Provision for a legal dispute: when and how to record it

A lawyer letter lands three weeks before year-end close. A former employee files at the labour tribunal. A supplier claims penalties you dispute. In each case the same question comes back: should you book a provision in the accounts, and for how much? This is not a matter of intuition. It follows precise accounting criteria, and even stricter tax conditions if the charge is to be genuinely deductible.

You must book a provision for a dispute when, at the closing date, there is an obligation towards a third party whose settlement will probably trigger an outflow of resources, and the amount can be reliably estimated. This is the typical case of litigation where your liability is engaged and a conviction or settlement is probable. Conversely, a merely hypothetical risk, with no formal proceedings or claim, is not provisioned: it is disclosed in the notes. Tax deduction of the provision additionally requires that the charge it covers be itself deductible, clearly specified and probable.

The reference definition is set out in article 321-5 of the French General Chart of Accounts (regulation ANC 2014-03): a provision is a liability whose timing or amount is not precisely fixed. The conditions for recognising a liability are laid down in article 322-1: there must be an obligation of the entity towards a third party at the closing date, and it must be probable or certain that this obligation will cause an outflow of resources to that third party, without an at least equivalent expected counterparty. The assessment and measurement of that liability at closing falls under article 322-2.

Three conditions must therefore be met at the same time.

• An obligation at the closing date. The triggering event, the event that creates the obligation, must precede or coincide with the closing date. A dispute arising from an event after the close is not provisioned in the closed financial year.
• A probable outflow of resources. The conviction, refund, indemnity or settlement must be more likely than not. A reasoned lawyer opinion is a central piece of evidence here.
• A reliable estimate. The risk must be quantifiable, even as a range. When only a maximum amount is known, the most realistic estimate is used, not automatically the cap.

If the outflow of resources is only possible, and not probable, no provision is booked: you are dealing with a contingent liability, disclosed in the notes, with no impact on the result.

This is where most reassessments happen. A provision can be perfectly justified in accounting terms and yet rejected for tax purposes. The French Tax Code, in article 39-1-5, sets cumulative conditions for deduction.

In practice, a provision for a labour-tribunal dispute covers a deductible charge (severance, salary back-pay), so it is in principle deductible. By contrast, a provision for a fine or a penalty in the nature of a sanction is not deductible, because the charge it covers is not deductible itself. For the trade-offs in detail, see the full regime of provisions for risks and charges and our rules on the deductibility of charges for corporate tax.

In the files we take over, the most common error is not the absence of a provision: it is the poorly documented provision. A provision for litigation recorded with no dated lawyer opinion, no risk assessment and no evidence supporting probability is a prime target during an audit. The tax authorities do not challenge the principle, they challenge the probable nature and the precision of the amount. A provision is defended with a file, not with a conviction.

The opposite pitfall is deliberate under-measurement to smooth results, or over-measurement to reduce tax. Both expose the company. A provision is not a result-adjustment variable: it is the accounting translation of a real obligation, estimated in good faith.

The real danger is not always provisioning wrongly, it is forgetting to reverse the provision at the right time. When the dispute is resolved, by a judgment, a settlement or a withdrawal, the provision must be reversed in the year of resolution, and the actual charge recognised. A provision left on the balance sheet after the risk has ended becomes a provision without purpose, reintegrated in case of audit, with late-payment interest. The annual review of provisions, line by line, is a closing step in its own right.

1. List ongoing disputes: lawyer letters, formal notices, writs, client or supplier claims, employment and tax litigation.
2. Qualify each risk: did the triggering event precede the closing date? Is the outflow of resources probable?
3. Measure the amount: ask the lawyer or adviser for a quantified estimate, keep the written record.
4. Test deductibility: is the covered charge deductible? A fine or sanction is not.
5. Record the entry: charge to account 681 or 687 depending on the nature, against account 151 or 158.
6. Document the closing file: supporting evidence for each provision, the measurement, the legal basis.
7. Re-examine prior provisions: reverse if the risk has disappeared or materialised.

A construction SME receives, in November, a writ from a client alleging defects and claiming 80,000 euros. The chartered accountant and the lawyer estimate, on the basis of the technical file, that the probable conviction lies between 25,000 and 40,000 euros. The outflow of resources is probable, the triggering event (the disputed works) precedes the close: a provision is justified. The amount retained will be the most realistic estimate, for example 32,000 euros, documented by the adviser written opinion. If the matter is finally settled at 30,000 euros the following year, the provision is reversed and the actual charge recognised. Construction and real-estate businesses, exposed to warranties and site disputes, are particularly concerned by this monitoring.

The French GAAP principles on liabilities and provisions are stable. The point of vigilance remains the alignment between the reality of the dispute and its accounting translation, and consistency with the tax treatment. Where a statutory auditor is involved, provisions for litigation are among the risk areas reviewed during the certification of the accounts: the file documentation must be ready. For material exposures, a review with the lawyer and the chartered accountant before the close avoids last-minute adjustments and challenges during review.

• Dispute identified and triggering event preceding the close
• Written adviser opinion on probability and amount
• Risk measurement kept in the closing file
• Deductibility test of the covered charge performed
• Provision entry recorded on the correct account
• Prior-year provisions re-examined and reversed where needed
• Disclosure in the notes for material contingent liabilities