What is provision in accounting?
Despite the best of intentions and planning, there is always the chance of an unplanned expense in a business. So, a business should always be prepared for such unplanned expenses. If there is no money set aside for this the business may find itself incapable of managing the expense without disrupting the daily operations. If the company suddenly has to refund a customer a large amount or if a large invoice remains unpaid, there may be a cash crunch.
The amount set aside for such unforeseen expenses is called provisions in accounting. It must be understood that the provisions are not savings. They are specifically earmarked for these future expenses. By creating provisions for the future the company acknowledges that there may be future expenses. So, it is also not recorded as a saving.
When a company makes a significant profit it may allocate or reserve the amount for a specific purpose. This is not to be thought of as a provision account as a provision is not a reserve fund. When a provision is made in accounting, its purpose should be very specifically recorded.
The liquidity of the provision fund is very important. Since the money may be required immediately when the need arises, it must be highly liquid. For example, an amount that is provisioned for a customer refund will have to be paid out as soon as the customer returns the item. The company cannot predict when this need will arise. If money is provisioned for repairs, it will be needed whenever there is a need for repair.
So, the money provisioned should be easy to access immediately as soon as it is required. The money that is provisioned must only be used only for the purpose that it is put aside for. It cannot be used for any other purpose as it would not then be treated as a provision in the accounts.
In accounting, the provision amount is stated as a liability on the balance sheet. If and when the provisions are used for unexpected expenses they are listed as an expense on the income statement. This means that the provisions are stated twice in the financial accounting statements.
This entry twice adheres to the accounting principle of matching. The matching principles are that the revenues and relevant expenses should be recognized within the same year. So when you have mentioned the provisions, they adjust the current year balance, ensuring that the costs are recognized in the same financial year.
This principle is often used in accrual accounting. Businesses that use the cash accounting system do not have to be particular about the year and record the expenses whenever they occur.
Types of provisions in accounting
Different companies make provisions for different purposes. So the types of provisions can vary wildly. However, the most common types are as follows:
Unpaid invoices: It is a reality that despite all the precautions, some invoices do get left unpaid. This causes bad debt when it is found that the payment from the defaulting client is unrecoverable. This is an amount that is hard to estimate. But an accountant would usually look at the past transaction record and study the bad debt amounts. This helps them make a similar estimate for the present.
Certain industries also have an average amount that they use to estimate bad debts. Provision for these uncollectible debts is as important as also having a credit policy that helps prevent such unpaid invoices.
Depreciation: Every asset inevitably has an operating expense that is incurred over time. This loss in value of an asset due to wear and tear caused by use is referred to as depreciation. Depreciation is usually provisioned as accumulated depreciation which is the collected value of the entire depreciation.
Provisioning for depreciation improves the accuracy of stating the value of the asset on the financial statements. The lowering of value will affect the value of the assets in the financial as well as relevant tax statements.
For example, if a business invests $100 million in equipment, it will be shown on the financial reports as an asset. However, the value of that equipment will fall over the years of wear and tear. It must be adjusted in the financial reports to show the true picture. When provisioning for depreciation only the value that is lost is considered and not the residual value that the equipment would be worth at the end of the period of time.
Guarantees and warranties: A guarantee is a liability that the company will take on the financial cost of any problem for a fixed amount of time. A warranty makes the company liable for any repairs or replacements during the warranty period.
Tax payable: At the end of the financial year, every business will have to pay taxes. It makes good business sense to provide for the amount of tax that has to be paid. In countries where tax returns such as GST are to be paid at the end of every month provisioning for the taxes ensures that the company is funded for the payment. Tally allows you to easily compute for an account GST, input credit, and provisioning for GST.
Accrued expenses: Sometimes a business accumulates expenses that will have to pay but that are not due yet. This can be provisioned as an accrued expense account. Customer refunds can be added to this account when it applies. It is a good practice to provide for these outflows to prevent cash flow problems and defaults.
Loan loss: Sometimes companies loan out money to a borrower. If that loan does not get repaid, the company stands to lose that amount. So, a loan loss provision is an amount that is set aside by the company to cover this. This type of provisioning can also be used for bad debt, unpaid invoices, customer defaults, and other similar incidents in business.
This specific type of provisioning for loan loss is particularly used in financial institutions that provide loans to people or businesses. The provisioning is similar regardless of whether the borrower is an individual, small business, or large business. Despite better regulations and screening for extension of credit, loan defaults are a reality in banks and other financial institutions. Bookkeeping software that allows for provisions to be made for loan loss is essential for such institutions.
Bonus payable: Some industries have the practice of rewarding employees with a bonus for an achievement or for good performance at the end of the year. Since this is a foreseeable expense that the company must have enough funds set aside, provisioning can be performed for bonuses or any other rewards payable.
Leave encashment: at the end of the year, some companies allow their employees to encash the leave that they have not availed of throughout the year. Though this number cannot be precisely determined, it can be determined by examining the amounts paid in the past and by studying the employee’s attendance history. Bookkeeping software that has an integrated payroll management system makes this aspect of provisioning even easier.
Some other types of provisions in accounting are accruals, asset impairments, inventory obsolescence, pension, restructuring liabilities, and sales allowances.
