Financial literacy and accountingModule 2, lesson 7 of 19
Provisions, contingent liabilities and impairments
When a company must record an expected cost as a provision, when a possible one is only disclosed as a contingent liability, and how impairments write assets down.
In this lesson
- Explain when a company records a provision and how it affects profit and the balance sheet.
- Tell a provision from a contingent liability, and find contingent liabilities in the notes.
- Explain an impairment and why it reduces profit without using cash.
- Recognise how provisions and impairments can be used to smooth or flatter reported profit.
Builds on
- Accrual accounting and cash accountingProvisions are accruals for costs that are expected but not yet paid.
- Depreciation, amortisation and capital expenditureAn impairment is an extra, one-off write-down of an asset on top of normal depreciation.
On this page
In simple terms
Accrual accounting asks companies to record costs when they are incurred, not when they are paid. Some costs, though, are uncertain: a company does not yet know exactly how much it will owe, or whether it will owe anything at all. Three accounting ideas deal with that uncertainty.
- A provision is a liability for a cost the company will probably have to pay, recorded now with a best estimate of the amount.
- A contingent liability is a possible obligation that is not likely enough, or not measurable enough, to record. It is described in the notes to the accounts instead.
- An impairment is a write-down of an asset when it has become worth less than the value at which it is carried on the balance sheet.
Under Ind AS, the accounting standards most listed Indian companies follow, provisions and contingent liabilities are covered by Ind AS 37 and impairments by Ind AS 36.
Provisions
A company records a provision when three things are true: it has an obligation now because of something that has already happened, it will probably have to pay, and it can estimate the amount reliably. Common examples are warranty repairs on goods already sold, legal claims it expects to lose, restructuring costs it has committed to, and the cost of restoring a site after mining.
Worked example: A warranty provision
A made-up company, Kaveri Pumps, sells 10,000 pumps with a one-year warranty. From experience, about 3% need a repair costing ₹2,000.
| Pumps expected to need repair: 10,000 × 3% | 300 |
|---|---|
| Provision: 300 × ₹2,000 | ₹6,00,000 |
Kaveri records a ₹6 lakh expense this year, matched to the sales that created the obligation, and a ₹6 lakh liability on the balance sheet. When repairs are carried out next year, the cash paid reduces the provision, not next year's profit.
Contingent liabilities
When an obligation is only possible, or cannot be measured, it is not recorded as a liability. Instead the company describes it in the notes, usually under "contingent liabilities and commitments", unless the chance of paying is remote. Typical items are lawsuits, tax demands under dispute, and guarantees given for loans taken by other companies, including group companies.
These items are easy to miss, because they never appear in the headline numbers. Yet a large disputed tax demand, or a guarantee for a struggling sister company, can turn into a real liability quickly. If the situation changes and a payment becomes probable, the company moves it from the notes into a provision and takes the charge to profit.
Impairments
Assets are normally carried at cost less depreciation. If something happens that makes an asset worth much less than that, such as a factory whose product falls out of demand or an acquisition that disappoints, the company must test it. If the asset's recoverable amount (the higher of what it could be sold for, after costs, and the value of the cash it is expected to generate) is below its carrying amount, the difference is written off as an impairment loss.
Worked example: Writing down an acquisition
Kaveri bought a smaller company for ₹300 crore, paying ₹120 crore more than the value of its separate assets. That extra is recorded as goodwill. Two years later the acquired business is struggling.
| Carrying amount of the acquired business, including goodwill | ₹280 crore |
|---|---|
| Recoverable amount, estimated by Kaveri | ₹220 crore |
| Impairment loss, charged against profit | ₹60 crore |
The ₹60 crore reduces profit and the value of goodwill, but no cash leaves the company this year. The cash was spent when the acquisition was made; the impairment admits that part of it was overpaid.
Goodwill is tested for impairment every year, because under Ind AS it is not amortised. Impairments are usually shown separately or as exceptional items.
Where judgement and incentives come in
All three areas rest on estimates: how many products will fail, how a court case will go, what a business will earn in future. That makes them a natural place for profit to be shaped.
- Cookie-jar provisions: setting up generous provisions in a good year, then releasing them in a weak year to lift profit.
- The big bath: a new management team writes down as much as possible in its first year, blaming the past, so that later years look better.
- Delayed impairments: keeping a failing acquisition at its old value to avoid admitting the mistake.
None of these is proof of wrongdoing on its own, and many provisions and impairments are entirely honest. But large provision releases, frequent "one-off" impairments, or contingent liabilities that keep growing deserve close reading of the notes.
Why it matters
Provisions and impairments explain many sudden swings in reported profit, and contingent liabilities can reveal risks that the balance sheet does not show. An investor who reads only the headline profit can be surprised by a lawsuit that was disclosed in the notes for years, or misled by profit boosted with released provisions.
Limitations
- Outsiders cannot check most of these estimates; they can only compare them over time and with similar companies.
- An impairment shows that value has already been lost. It is a lagging signal, not an early one.
- Accounting standards set the principles, but companies apply them differently. This lesson explains the general idea, not every rule.
Common mistakes
- Ignoring the notes. Contingent liabilities appear only there.
- Treating an impairment as a cash loss this year. The cash was lost earlier, when the asset was bought.
- Assuming one-off charges never recur. If "exceptional" impairments appear most years, they are part of the business.
- Celebrating profit boosted by released provisions without checking where it came from.
Try it yourself
- In an annual report, find the note on contingent liabilities. Add up the amounts and compare the total with the company's net worth (shareholders' equity).
- Find the note on provisions. Which provisions grew or shrank during the year, and why?
- Search the report for "impairment". Did the company write anything down this year or last? What reason does it give?
Key takeaways
- A provision is a liability for a cost the company probably owes but whose exact amount or timing is uncertain, such as warranty repairs. It reduces profit when it is recorded.
- A contingent liability is a possible obligation that is not probable, or cannot be measured reliably. It is described in the notes, not recorded as a liability.
- An impairment writes an asset down when it is worth less than its value on the balance sheet. It reduces profit but uses no cash.
- All three rest on management's judgement, which makes them a common place to smooth or flatter profit.
- Large contingent liabilities in the notes can matter as much as the debts on the balance sheet.
Check your understanding
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Terms used in this lesson
- Provision
- A liability for a cost a company will probably have to pay but whose amount or timing is uncertain, recorded with a best estimate.
- Contingent liability
- A possible obligation, such as a lawsuit or disputed tax demand, that is not probable or cannot be measured. It is described in the notes, not recorded.
- Impairment
- A one-off reduction in an asset's value on the balance sheet when it is worth less than its carrying amount. It reduces profit but uses no cash.
- Goodwill
- The amount a company pays for an acquisition above the value of the acquired business's separate assets less its liabilities.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.