Definition
In accounting, a provision is a liability or a potential liability set aside for future anticipated expenses or losses. These are amounts estimated by a company based on specific uncertainties, such as uncollectible accounts receivable or potential legal costs. The goal of a provision is to ensure resources are available when such costs come due without interrupting normal business operations.
Key Takeaways
- Provision in accounting is an amount that you put aside in your accounts to cover a future liability or loss. It is essentially a form of financial preparation for potential future expenses, like legal costs, or loan losses.
- The provision is recognized in the company’s financial statements to comply with the accruals concept and prudence concept. These two accounting principles dictate that expenses should be recognized when they are incurred, not when they are paid, and that financial statements should be conservative and not overstate the company’s financial health.
- Provisions can significantly impact the perceived financial performance and health of a company. For example, if a company recognizes large provisions, it may appear to be less profitable in the short term. However, this could potentially create a more accurate picture of the company’s future obligations and overall financial stability.
Importance
Provisions in accounting are extremely important as they account for future liabilities or potential losses that are predicted by a company, making them a key element of financial risk management.
By recognizing these expected expenses, the company maintains an accurate picture of its financial health, ensuring that there are no sudden dips in profit due to unforeseen costs.
Provisions are a conservative approach to accounting, serving as a cautionary measure that safeguards a company’s financial stability, preventing the overstatement of assets or understatement of liabilities.
They provide transparency to stakeholders about potential financial obligations and impact business decisions by highlighting areas of financial risk.
All these factors make provision in accounting an essential part of maintaining financial integrity and business planning.
Explanation
Provisions in accounting serve a critical role in safeguarding the financial health of a company. Their main purpose is to anticipate future liabilities or losses that the company may incur, even though it may not know the exact amount or when they may occur.
These are expenses that a company expects to pay in the future due to events that have taken place in the present or past. A business, therefore, sets aside a part of its revenues as a provision to cover these future probable costs.
An integral element in the process of maintaining prudent financial management, provisions are used to adhere to the principle of conservatism. This principle integral to accounting is based on caution and prevents businesses from understating their future obligations, thus ensuring that profits aren’t overestimated.
By creating a provision, companies can plan and prepare for financial obligations, even if the exact amounts are uncertain. The provisions also assist in ensuring the income statement reflects an accurate financial picture, providing a more honest appraisal of a company’s profitability.
Examples of Provision in Accounting
Loan Loss Provision: Banks and other financial institutions use provisions to cover potential loan defaults or non-payment by borrowers. Suppose a bank has offered a loan to a company, but due to financial issues, the company is unable to repay the loan. The bank, anticipating this non-payment, will make a provision in its accounts to guard against the potential loss from the loan default.
Depreciation Provision: Businesses use this to acknowledge the depreciation of their tangible assets, such as machinery or equipment. A yearly provision is made to accumulate funds for when the asset may need to be replaced. For example, if a business buys machinery worth $100,000 with a life expectancy of 10 years, it can make an annual depreciation provision of $10,
Provision for Bad Debts: Companies can create a provision for expected bad debts to account for customers who are likely not to pay their credit purchases. For example, a retail store may have sold goods worth $20,000 on credit. Based on past experiences, if the company anticipates that about 5% of the amount may not be collectable, they would make a provision for bad debts of $1,000 ($20,000*5/100).
FAQ Section: Provision in Accounting
1. What is Provision in Accounting?
A provision in accounting is an amount set aside to cover a probable future liability or loss in the business. It represents an estimated amount that is expected to be payable due to the business operation but the exact amount can’t be ascertained.
2. How is a Provision Calculated?
In most instances, the provisions are calculated by analysing the history of the organization and by estimating the likelihood of the occurrence of the event. It’s often assessed by the management of the organization based on their judgement and potential risk of the liability.
3. When is a Provision in Accounting Used?
A provision is used when an entity undergoes a present obligation as a result of a past event, it is probable that the entity will be required to surrender resources and the amount can be estimated reliably. Provisions are mainly used for depreciation, bad debt, etc.
4. What is the Difference Between Provision and Reserve?
Provision and reserve both are amounts kept aside to cover future uncertain events. However, a provision is an amount that you expect to pay without any potential for economic benefit, whereas a reserve is an appropriation of profit for a specific purpose.
5. How Often Should Provision be Updated?
A provision should be reviewed at the end of every accounting period and adjusted to reflect the current best estimate. If it is no longer probable that a transfer of economic benefits will be required, then the provision is reversed.
Related Entrepreneurship Terms
- Allowance for Doubtful Accounts: An estimate of the amount of bad debt that will need to be written off during a period.
- Depreciation: The systematic allocation of the cost of a fixed asset over its useful life.
- Accrued Expenses: Expenses recognized in the books before they are paid.
- Contingent Liabilities: Possible obligations that may occur depending on the outcome of a future event.
- Deferred Tax: Amount of income tax payable in future periods in respect to taxable temporary differences.
Sources for More Information
- Investopedia: A leading source of financial content on the web, ranging from market news to retirement strategies, investing education to insights from advisors.
- AccountingCoach: A website that specializes in providing free and quality accounting education to people all around the world.
- Accounting Tools: An online resource for the accounting community, offering hundreds of pages of book summaries, articles, and accounting courses.
- Corporate Finance Institute: An educational platform that provides financial modeling and valuation courses to help individuals advance their careers in corporate finance.
