For businesses, many costs can be unavoidable yet uncertain in terms of time and amount. When a business allocates funds for such expenses, these are called provisions.
Under provisions happens when the actual amount of expense exceeds the amount allocated in the provision account. Similarly, over-provision happens when the allocated provision is greater than the actual expense.
Let us discuss what are provisions, under provisions, and the accounting treatment for them.
Provision in Accounting
A provision expense or simply provision is an amount set aside for a probable future expense. Provisions are allocated funds as recognition of future liability.
A provision is of uncertain time or amount for possible future liability. Since these expenses are uncertain, they must be estimated. Companies can use historic data and other available information to estimate these future liabilities.
Provisions are recorded as liabilities first in the balance sheet. Then, the entry is recorded as an expense in the period in which an expense occurs.
Although provisions are uncertain for time or amount, they must be recorded for events that are in near-future or are highly probable. For that, an entity must have a current obligation that must happen in the future.
Types of Provisions
Businesses can set aside funds for various types of future liabilities in the form of provisions. These provisions are created by estimating future liabilities at a probable future time.
Here are a few common types of provisions.
- Bad Debts: These provisions are allocated for bad debts based on historic average amounts.
- Depreciation: It is called accumulated depreciation and is the collected value of all depreciation over years.
- Guarantees: These provisions are set aside for commitments made for third-party services, products, or financial liabilities.
- Income Tax: A common form of provisions that come with income tax provisions. A business allocates estimated income tax for future liability.
- Accruals: These are expenses that occurred in the past but haven’t been paid yet. These estimates may also change over time due to a change in the interest rate or other factors.
- Returned Sales Allowances: These are allowances for damaged products or warranty claims through returned sales.
How to Use Provisions?
Provisions help businesses to estimate and allocate funds for uncertain expenses or future liabilities. Businesses can use provisions to handle several types of uncertainties.
Businesses can face uncertain liabilities due to several reasons. For instance, provisions for income tax liabilities are commonly used by businesses.
Instead of recognizing losses immediately, businesses can allocate funds in the form of provisions. These items are first realized on the balance sheet and then recorded on the Income statement. This way, businesses can better manage uncertain events.
Provisions are useful for certain future liabilities that cannot be estimated accurately. For instance, a business cannot fully determine the funds required for warranty claims in the coming days.
Accounting Recognition of Provision
The accounting recognition of provision comes under IAS 37 guidelines.
An entity can recognize a provision when:
- There is a present obligation as a result of past events. For instance, a warranty claim is a current liability due to a past event (policy of refund).
- The payment is probable or a payment results in the outflow of benefits (in cash or services).
- The amount of liability can be estimated reasonably.
When a business can avoid liability, it does not need to recognize a provision. However, if a future liability is unavoidable, a provision must be recognized.
Under Provision in Accounting
Under provision is a state when the amount allocated for a provision liability is less than the actual liability amount. It means the provision earlier was estimated fewer than the actual amount.
As provisions are estimated amounts for certain liabilities (with the uncertain date and amount), they can be different from actual amounts. In other words, an under-provision is a variance of an estimate from the actual.
Under provision can be accounted for only when the estimated liability transaction is completed. For instance, when a company allocates funds for warranty claims, it can only estimate the amount. It will reconcile only when warranty claims have been made for a particular period. Any variance is then adjusted for in the financial statements of the entity.
In the case of under-provision, the company will simply add the further amount to its current period’s provision account. It will have no effect on the profit or loss of the company for the previous period as the amount is only an adjustment to an already estimated liability.
How to Adjust for Under Provision?
The company first creates a provision account. The contra entry for the provision account is for the relevant expense for which an estimated liability (provision) is allocated.
Any adjustments for under-provision are simply replenishing of earlier allocations.
The general journal entry to record the provision is:
|Relevant Expense||$ XXXX|
|Provision Account||$ XXXX|
Suppose a company ABC has estimated warranty claims of $ 10,000 for the current quarter. The journal entry to record the transaction will be:
|Warranty Costs||$ 10,000|
|Provision Account||$ 10,000|
Suppose warranty claims were higher than the allocated provision. If the warranty costs were $ 15,000 for the quarter, then the adjustment for the under-provision will be:
|Warranty Costs||$ 10,000|
|Provision Account||$ 5,000|
|Profit and Loss Account||$ 15,000|
The adjustment for under-provision at the end of the accounting period is simply an additional amount to the provision account. The contra entry is to the profit and loss account for the actual figure of warranty costs.
Under Provision Vs. Over Provision in Accounting
Over-provision in accounting is similar to under-provision. If the allocated provision amount is greater than the actual expense amount, it results in over-provision.
It is the variance in the provision account from the actual amount. The accounting entry to adjust the over-provision is a debit to the provision account.
An over-provision results in additional revenue for the current year. However, the accounting entry does not affect the profit/loss of the previous accounting period.
Provision Vs. Reserve
Reserve funds are usually allocated from the profits of a company. These funds are highly liquid and held separately. Reserves are estimated for certain expenses but can be used for various expense categories.
Reserve funds are uncertain expenses that may not occur. It means they cannot be classified as probable liabilities as is the case with provisions.
On the other hand, provisions are probable liabilities. The amount for provision expenses can be reasonably estimated. These are also future liabilities as a result of past decisions.
In short, provisions are set aside for specific expenses with uncertain amounts and time but probable liabilities. Reserve funds are dedicated to uncertain future expenses that cannot be reasonably estimated.
Provisions Vs. Accrued Expenses
Both accrued expenses and provisions are future liabilities. However, both of them are very different in nature.
Accrued expenses are those that have already been incurred in the past but not paid yet. It means accrued expenses are also paid in the future at some stage.
Contrarily, provisions are both unpaid and uncertain but probable future liabilities. It means provisions are uncertain whereas accrued expenses are certain.