Difference between Provision and Contingent Liabilities
Provisions and contingent liabilities are both accounting terms that refer to potential future obligations of a company. However, there are some key differences between the two. A provision is a liability of uncertain timing or amount, while a contingent liability is a possible obligation of a company that arises from uncertain future events. Let us learn about the difference between provision and contingent liabilities.
Comparison Table – Difference between Provision and Contingent Liabilities
A provision is a liability about which there are doubts regarding its amount and maturity, while a contingency is an obligation with uncertainty about its existence. In this article, we highlight the difference between provision and contingent liabilities.
| Aspect | Provision | Contingent Liability |
|---|---|---|
| Nature | Known liabilities that are certain or likely to occur | Potential liabilities that are uncertain and contingent on future events |
| Recognition | Recognized on the balance sheet as a liability | Not recognized on the balance sheet until specific conditions are met |
| Timing | Recognized when the obligation is present or probable | Recognized only when specific conditions are met in the future |
| Amount | Recorded at the best estimate of the expected cost | Not recorded until the amount can be reasonably estimated |
| Measurement | Measured with reasonable certainty | Not measured until they become probable and estimable |
| Balance Sheet Presentation | Appears on the balance sheet | Does not appear on the balance sheet until recognized |
| Disclosure | Details disclosed on the financial statements | Disclosed in footnotes or other financial statement disclosures |
| Examples |
|
|
| Certainty | Certain or likely to occur | Uncertain and contingent on future events |
| Impact on Financial Statements | Affects the company's financial statements directly | May affect the company's financial statements indirectly |
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What is Provision?
Provisions in accounting refer to the amount that companies keep aside from the profit with an aim to meet a potential expense or obligation. A provision is a liability account and consists of establishing and “saving” a number of resources for the said expense or obligation.
That is, when we assume that some asset of the company will lose value or we have to satisfy an obligation within a period of time, we allocate a provision for the value of the obligation. The purpose of making a provision for an expense is to ensure that we have the necessary resources to satisfy the obligation when necessary.
As the company creates provisions, the expense increases, and the benefits decrease. With this, an entity protects itself and ensures that it has the necessary resources in the future.
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Provisions can be allocated when:
- The company incurs an obligation previously
- The company must take charge of this obligation with its own economic resources.
- The amount of the obligation is known or can be easily estimated.
Some examples of provisions are the following:
- Doubtful debts
- Depreciation
- Pension
- Litigation
- Refunds to customers
- Onerous contracts that generate losses
- Restructuring and plant closures
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Types of Provisions
According to the type of expense, the types of provisions are:
- Impairment provisions: Set up to offset the loss of value of a fixed asset or the possible loss of customers.
- Provisions for contracted and unpaid debts: These provisions are established when payment commitments have been acquired but have not been fully cancelled.
- Provisions for expected debts: Those made when acquiring new debts are planned. They are uncertain, and only a percentage to be paid is estimated.
What are Contingent Liabilities?
Contingent liabilities are those probable obligations that may arise in the future due to present or past situations. Their fulfilment or appearance is not fully assured in the future. According to IFRS, contingent liabilities are recognized if the following conditions are met:
- An obligation exists as a consequence of a past event.
- The company may have to part with resources.
- An estimate of the amount of the obligation can be made.
How to Deal with Contingent Liability?
For accounting purposes, keeping contingent liability obligations in the daily books would be inaccurate and impractical since these expenses cannot be quantified. Accounting must satisfy these contingent liabilities with provisions. In case of a certain contingency, it will be financially prepared to satisfy the obligation.
These provisions are commonly referred to in accounting as risks and expenses. The main objective is to assume that a company acts economically, running a series of risks. For this reason, they prudently prepare to act accordingly. This means that provisions are uncertain future payments that a company must keep preventively.
We hope this article on the difference between provision and contingent liabilities was helpful.
FAQs - Difference Between Provisions and Contingent Liabilities
How are provisions and contingent liabilities recognized in financial statements?
Provisions are recognized on the balance sheet, while contingent liabilities are typically disclosed in the footnotes or other financial statement disclosures.
When are provisions recorded?
Provisions are recorded when there is a present obligation, it is probable, and the amount can be reasonably estimated.
When are contingent liabilities recognized?
Contingent liabilities are recognized when specific conditions are met in the future, such as a lawsuit settlement becoming probable.
Do both provisions and contingent liabilities impact a company's financial statements?
Yes, provisions directly impact a company's financial statements by increasing liabilities and reducing profit. Contingent liabilities may indirectly affect financial statements if they materialize in the future.
Can a contingent liability turn into a provision?
Yes, a contingent liability can eventually become a provision when the conditions for recognition are met, and the amount can be reasonably estimated.
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