What Is The Provision Meaning In Accounting? (With Types)
Updated 13 August 2023
Provisions in accounting refer to the money a company sets aside to cover its present and future liabilities and obligations. As these funds are probable expenses that a company is likely to incur, accountants list them on the balance sheet under the liabilities section. If you want to work in the finance sector, understanding the provision meaning in accounting can help you measure a company's obligations and protect it from potential losses.
In this article, we discuss what accounting provisions are, review the characteristics, provide the benefits, outline the types of provisions in accounting, highlight how companies can use them and explore some examples.
Please note that none of the companies, institutions or organisations mentioned in this article are associated with Indeed.
Provision Meaning In Accounting
Knowing the provision meaning in accounting can help you understand the company's position and make informed decisions about its future operations and expenses. An accounting provision is the funds that a company uses to cover anticipated future expenses and other financial impacts. Provisions are not a company's savings. Instead, they are a way of recognising future liabilities. Examples of provisions include asset impairment, accruals, depreciation, bad debt, guarantees, inventory obsolescence, pension, restructuring liabilities, doubtful debt and sales allowances.
When a company earns profit, it might allocate or reserve some amount for a specific purpose. This amount is not a provision in accounting because it is a reserve fund. Typically, when making a provision in accounting, it is beneficial to record its purpose. In addition, a company create a highly liquid provision fund because it might require the money immediately. For instance, an amount provisioned for a customer refund gets paid as soon as they return the product. The company cannot predict when this need might arise.
Characteristics Of Accounting Provisions
Here are a few characteristics of accounting provisions:
A company creates a provision when there is an uncertain future liability and accountants cannot fully quantify the amount of liability.
It reduces business profits.
A company might create an accounting provision when there is a probability of an outflow of funds.
Benefits Of Provisions In Accounting
Provisions can help a company gain more insights into its financial position. This helps a company make better business decisions and provides shareholders with an overview of the company's finances. For example, a company that provides guarantees on its product knows they are likely to face replacement or repair costs for a percentage of products they sell. To ensure expenses and revenue match, a company creates a provision for these repair or replacement costs. This helps in understanding the company's profitability.
Types Of Provisions In Accounting
Provisions in accounting might vary from company to company. Some common types of provisions are:
Bad debt or doubtful debt is an expense that occurs because of an incomplete or unrecoverable payment from customers who do not pay their past invoices. Doubtful debt decreases a company's accounts receivable for a certain period. Depending upon the historical data and industry average, a company creates a provision for bad debt and doubtful debt.
Depreciation is the process in which an asset loses its value due to use. It is an operating expense. A company creates a provision for depreciation, which represents the collected value of all depreciation. When making a journal entry, an accountant does not record this provision by crediting the asset account because they show assets in their original value. Instead, they credit the depreciation amount in the accumulated depreciation account. During the sales of the asset, an accountant debits the accumulated depreciation and credits it in the asset account.
Guarantees or warranties
Guarantees and warranties help build customer trust because they show that a product might not fail. A customer can avail these warranties when encountering product failures. If the product fails, the company can reimburse the money and replace or fix the product. A company estimates the warranties payable at the time of sales to ensure it meets the financial obligation of providing repair and replacement.
Often, a company provides pension plans to employees for which an employee and the company contribute funds. The company provides this amount to employees upon their retirement. As pensions create expense obligations, a company creates a pension provision that helps make future payments.
Asset impairments occur when the market value of an asset is less than the value listed on the company's balance sheet. Accountants might test asset impairments regularly to prevent overstatement of assets on the balance sheet. Some impaired assets can be accounts receivables, intangible assets and fixed assets. When the company writes the value of the impaired asset on the balance sheet, an accountant records a loss on the income statement.
A sales allowance is a reduction in price charged by sellers when a customer receives a defective product, did not receive some part of the product or paid the incorrect price. Typically, a sales allowance occurs when a seller offers a customer an alternative for the product they are returning. Accountants create a sales allowance after completing the product's initial billing. When a company creates a sales allowance, it automatically creates a financial obligation. Companies might create a provision for sales allowances to pay for these obligations.
Obsolete inventory is that which is at the end of its product lifecycle. This is the inventory that a company might not sell, did not use for a long period and might not sell in the future. A company might write inventory obsolescence as debited expenses. To prevent the loss incurred from inventory, a company creates a provision for inventory obsolescence.
At the end of every financial year, it is necessary for a company to pay taxes. To account for these taxes, a company creates a tax provision. This provision helps in paying the company's estimated taxes on time. It prevents a company from paying penalties and interest on late taxes.
Often, when a company provides a loan, the borrower might not repay it. A company then loses the loan amount resulting in a loan loss. A company may create a loan loss provision, which is the amount it sets aside to cover the loan losses. Typically, financial institutions and companies that provide loans to people create this type of provision in accounting.
How Can Companies Use Accounting Provisions?
Provisions secure a company against future liabilities and the occurrence of uncertain events. Rather than affecting the income statement with an expense, provisions allow a business to create a liability account on the company's balance sheet. As a company might have bad debts and tax liabilities, it cannot estimate the values at the beginning of the financial year. That is why companies focus on provisions, as it helps a company manage such unforeseen yet likely events.
Examples Of Provisions In Accounting
Here are some examples of using provisions in accounting:
Here is an example of a furniture company using accounting provisions:
A furniture company, Superior Woods Private Limited, sells 50 sofa sets for ₹17,50,000 in a month. The historical data shows the company's average bad debt is 6%. Based on the historical data, the company might fail to collect ₹1,05,000 of the month's revenue. A company creates a bad debt provision for ₹1,05,000.
Here is an example of a manufacturing company using accounting provisions:
A company, Sunwila Manufacturing, provides a two-year warranty on every air purifier it sells. The warranty specifies that the manufacturing company agrees to compensate the customer for a defective product. Last year, the company sold 2000 air purifiers, each costing ₹11,000. Based on the previous year's data, the company expects 10% of the air purifier to be defective. The company estimates an average repair cost of ₹2,000 per unit. This means there is likely 200 defective air purifiers with a collective repair cost of ₹4,00,000. The company creates a provision for warranty amounting to ₹4,00,000.
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