If you had ever been to business school, having this equation proven in preparing financial statements would have been your dream!
The equation, Assets= Liabilities+ Capital, is referred to as the accounting equation.
But, any accounting student will have panicked every other time while equating the assets with liabilities and capital in preparation of the balance sheet.
There is no one reason why your balance sheet didn’t balance, but one nightmare accounting treatment is Provisions.
You never know where to put a provision. If it’s a bad debt provision, subtract it from the realized bad debts and balance it with last year’s provision, and still, you got to adjust it with debtors of the asset side.
One thing that needs to be ascertained is that provisions are created for assets and liabilities. The provision expenses are the contingent liabilities, and provision for incomes are contingent assets subject to happening of a certain event
If it’s a tax provision, then it will go to liabilities, and similarly, there are dozens of provisions requiring different accounting solutions.
Being an accounting student, I had faced this issue tons of times, and I understand most people either in the field or in school can get stuck with the provision’s treatment.
Therefore, we will analyze provision expense, its types, accounting treatment, accounting nature, and recording.
So take a deep and let’s get solve this mystery of the provisions once and for all.
What is provision expense?
Sometimes, we confuse the provision expense with saving because we are putting aside an amount in anticipation.
But actually, provision is only made for the future expense that is expected to occur and is meant to occur, but timings and amounts might vary
We cannot just make a provision account based on gut feelings, but much financial analysis goes in before making a provision.
So to formally define a provision expense, we can say,
In accounting, the provision means a set-aside fund in anticipation of a future expense or reduction in the assets’ value.
According to IAS 37 of International Financial Reporting Standards,
A provision is a liability of uncertain timing or amount. The liability may be a legal obligation or a constructive obligation that arises from the entity’s actions. It has indicated to others that it will accept certain responsibilities and has created an expectation that it will discharge those responsibilities.
From the definition of the provisions, we can establish that a provision:
- Only arises in anticipation of expected obligation arising from an entity’s action
- Is a contingent liability
- It might vary in amount and time of payment
Examples of Provisions
Some most common examples of provision we often come across during the preparation of financial statements are
- Bad debts
- Any penalty for an ongoing lawsuit
- Customer Refunds
- Tax Obligation
There are different types of provision expenses, and we will look into each type separately
Types of Provisions
Here are the types of provision expenses we come across during studying or preparing the financial statements of an entity
1) Provisions For Doubtful Debts
Provision for doubtful debts which is often referred to as provision for bad debts is recorded in anticipation of probable bad debts that might arise in accounts receivable.
There are two types of doubtful debt allowances. One is a specific allowance, and the other one is a general allowance.
The general allowance corresponds to the general estimation of bad debts that might arise due to any reason based on past years’ estimation.
However, specific allowance for doubtful debts relates to specific account receivables. They are related to the debtors about whom the entity knows they face some financial issues and might fail to pay their dues.
2) Provisions For Discounts To Debtors
Most businesses opt for rewarding the early payers and encouraging the debtors to clear their dues earlier by offering a certain amount of discount on their bills. This is an expense for an entity if realized.
Therefore, a provision for discounts to debtors is made. So that in the future, if a debtors come and claim the discount, a business can accommodate him.
3) Deferred Tax Payments
The IAS 12 of International Financial Reporting Standards defines deferred tax payments as the future expense concerning the Taxable Temporary Differences. The amount of deferred tax liability is calculated by adjusting the income before taxes with the amount an entity claims as a tax deduction.
You can not fully understand the concept in the deferred tax liability unless you know the meaning of Taxable Temporary Differences.
Temporary differences are defined as the difference between an asset’s carrying cost for financial reporting purposes and its value for tax purposes.
4) Contingent Liability For A Law Suit
Another provision expense arises in lawsuits, social responsibility, and other legal obligations.
For instance, a business has been accused of violating the community standards by a social responsibility organization. It is expected that the company might lose the lawsuit and will be obligated to pay the penalty or fine.
In such a case, the contingent liability will be created and recorded under the liabilities in a business’s balance sheet.
Warranty provision arises at the time of sales of a product due to the entitled warranty. The warranty provision includes any replacement, repair, or amendment that which a customer is entitled to under a certain product warranty.
The recording of warranty provision is made concerning the matching principle of the accounting that says the expenses related to certain revenue must be recorded at the same time when revenue is realized.
Therefore, any entity that gives product warranties will record the payable warranty provision at the sale time.
6) Inventory Obsolescence
Now, the recording of inventory obsolescence varies from business to business. If your business’s nature is something where there are occasionally obsolescences of inventory, you can write off the obsolete inventory amount in the profit and loss account.
However, suppose your business relates to products with high obsolescence rates. In that case, a provision for inventory obsolescence will be created to write off the amount in every financial year.
7) Provision For Depreciation In Assets
The purpose of creating depreciation provisions is to make a balance sheet more realistic and reflect the true value of the fixed assets of an entity. The depreciation provision is calculated depending on the depreciation method used by the entity.
It can be a straight line method where an equal amount of depreciation is written off every year. Or it can be the declining balance method where depreciation value is calculated on the remaining value of the asset at the end of every year.
When To Recognize An Expense Provision?
Any business can not create an expense provision for anything. As earlier mentioned, much financial analysis goes into the creation of expense provisions or income provisions.
The IAS 37.14 of International Financial Reporting Standards(IFRS) binds the entities to recognize the expense or income provisions in certain cases that are:
- A present expense payable arose as a result of any legal or constructive obligation
- A probable expense
- The amount can be estimated reliably
The measurement for different provisions is regulated under different clauses of the IAS 37 of IFRS.
Journal Entries For Provisions
For the accounting treatment of the provision expenses, the treatment for every provision will be different.
We are making entries of provisional debts, discount provisions, warranties provisions, and deferred tax provisions for you.
Are Provisions Non-Cash Expenses?
Yes, provisions are non-cash expenses or accounting loss reservations that are being charged to the current period.
The element of probability that gives rise to uncertainty of whether the event will occur or not makes the provisions from the regular accrual expenses.
For instance, there is no outflow of cash in the case of bad debts, discounts, or warranties. Therefore, the provisions are given an accounting treatment of non-cash expenses
Is Provision An Asset Or Liability?
Provisions generally represent the set-aside funds of an entity in anticipation of the expected losses. The expected losses are related to the events that had happened in the past. Therefore, if a loss arises in the future, it will have to be compensated by the entity.
So such a case leads to the creation of contingent liabilities. These are recorded under the liabilities column in the balance sheet or adjusted against receivables in case of bad debt provisions.
Therefore, provision expenses are treated as a liability in financial reporting.
Contingency planning is a very important function of the accounting department and financial reporting procedure. And provisions are the essence of contingency planning that help the entities and individuals estimate an expense or loss in anticipation.