What are Provisions?
Provisions represent funds put aside by a company to cover anticipated losses in the future. In other words, provision is a liability of uncertain timing and amount. Provisions are listed on a company’s balance sheet under the liabilities section.
The IFRS sometimes calls a provision a reserve; however, reserves and provisions are not interchangeable concepts. Whereas a provision is intended to cover upcoming liabilities, a reserve is part of a business’s profit, set aside to improve the company’s financial position through growth or expansion.
Provisions in accounting
In accounting, the matching principle states that expenses should be reported in the same financial year as the correlating revenues. This is because costs that belong to a certain year can become misleading if accounted for in previous or future financial years.
Provisions, therefore, adjust the current year balance to be more accurate by ensuring that costs are recognized in the same accounting period as the relevant expenses.
Provisions are recognized on the balance sheet and are also expensed on the income statement.
Creating a Provision
There are a number of factors that could cause a company to create provisions; however, there are certain requirements that must be fulfilled before a financial obligation can be viewed as a provision. These include:
- The company must perform a reliable amount of regulatory measurement of the obligation. The measurement must be undertaken by company management.
- It must be probable that the obligation results in a financial drag on economic resources.
- An obligation must be a result of events that will advance the balance sheet date and could result in a legal or constructive obligation.
- An obligation must be determined to be probable, but not certain. It must be estimated to have a more than 50% probability of occurring.
Types of provision
The most common type of provision is a provision for bad debt. A provision for bad debt is one that has been calculated to cover the debts encountered during an accounting period that is not expected to be paid.
This provision is usually included in the budget created by a company and can be estimated based on past experience with bad debt amounts as well as industry averages.
Other common kinds of provisions in accounting include:
- Restructuring Liabilities
- Provisions for bad debts
What are tax provisions?
Another type of provision in accounting to be aware of relates to taxes. A tax provision is set aside to pay your company’s income taxes, which are calculated by adjusting gross income by claimed tax deductions. Once tax calculations have been worked out, the company can enter the tax provision into its accounting books. These funds are then allocated to tax payments when they’re owed.