Specific deductions: provisions: accounting standards and GAAP: when a provision can be made
Under Section 21 of FRS102 provisions should be made in the financial statements when and only when:
- the business is under a legal or constructive obligation at the reporting date as a result of a past event - a ‘constructive obligation’ is where as a result of ‘an established pattern of past practice, published policies or a sufficiently specific current statement’ the business has created a ‘valid expectation’ that it will meet certain responsibilities. For example, where it is well known that a shop habitually gives refunds on purchases, it may have a constructive obligation to do so even when there is no legal obligation;
- it is probable that the business will be required to transfer economic benefits in settlement. For example, if a company is sued for alleged damages a provision can be made only if the company, on legal advice, considers it more likely than not that it will have to pay something. Where a transfer of economic benefits is possible, but not probable, a provision should not be made but should be disclosed as a ‘contingent liability’ instead; and
- a reliable estimate of the amount of the obligation can be made.