Definition
Accrual in finance refers to the recognition of revenue or expenses that have been incurred but have not yet been recorded in the accounts, while the economic event itself occurs over a range of time. On the other hand, a provision is a reserve that a company sets aside to cover future liabilities, losses, or expenses that are anticipated but the amount and timing are uncertain. These concepts are part of the accrual accounting method, which records financial events based on occurrences rather than on cash flows.
Key Takeaways
- “Accrual” refers to the recording of revenues when they are earned or expenses when they occur, irrespective of when cash is exchanged. It follows the Accrual Accounting principle, which ensures that financial events are reflected in the accounting periods when they are actually incurred, not necessarily when the cash transactions happen.
- “Provision”, on the other hand, is an amount set aside to cover a probable future expense, or reduction in the value of an asset. Provisions are usually estimated based on previous experiences, statistical analysis, or expert opinions. They do not necessarily represent actual liabilities but are an anticipation of potential liabilities.
- The distinction between accruals and provisions primarily lies in their nature of occurrence. While accruals deal with past events and are more definite in terms of their amount and timings, provisions deal with future uncertainties and are less definite in terms of amount and timings. Both, however, are crucial for prudent financial management and align with the matching principle, ensuring that all relevant expenses are recorded and matched to the corresponding revenues in the same accounting period.
Importance
Accruals and provisions are important finance terms that play a pivotal role in financial accounting and the overall health of a company’s financial statements.
Accruals refer to the recognition of expenses or revenues that have been incurred or earned but not yet recorded.
On the other hand, provisions refer to amounts set aside to cover anticipated future liabilities or losses, which the company knows it will incur, but does not know the exact amounts.
Understanding the distinction between accruals and provisions is crucial as it helps in preparing and interpreting financial statements more accurately.
Moreover, these terms ensure that the financial records adhere to the matching principle— matching revenues with the related expenses in the same accounting period, resulting in a more accurate portrayal of a company’s financial condition.
Explanation
Accruals and provisions are key concepts used in accounting to ensure businesses accurately represent their financial performance and position over time. Accruals aim to match the revenues generated in a particular period with the expenses that were required to earn that revenue, regardless of when cash changes hands. By applying the accruals concept, businesses can provide a more accurate picture of their financial performance, as it reflects all their earning activities at the time they occur, irrespective of the receipt or payment of cash.
It serves to ensure that the income statements do not have periods of skewed results because of cash-based transactions, thereby aligning financial outcomes more closely with business activities. Provisions, on the other hand, are aimed at taking into account future liabilities or losses that are expected but are uncertain regarding the exact amount or timing. They are used to reflect the principle of conservatism in accounting, which aims to ensure that businesses prepare for potential future outflows.
By setting aside funds as provisions, companies allow for predicted future expenses or liabilities, ensuring that their current profits are not overestimated and future periods are not burdened with unexpected costs. Provisions are beneficial for managing risks and ensuring financial stability. They also enhance the quality of financial reporting by incorporating future expectations and planning.
Examples of Accrual vs Provision
Prepaid Expenses: This is an example of accrual accounting where a company pays upfront for services or goods. For instance, a business might pay annually for insurance policies, but this would be accounted for on a monthly basis. So, if a company pays $1200 for a yearly insurance, on an accrual basis it expends $100 each month. The rest amount is considered as “Prepaid Insurance” on the balance sheet.
Building Depreciation: Businesses use provision accounting for anticipated costs, such as the depreciation of assets like buildings or equipment. If a company purchases a building for $500,000 with an expected useful life of 50 years, it creates a provision for depreciation. Each year, $10,000 (i.e., $500,000/50 years) would be provisioned for this cost.
Revenue Recognition: Under accrual accounting, companies recognize revenue when earned, not necessarily when the payment is received. For example, if a company sells $10,000 worth of goods in December but won’t receive payment until January, it still reports those earnings in its December financial statements. That’s because the company has earned the revenue, even though payment is forthcoming.
Loan Loss Provisions: A bank estimates that a certain percentage of its loans will not be repaid. The expense related to these potential losses is booked on an ongoing basis using provision accounting. By making a provision for loan losses, the bank follows the principle of prudence by preparing for potential future losses. These loan loss provisions are a common example of provision accounting in the banking industry.
FAQs: Accrual vs Provision
What is Accrual?
Accrual refers to an accounting method that records revenues and expenses when they are incurred, regardless of when cash is exchanged. The term accrual can also refer to business practices or adjustments, such as accrual of depreciation, or accrual of interest expenses.
What is Provision?
Provisions are amounts set aside to cover anticipated future liabilities or losses. Provisions are established by accounting procedures and it’s essentially a charge for a cost that we expect to incur in the future.
What is the main difference between Accrual and Provision?
The main difference between accrual and provision is that while accrual is the recognition of revenue and expenses, provision is setting aside the part of profits for probable liabilities. Accrual helps in demystifying the actual position of the business, and it’s mostly used in the businesses where there is a time gap between the exchange of goods and money. On the other hand, provision is made to meet a specific liability, a particular contingency, or a commitment.
When should we use Accrual?
We should use Accrual when we want to understand the real position of our business regarding total profits or losses because it shows the actual image of income and expenses during a period. It is widely used in businesses where there is a time gap between the performance of activity and its financial settlement.
When should we use Provision?
We should use Provision when we want to set aside a part of profit for a future probable liability or depreciation. It is generally recorded in a company’s balance sheets.
Related Entrepreneurship Terms
- Accrual Accounting
- Provision for Loan Losses
- Accrued Expenses
- Provision for Tax Liabilities
- Prepaid Expenses (Accrual)
Sources for More Information
- Investopedia – One of the leading sources of financial information on the internet. They offer comprehensive definitions and explanations on a variety of financial terms, including accrual and provision.
- Accounting Tools – This site provides a wide range of resources related to accounting, including guides, courses, and articles about different accounting concepts like accrual and provisioning.
- Corporate Finance Institute – They offer a variety of online courses and resources on finance and accounting. They offer detailed explanations and guides on financial terms and concepts.
- My Accounting Course – This site offers numerous free online courses and resources on accounting. It also provides detailed information on specific terms like accrual and provision.
