Detailed Guide On Accounting Provisions | Concept and Types

Provisions for liabilities differ from savings as it covers unexpected expenses, recognising likely obligations. There are some costs in a business that you cannot avoid, whether they come from a non-paying customer, a decrease in asset value, or malfunctioning appliances.

By making provisions, businesses can account for these costs and prepare for future expenses. The provision meaning in accounting is money set aside for future payments. This article explains a provision in accounting, available accounting provisions, examples from business, and other essential provisions.

Did You Know? Ancient Mesopotamia discovered the earliest accounting records over 7,000 years ago. People relied on accounting to keep track of the growth of crops and herds.

What are Provisions in Accounting?

The cost of depreciation and restructuring payments are among the expenses businesses face in any accounting year. Provisions are money from your company's profits to cover liabilities or obligations, and accounting provisions are funds used for offsetting asset value decreases.

Liabilities differ from savings because, whereas savings aim to cover unexpected expenses, provisions aim to recognise likely obligations in the future.

Accounting relies heavily on provisions. Businesses should report revenues and expenses in the same financial year, as listing costs from previous years could be misleading. Provisions ensure that business expenses are recognised in the same year, thereby adjusting the balance. In addition to the income statement, the balance sheet includes provisions for liabilities.

Also Read: Costing: Definition, Objectives, and Advantages

Recognising Accounting Provisions

Businesses can't record provisions in accounting whenever they see fit. IFRS (International Financial Reporting Standards) creates criteria that companies should meet.

Follow the below requirements to keep provisions for your company:

• Due to a past event, there is a present obligation. We'll assume your business' return policy states that if a customer returns a faulty product, they have 30 days to do so. The past event's return policy creates a present obligation within those 30 days.
• You can expect benefits to flow from the settlement of the obligation. Another example is an excellent return policy, which encourages customers to commit to purchases and builds trust in the company.
• Estimating this amount of obligation requires accuracy and reliability. Refunds to customers are calculated based on the price of the returned product plus any additional shipping fees.
• Still not sure if you should recognise a provision? Then, ask yourself one question: can I avoid liability in the future? In this case, it is not necessary to recognise a provision. For example, this can apply to the decision not to make provisions for employee training.
• If you cannot avoid provisions through your future actions, then a provision will always be necessary. It is always required to provide a provision associated with the expected costs of warranty repairs if you promise such maintenance to your customers.

Recording Provisions

In accounting, first, recognise provisions as liabilities on the balance sheet, and liability is then expensed on the income statement after it occurs. Now, you may wonder, What is the purpose of recognising provisions twice in two separate financial accounts?

It's because of the matching principle, an important accounting principle.

According to the matching principle, you should record the expenses during the same financial year as revenue. Also, ensure that you add provisions to the current year balance by simultaneously recognising costs and revenues. Accrual accounting businesses are the only ones who can use this principle.

The expense is only recognised when paid rather than incurred if your small business uses cash accounting.

Also Read: Accounting Period - Definition, Types & How Does an Accounting Period Work?

Types of Accounting Provisions

There are different purposes for which companies make provisions. There are, however, several common types:

1. Unpaid Invoices

It is a fact that some invoices do not get paid despite all the precautions. Bad debt occurs when you cannot recover a defaulting client’s payment. Estimating this amount is problematic. But an accountant usually examines past transactions and studies alarming debt amounts, and they can use this information to make a similar estimate for the present. Specific industries estimate bad debts based on an average amount. Credit policies that prevent unpaid invoices are equally crucial for these uncollectible debts.

2. Depreciation

Every asset incurs an operating expense called depreciation. Total depreciation is if you calculate the amount of depreciation as accumulated depreciation. If depreciation is present in the financial statement, it is more accurate to state the asset's value in the report. Financial information will be affected by the lowering of weight.

3. Guarantees and warranties

A guarantee is a commitment that the company will cover the financial cost of any problems for a fixed period. Any repairs or replacements during the warranty period are the company's responsibility.

4. Tax Payable

Every business has to pay taxes at the end of the financial year, and provisioning for taxes makes good business sense. Provisioning for tax payments is essential in countries where tax returns, such as GST, are due at the end of each month. With Tally, you can easily calculate and account for GST, input credit, and provisioning.

5. Accrued Expenses

Businesses sometimes accumulate expenses that are not due. You can set up an accrued account for this. If a customer refund applies, you can add that to this account. Provision is a must to handle all cash flow and default-related issues.

6. Loan Loss

A loan loss occurs when a company lends money to a borrower. Unless that loan is repaid, the company will lose that money. A provision for loan loss is an amount that the company sets aside to cover this. Similarly, you can use provisioning for bad debts, unpaid invoices, and customer defaults in business. Firms and people who receive loans from financial institutions tend to use this specific type of provisioning for loan loss. No matter what type of borrower the borrower is, provisioning is the same. Despite better regulations and screening, loan defaults remain a reality in banks and other financial institutions. For such institutions, accounting software that allows loan loss provision is essential.

7. Bonus Payable

In some industries, employees are rewarded with bonuses for achievements or good performance at the end of the year. It is a foreseeable expense that the company must set aside, which can help perform provisioning for bonuses or other rewards. Encashment of leave: some companies allow their employees to cash in their unused vacation at the end of the year. Examining past payment amounts and studying an employee's attendance history makes it easy to determine this number, though it cannot be defined precisely. Provisioning is even easier when a bookkeeping system integrates payroll management.

Some other types of provisions in accounting are 

• Accruals,
• Inventory obsolescence, 
• Asset impairments, 
• Restructuring liabilities, 
• Pension, and 
• Sales allowances. 

Also Read: What is an Accounting Transaction? Example & Types of Accounting Transaction

Accounting Provisions – Examples

Let's look at a business example of a provision for bad debt and how it's recorded in a journal entry.

Take the example of XYZ Company starting a business on January 1 and making most of its sales on account. There are ₹10,000 accounts receivables for that business as of January 31.

According to the business owner, approximately two percent of these accounts are expected to be uncollectible. For January, the provision for bad debts would be ₹200 (2% of 10,000).

Using your accounting journal, you would record this provision as follows:

Difference Between Provisions and Reserves

Below mentioned are some of the essential differences between provisions and reserves.

Also Read: What are the Responsibilities of Debtors?

Conclusion

A provision is a set of expected financial liabilities that businesses will need to cover in the future, and a balance sheet records them. 

You can register provisions only if it meets the following criteria:

• Relating to a past event, a present obligation
• Expecting a benefit outflow from the obligation
• Reliable estimates of this obligation

A provision for bad debts is the most common accounting provision. Amounts deducted for accumulated depreciation, guarantees and warranties, and income tax are also provisions. Streamlines provisions and other accounting processes with accounting software. 
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