Provision Definition
A student might have noticed that the liabilities side of the balance sheet includes an entry referred to as provisions. Understanding how and why such a provision is necessary for accounting will be a benefit that one can get from reading this article.
Definition of Provisions
A provision refers to the amount that is typically set aside from profits in order to cover probable future expenses or an asset reduction, although it is uncertain exactly how much is set aside.
Despite the fact that provision cannot be considered savings, it can be viewed as a method of identifying any potential liabilities in the future.
The majority of the time, a provision is used as a reserve. However, a provision is different from a reserve. Reserves are part of a profit that is set aside to be used to assist the company's growth and expansion. A provision is set up to cover probable liabilities in the future, while a provision covers probable future assets.
The Provision in Accounting
A matching principle states that every expense incurred in a given year must be reported alongside the revenue gained. By doing this, it will prevent financial statements from looking misleading if costs related to a certain year appear on previous or future balance sheets.
Provisions, therefore, ensure that revenues and expenses are included within the same accounting period, balancing the balance of the current year.
Provisions - Why are they Created?
It is important to create provisions for a specific purpose since they account for corporate costs that will need to be paid in the same year. Creating the provision is beneficial to the company since it also makes its financial statements more accurate.
Having set aside this amount does not represent a form of savings, as the expense is estimated and is expected to be spent.
Is a Provision a Reserve?
A reserve is not considered a provision if it does not exist.
In contrast, a provision is a fund that is allocated for a specific expense, whereas a reserve is one that is formed from the profit made by the company. In a reserve account, money is held that is readily accessible. The money can be accessed from the savings account, for example.
Owners' associations, for example, may use reserve funds. A reserve fund may also have been set aside for unscheduled repairs. The exact reason for the repairs is unknown, nor are the exact costs associated. They only know that repairs will be needed at some point.
As an example, an automobile company could set aside money itself for the repairs under warranty that have occurred within the last year.
An Example of a Provision in Accounting
The majority of provisions are associated with bad debts. An accounting period is calculated by adding up the cost of the remaining unpaid debts.
Examples of provisions are:
1. Doubtful debts
2. Depreciation
3. Pension
4. Restructuring liabilities
5. Income taxes
6. Guarantee (product warranties)
FAQs on Provisions: Meaning and Practical Examples
1. What is a provision in accounting, with a simple example?
A provision is an amount of money a business sets aside to cover a future expense or loss that is likely to happen, but where the exact timing or amount is not yet certain. For example, a company that sells products with a warranty will create a provision for warranty claims to cover the expected costs of future repairs.
2. What are some common types of provisions a business creates?
Businesses create provisions for various expected liabilities to present a true financial picture. The most common types include:
- Provision for Doubtful Debts: To cover potential losses from customers who might not pay their bills.
- Provision for Warranty: To account for the future cost of repairing or replacing products.
- Provision for Taxes: To set aside money for paying the company's income tax liability.
- Provision for Depreciation: To systematically account for the reduction in an asset's value over its useful life.
3. How is a 'provision' different from a 'reserve'?
A provision is a charge against profit, created to cover a known liability or an expected loss where the amount is uncertain (e.g., provision for bad debts). In contrast, a reserve is an appropriation of profit, meaning it is money set aside from profits to strengthen the company's financial position, not to cover a specific known loss. A good example of a reserve is the 'General Reserve' used for future growth.
4. Why is it important for a business to create provisions? What could happen if it doesn't?
Creating provisions is crucial for following the prudence principle of accounting, which ensures that a company's financial statements show a true and fair view. If a business doesn't create provisions, its profits would appear artificially high and its liabilities would be understated. This can mislead investors and management, potentially leading to a sudden, large, and unexpected loss in the future when the liability actually occurs.
5. How does making a provision affect a company's profit?
When a provision is created, it is treated as a business expense for the current accounting period. This expense is shown in the Profit and Loss Account, which reduces the company's reported profit for that period. This ensures that profits are not overstated by accounting for expected future losses in the present.
6. What is the main difference between a 'bad debt' and a 'doubtful debt'?
A bad debt is an amount that a business is certain it will never be able to collect from a customer. It is a confirmed loss. In contrast, a doubtful debt is an amount that is unlikely to be paid, but there is still a small possibility of recovery. A provision is created for doubtful debts, whereas bad debts are directly written off as a loss.
7. Are there specific rules for creating a provision in accounting?
Yes, a business cannot create a provision just to reduce its profits. According to accounting standards, three conditions must be met:
- There must be a present obligation as a result of a past event.
- It must be probable that money will be required to settle the obligation.
- A reliable estimate of the obligation amount can be made.
If any of these conditions are not met, a provision cannot be legally recognised in the books.
