inflow becomes virtually certain; disclosed if inflow is probable, material, and sufficiently reliable to describe.

Equity finance

Funding raised from owners through share issues, increasing equity and not creating interest expense.

Borrowed finance

Funding raised through interest-bearing obligations, creating liabilities and finance costs recognised on an accrual basis.

Share capital

The nominal value of shares issued, presented within equity.

Share premium

Amounts received above nominal value on share issues, presented as a separate reserve within equity.

Rights issue

A cash share issue offered to existing shareholders in proportion to their holdings at a set subscription price.

Bonus issue

An issue of shares for no cash, funded by transferring amounts from reserves to share capital.

Dividend

A distribution to owners, recognised as a liability only when authorised such that it is no longer at the entity’s discretion at the reporting date; otherwise disclosed if material.

Finance cost

The cost of borrowing (typically interest), recognised in profit or loss for the period it relates to, with a payable recognised if unpaid at the reporting date.

Recognition

Including an item in the primary financial statements when it meets the criteria to be presented as an asset, liability, income, or expense.

Disclosure

Providing information in the notes to help users understand relevant uncertainties, exposures, and significant post-reporting-date matters.