Why we create provisions

Provisions help adjust this balance by ensuring that business expenses are recognised in the same year. Provisions are also different from reserves, or reserve funds. While reserve funds are set aside by a business for a specific purpose, provisions are allocated for expenses.

Reserve funds are usually highly liquid, making them easily accessible for expenses. The reserve is for a specific purpose, but there is some flexibility involved when it comes to cost and timing.

By contrast, a provisional amount is set aside for a specific expense. For example, a maintenance company might set aside provisions for boiler repairs in an apartment building during the final quarter of the year. This use is specific and is all the money is intended for. Bad debt is one of the most common reasons for provisions, which are calculated during a time-limited accounting period.

However, this is far from the only type of accounting provision. Here are some additional types of provisions in accounting:. As you can see, there are multiple reasons for provisions in accounting. Yet not every expense will qualify. Before an obligation can be treated as a provision for accounting purposes, some requirements must be satisfied:.

The obligation must be due to events that result in legal or constructive liabilities. Another type of provisions in accounting to be aware of relates to taxes. Once tax calculations have been worked out, the company can enter the tax provision in its accounting books. GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices.

Examples of Provisions. What Are Tax Provisions? NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks.

If you need income tax advice please contact an accountant in your area. Provisions are important because they account for certain company expenses, and payments for them, in the same year. Provisions are not a form of savings. A reserve, or reserve fund, is money allocated from profit for a specific purpose. A reserve fund is typically highly liquid, so that funds can be accessed immediately, like from a savings account.

They could have a reserve fund for unscheduled repairs. The dues the homeowners pay will keep the fund filled up, and interest will be earned. An example of a provision could be a car company setting aside money for warranty repairs for the last quarter of the year. A provision for depreciation represents the accumulated or total depreciation that a particular asset has experienced. Guarantees or warranties refer to the repair or replacement infrastructure that companies build into purchases their customers make.

Since customers are likely to cash in on their warranty protections, companies must anticipate that they will need to meet the financial obligations of providing those protections.

Therefore, companies often estimate their warranties payable at the time of sale and create a provision to account for the future expenses that may be incurred through meeting warranty obligations. Obsolete inventory is inventory that has reached the end of its product life cycle that may need to be written down as debited expenses or written off by a company.

Companies create provisions for obsolete inventory to establish the dollar amount of loss expected from inventory obsolescence. Establishing this amount can help companies adjust their purchasing methods and inventory amounts to avoid inventory obsolescence in the future. Pensions are employer-sponsored retirement plans that require employers to contribute funds over time on behalf of their employees.

Often, the employer invests the funds on behalf of the employee and the earnings generate income that will be awarded to the employee upon retirement. Since pensions create expense obligations for companies, many companies will create pension provisions for financial benefits that will be paid in the future.

When companies restructure or reorganize, they often restructure their financial liabilities, such as debt, as well. This helps companies avoid loss incurred by defaulting on existing debt. To account for the changes made to these liabilities and any other liabilities incurred through reorganization itself, companies may create provisions for restructuring liabilities.

These provisions can help them accurately designate funds and remain solvent over time. A sales allowance is the reduction of price charged by a company, vendor or distributor as recognition of a problem with the product or service. These problems can include the quality of a product, an incorrect amount of product or an incorrect original price.

Sales allowances are established after the initial billing for the product or service, and therefore, when sales allowances are calculated, they create a financial obligation for companies. Companies may create provisions for sales allowances to effectively account for such obligations as deductions.

Find jobs. Company reviews. Find salaries. Upload your resume. Sign in. Career Development. What is an accounting provision? How do accounting provisions work? Obligation: A company recognizes a current obligation because of past events that could eventually result in legal or constructive obligation. Estimation: A company can make a reasonable estimate of the amount the obligation will cost them. Responsibility: A company will accept responsibility for certain particularities and other parties expect them to follow suit.

The difference between accounting provisions and other line items. Tax provisions. Loan loss provisions.