Every now and then there are situations which may but may also not result in expenses for the company. It’s called uncertainty and something to measure it is called probability.
In a situation where it’s unsure whether you have to pay anything or not, it’s really difficult to recognize the balance in the accounts as such. In a situation where it’s probable the amount is due, you recognize a provision in the accounts. However, if you believe it’s more unlikely than likely (i.e. the probability is less than 50%), you do not recognize the amount in the accounts. So, as you might have guessed, your first course of action is do assess the probability – it’s all an estimation so there really isn’t a right or wrong answer. What the management estimates, is their decision. Just make sure it’s based on reasonable assumptions and accurate information.
If the result reached is that it’s to be recognized in the accounts, you debit for expense and credit the liability. Now, if you determine however that it’s less likely that you would have to pay something, it’s a contingent liability and it’s not recognized in the accounts. If you assess the probability to be let’s say 20%, you do not account for that 20% of the expense. You don’t account for anything.
Something to watch out for though is the disclosure in the annual report. If you do account for a provision, it’s to be expected that you also explain further in the notes what the balance is about. If a conclusion is reached that the liability is less then likely to be paid, you should still disclose the information about the possible payable, even though you do not account for the liability and expense itself in the accounts.