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Corporate Financial Reporting and Analysis, 3rd Edition by Jacob Cohen, David Young

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Chapter 13

Provisions and Contingencies

Introduction

The purpose of this chapter is to address the accounting treatment for provisions and contingencies. The chapter draws on the examples of L’Oréal and Merck to illustrate the key concepts. Sources of provisioning include corporate restructuring, warranties, environmental clean-up, litigation, and onerous contracts.1 Contingencies can arise for several reasons, but litigation-related costs are the most common.

To begin, let’s imagine a vacuum-cleaner manufacturer offering a two-year warranty for its products. If something goes wrong within the warranty period, the company either repairs the machine or replaces it. This means that every time a vacuum cleaner is sold, a potential liability is assumed. For accounting purposes, the company could, in theory, report a warranty-related expense only when resources are paid out to service a warranty (as, for example, when a faulty machine is brought in by a customer for repair). But this approach would violate both the matching principle and conservatism. The matching principle says that any costs incurred to generate revenue must be “matched” against the revenue in the period in which the revenue is recognized, even if cash payments will not be made until a future period, and the amount is not known with certainty. Conservatism says that companies should not understate liabilities or expenses. If we have reason to believe that the company has incurred obligations as a result of past transactions ...

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