Estimate at sale, draw down as claims come

◈ 10 cards

Measure and record a provision (most-likely amount for a single obligation, expected value for a large population); run a warranty provision through a period; remeasure.

The entry

A provision is recognised with the same shape as any accrued cost: debit the expense that caused it, credit the provision. Boreal Bikes’ frame-failure lawsuit from lesson 6.4 — 60 % likely to lose, best estimate $150,000:

Dr Legal Expense                 150,000
    Cr Provision for Lawsuit             150,000

The credit is a real liability account, presented separately on the balance sheet. There is no account called “Contingent Liability” — a contingent liability is by definition not recognised, so it can never be a credit.

Measuring the estimate

IAS 37 asks for the best estimate of the expenditure, and how you find it depends on the population:

A single obligation — one lawsuit — is measured at its most likely outcome, adjusted if the other outcomes cluster above or below it. Counsel’s $150,000 is that figure.
A large population of similar items — thousands of warranties — is measured at expected value: each outcome weighted by its probability. No individual bike’s claim is predictable; the population’s cost is.

Boreal’s premium frame carries a two-year warranty. For a batch of 1,000 frames, engineering estimates that 70 % will have no defect, 20 % a minor defect costing $50 to fix, and 10 % a major defect costing $300:

$Expected cost per unit = 0.70 \times 0 + 0.20 \times 50 + 0.10 \times 300 = 0 + 10 + 30 = 40$

Provision for the batch: $1, 000 \times 40 = 40, 000$ . In Excel this is =SUMPRODUCT(probabilities, costs) times the unit count.

The warranty cycle — the workhorse example

Most provision questions on the midterm are warranties, because the cycle exercises every rule. Boreal sells 2,000 standard bikes this year; history says 5 % will come back under warranty at an average cost of $90.

At sale — estimate the whole cost. $2, 000 \times 5% \times 90 = 9, 000$ . The matching principle puts the cost in the year of the sale that created the obligation, not in the year the bikes come back:

Dr Warranty Expense                9,000
    Cr Warranty Provision                  9,000

As claims arrive — draw down the provision. During the year Boreal pays $3,200 to outside shops for repairs, and its own mechanics fit $1,500 of parts taken from inventory. Neither is an expense: the expense was recognised at sale. Each claim reduces the liability:

Dr Warranty Provision              3,200
    Cr Cash                                3,200

Dr Warranty Provision              1,500
    Cr Inventory                           1,500

Debiting Warranty Expense when a claim is paid is the trap: it charges the cost twice — once as an estimate, once as a fact. The provision ends the year at $9, 000 - 3, 200 - 1, 500 = 4, 300$ , the estimated cost of claims still to come.

Remeasuring

Provisions are re-estimated at every reporting date. If, by year-end, counsel raises the lawsuit estimate from $150,000 to $180,000, the provision is topped up by the difference — Dr Legal Expense 30,000 / Cr Provision for Lawsuit 30,000 — never re-recorded in full. A reduction reverses through the same expense line.