When a business sets aside some money to cover future costs or liabilities, this is called a provision. Provisions in accounting have a different meaning to savings. Here’s a closer look at the meaning of provisions in accounting terms, and what they’re used for.
Understanding provisions in accounting
Businesses face all kinds of expenses in any given accounting year, from the cost of depreciation to restructuring payments. To help budget for liabilities or obligations, provisions are set aside. Provisions essentially refer to any funds set aside from company profits for this express purpose. To qualify as a provision in accounting, the funds must be for a specific purpose, such as to offset the decrease in an asset’s value.
Provisions for liabilities differ from savings because while savings are there to cover any unexpected expenses, provisions recognise likely obligations.
They play an important role in accounting. According to the matching principle, business expenses and revenues should be reported in the same financial year. Otherwise, costs from one year could be misleading if listed in prior or future financial years. Provisions help adjust this balance by ensuring that business expenses are recognised in the same year. Provisions for liabilities are entered on the balance sheet as well as on the company’s income statement.
Provisions vs. reserves
When looking at the meaning of provisions, we’ve already noted that the term is different from savings. Provisions are also different from reserves, or reserve funds. While reserve funds are set aside by a business for a specific purpose, provisions are allocated for expenses. Reserves improve the company’s standing through expansion, making them part of its profit.
Reserve funds are usually highly liquid, making them easily accessible for expenses. For example, a homeowner’s association might have a reserve fund set aside for any shared building repairs that pop up. The reserve is for a specific purpose, but there is some flexibility involved when it comes to cost and timing.
By contrast, a provisional amount is set aside for a specific expense. For example, a maintenance company might set aside provisions for boiler repairs in an apartment building during the final quarter of the year. This use is specific and is all the money is intended for.
Types of provisions in accounting
There’s a multitude of expenses that would lead to provisions in accounting. Bad debt is one of the most common reasons for provisions, which are calculated during a time-limited accounting period. The company’s budget would estimate the cost of this provision based on prior experience with bad debts.
However, this is far from the only type of accounting provision. Here are some additional types of provisions in accounting:
Deferred tax payments
Product warranties or guarantees
Requirements for creating provisions
As you can see, there are multiple reasons for provisions in accounting. Yet not every expense will qualify. Before an obligation can be treated as a provision for accounting purposes, some requirements must be satisfied:
The obligation is likely to impair the company’s economic resources.
The obligation must have a probability of over 50%.
The obligation must be due to events that result in legal or constructive liabilities.
The company’s management should take regulatory measurement of the obligation.
What are tax provisions?
Another type of provisions 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 in its accounting books. These funds are then allocated to tax payments when they’re owed.
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