A student might have noticed that the liabilities side of the balance sheet includes an entry referred to as provisions. Understanding how and why such a provision is necessary for accounting will be a benefit that one can get from reading this article.
Definition of Provisions
A provision refers to the amount that is typically set aside from profits in order to cover probable future expenses or an asset reduction, although it is uncertain exactly how much is set aside.
Despite the fact that provision cannot be considered savings, it can be viewed as a method of identifying any potential liabilities in the future.
The majority of the time, a provision is used as a reserve. However, a provision is different from a reserve. Reserves are part of a profit that is set aside to be used to assist the company's growth and expansion. A provision is set up to cover probable liabilities in the future, while a provision covers probable future assets.
The Provision in Accounting
A matching principle states that every expense incurred in a given year must be reported alongside the revenue gained. By doing this, it will prevent financial statements from looking misleading if costs related to a certain year appear on previous or future balance sheets.
Provisions, therefore, ensure that revenues and expenses are included within the same accounting period, balancing the balance of the current year.
Provisions - Why are they Created?
It is important to create provisions for a specific purpose since they account for corporate costs that will need to be paid in the same year. Creating the provision is beneficial to the company since it also makes its financial statements more accurate.
Having set aside this amount does not represent a form of savings, as the expense is estimated and is expected to be spent.
Is a Provision a Reserve?
A reserve is not considered a provision if it does not exist.
In contrast, a provision is a fund that is allocated for a specific expense, whereas a reserve is one that is formed from the profit made by the company. In a reserve account, money is held that is readily accessible. The money can be accessed from the savings account, for example.
Owners' associations, for example, may use reserve funds. A reserve fund may also have been set aside for unscheduled repairs. The exact reason for the repairs is unknown, nor are the exact costs associated. They only know that repairs will be needed at some point.
As an example, an automobile company could set aside money itself for the repairs under warranty that have occurred within the last year.
An Example of a Provision in Accounting
The majority of provisions are associated with bad debts. An accounting period is calculated by adding up the cost of the remaining unpaid debts.
Examples of provisions are:
1. Doubtful debts
4. Restructuring liabilities
5. Income taxes
6. Guarantee (product warranties)