Provisions in Accounting: Meaning and Types

Provisions in Accounting: Meaning and Types
|Updated on: March 27, 2023

In the ideal world, all people would pay their dues, and companies would have no amounts outstanding. However, it sometimes happens that invoices are unpaid, machinery has a breakdown or an unexpected lawsuit is filed against the company. In order to be prepared to offset these unforeseen financial losses, a company must be prepared. The money that is set aside for these future expenses that may or may not happen is called provisions in accounting.

What is Capital in Accounting – Capital Account

Differences Between Cash Accounting and Accrual Accounting

What are provisions 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 a future expense. 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 the 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.

How to recognize provisions in accounting?

When you use provisions in accounting you should adhere to the principles of the International Financial Reporting Standards (IFRS). These principles are:

  • There should be an obligation for the amount that is a result of an event that has occurred in the past. For example, if you have sold to a customer and have a 30 day return window, an obligation for that amount is active for the 30 days.
  • Despite the possibility of the obligation to refund or payout some money, the action that causes the obligation is ultimately of benefit to the company. For example, by offering the 30 day return window the company may be obligated for a refund, the sale ultimately does benefit the company. It makes the product more attractive to the buyer.
  • There should be a reliable estimate of what this amount will be. If the amount that needs to be provisioned is for a refund, it is easy to determine the amount and the estimated shipping fees.
  • If the obligation for the payment can be avoided through some future action it does not count as a provision. Warranties and free replacements are such obligations that once made cannot be avoided and must be provisioned for.

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 replacement 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 provision 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 and 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 provision 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 for, 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. A bookkeping 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.

Accounting provisions with online accounting software

 A basic accounting system will only record the credits and debts of transactions. But a complete accounting software such as Tally makes provisioning in accounting easier. Since Tally can also be used to manage sales invoices and inventory, it helps make inventory and sales related provisioning seamless. Tally also lets an accountant easily analyze present and past transaction data. So, estimating the amount that should be provisioned also becomes very easy and more accurate.

Tally can accurately and quickly help you estimate the value that you should be provisioning for a particular expense. It also accounts for the provision accurately and as per accounting principles for provisioning. Provisioning for taxes along with the calculations and adjustments for input credit, depreciation or other factors that affect a tax payment are simple to perform. The generation of tax filing papers and other important reports accurately incorporate the details of provisions without the need for manual adjustments. It is useful in situations where the tax payout is uncertain when the estimates are being made.

If you need to create a provision to account an expense within the same year as the revenue, it can be done with Tally. Tally also allows you to use provisioning in sync with payroll, inventory or for tax purposes. It helps you view the summaries of the amounts and also drill down to the transactional details. With bookkeeping software this is achieved in seconds and makes the accountant’s job easier and the entire process more accurate.

Since the entries for provisions in accounting are automatically carried to the relevant reports, there is no need for any manual computation or entries when using Tally. A centralized system that can be used in multiple departments and locations ensures that the data in the system maintains its accuracy and integrity at all times.

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