Provision Accounting: A Guide to Understanding this Key Financial Concept

Provision Accounting: A Guide to Understanding this Key Financial Concept

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Chanchal
Chanchal Aggarwal
Senior Executive Content
Updated on Oct 31, 2023 02:13 IST

Provision accounting involves setting aside a specific amount of money for anticipated future liabilities or losses, ensuring financial preparedness. This practice enhances financial accuracy and integrity by recognizing potential expenses in the period they are estimated to occur, aligning with the accounting principle of matching expenses with revenue.

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The business environment is volatile. It is hard to predict your future expenses as uncertainty is always associated. You know about your fixed expenses such as permanent staff salary, rent, bills payment, etc. Apart from this, there are certain expenses for which you will be unsure. A debtor who promised to pay money this financial year but deferred it until next year at the last minute. In order to deal with such kind of instances, business owners create a provision. Provision accounting has a distinct meaning from saving. Scroll your screen down to find out the meaning of Provision. 

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Table of Content

Understanding Provision Accounting

A provision is when a company sets aside money to cover unforeseen future costs or liabilities. They are significant in accounting.  Businesses must report their expenses and revenues in the same year in accordance with the matching principle. The inclusion of costs from one year in current or subsequent fiscal years may be deceptive. Provisions aid in adjusting this balance by guaranteeing that business expenses are recorded in the same year. The business’s balance sheet and income statement both include liabilities provisions.

Future losses are unavoidable in the business world, resulting from a declining asset’s resale value, defective products, legal actions, or an insolvent client. Companies need to ensure they have enough money to cover these risks.

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However, the recognition of a provision cannot be done at any time by an organization. Instead, they must adhere to a set of standards established by authorities. Guidelines for contingencies and provisions are provided by Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). While IFRS presents its information in International Accounting Standard (IAS) 37, GAAP presents its information in Accounting Standards Codification (ASC) 410, 420, and 450.

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Types of Provision Accounting

Business expansion often necessitates accounting allowances for a number of reasons. Examples of accounting provisions include bad debts, depreciation, warranties, inventory obsolescence, pensions, sales allowances, and restructuring liabilities. Here are some types of accounting provisions that a business could establish:

Bad Debts

One of the most typical forms of provision is bad debt. The amount of accounts receivable estimated not to be recovered known as a bad debt provision. Businesses often estimate this value using historical accounting periods or sector averages.

Check out: Difference Between Debt and Equity

Guarantee

A guarantee arises when one company assumes liability for another company’s financial obligations if the latter cannot pay its debts. If a business has a stake in the success of the other business, it may make such a guarantee.

Must read: Difference Between Warranty and Guarantee

Loan Losses

Banks and other lenders may set up loan loss provisions to account for unpaid loan principal and payments.  Loan loss provisions can cover loan defaults, bankruptcies, and renegotiated loans that result in less money than expected.

Tax Payments

Tax provisions are funds set aside to cover the company’s anticipated income taxes.

Pensions

Businesses that provide pensions may be liable for future retiree expenses. Many businesses create pension provisions to deal with these upcoming obligations, 

Warranty

Many businesses provide a warranty with their goods. They must set aside money for repairs and replacements based on the expected percentage of products requiring warranty service.

Obsolete Inventory

When inventory is unsold or obsolete, companies must mark it down to compensate for lost revenue.

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Severance Payments

Businesses use severance provisions to track severance payments made to workers who leave the company due to layoffs or other circumstances. Company restructuring can increase a company’s profitability in the long run, but it may come at a high cost in the short run. Restructuring provisions outline the likely upfront costs of the restructuring, such as the costs associated with closing down facilities or hiring new staff.

Depreciation

 Depreciation is a technique for recording an item’s value loss over time. A depreciation provision represents the depreciation for the current accounting period.

Must read: Methods of Depreciation and Their Uses

Asset impairments

In a company’s balance sheet, an asset is considered impaired when its current market value falls below its carrying value. A provision for impairment prevents overstating the asset’s value.

Must read: What is Assets and Why Do We Own Them?

How to Recognize Provisions in Accounting

Businesses cannot just record provisions whenever they feel like it. Under International Financial Reporting Standards (IFRS), a provision must satisfy the following requirements:

  • An entity owes a current duty originating from earlier actions;
  • An outflow of capital will most likely cover the liabilities; a company can accurately predict its size; and the entity will agree to take on a particular responsibility, and other parties will look to the entity to fulfill its obligations.
  • Provisions do not apply to operational costs, or expenditures that an organization must make to continue operating.

How to Record Provisions in Accounting

The process of estimating and recording provisions involves several steps. Here’s the procedure we follow:

  • Calculate how much money you’ll need to set aside. There must be some basis for this estimate. Businesses frequently turn to the latest financial statements, historical data, or industry statistics to determine the estimated amount, 
  • Create an expense for the due amount for the current period. The income statement for the business will reflect this.
  • This sum similarly increases the opening balance of the associated liability or contra-asset account. This will appear on the balance sheet of the business.
  • Tracking the amounts over time and adjusting to represent facts is essential. For instance, a business might make a provision for bad debt. The amount of the bad debt provision and the total amount of accounts receivable is decreased if the company quits trying to collect the money owed to a particular customer.

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Conclusion

The term “provisions” refers to money set aside for various reasons, including bad debt, income taxes, warranty repairs, and inventory write-offs. When there is ambiguity regarding the expense’s amount or timing, provisions allow businesses to represent the expected impact of upcoming costs or losses.

FAQs

What is Provision Accounting?

It's a practice of setting aside a specific amount for anticipated future liabilities or losses.

Why is Provision Accounting Important?

It ensures financial preparedness and accuracy by recognizing potential expenses in the relevant period.

How is Provision Accounting different from Reserves?

Provisions are mandatory and address known liabilities, while reserves are discretionary and cater to unforeseen contingencies.

When is Provision Accounting used?

It's used when a financial obligation is probable but the exact amount or timing is uncertain.

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Chanchal Aggarwal
Senior Executive Content

Chanchal is a creative and enthusiastic content creator who enjoys writing research-driven, audience-specific and engaging content. Her curiosity for learning and exploring makes her a suitable writer for a variety ... Read Full Bio

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