Provision may be defined as an amount that is set aside in company’s account for a unknown liability (time and amount unknown). It is an account with a purpose to record any present liability of an company to another company.
A provision can be a liability of uncertain amount or timing. A liability represents a current obligation of the entity which arises from past transactions, and its settlement will require an outflow of resources containing economic benefits.
Meaning and purpose
A provision is charged against the profit and loss account. It is created for meeting an unknown loss of liability. Provision is maintained for meeting an anticipated loss or liability of uncertain amount.
Provision allows the company owner to have more accurate year’s balance. The main reason for that is that data for current year often doesn’t apply for that year only. The transactions may be made for the future or the past, but provisions should always be up to date.
There are certain criteria that need to be fulfilled in order for the provision to be recognized:
- An entity has a current obligation resulting from an event in the past.
- The settlement of the obligation may require potential outflow of resources embodying economic benefits.
- A reliable estimate can be made of the amount of the obligation.
- The entity accepts its responsibilities to cover the obligation, so that other parties can expect the entity to clear off its obligations.
What can a provision be?
Some of the most common provisions are:
- Restructuring liabilities – periodically, a company may decide to restructure all or some portion of its operations. A restructuring involves substantial changes to the scope or conduct of the business.
- Provisions for doubtful debts – whether some receivables can be recovered or not might be doubtful, but they cannot be definitely described as irrecoverable. Those receivables are called doubtful debts. An allowance needs to be created in order to recognize the contingent loss occurring from the possible emergence of bad debts.
- Guarantees – formal promises or assurances that certain conditions will be fulfilled.
- Depreciation – permanent and continuing diminution in the value of an asset regarding its quality or quantity.
- Accruals – expenses incurred in a period for which no invoice had been received at the end of that period.
- Pension – provisions for pensions are recognized for commitments in the form of retirement, invalidity and benefits payable for dependents under pension plans.