Often we confuse ourselves with the terms provisions and reserves. Provision is the amount which is retained to meet a predicted contingency whereas reserve is the amount which the company retains to meet an unexpected future contingency. The entity estimates this amount with the previous year’s expense which may be probable this year that may or may not happen.
Reserves come under shareholders’ capital, whereas provisions come under liability which are further divided into long term and short term provisions.
Provision is a liability known to exist, but unknown in terms of amount. Proper estimations from the past events which may or may not happen in the present accounting year. When the prediction is fulfilled, then the amount is matched with expense and deducted from the provisions created.
According to IFRS (International Financial Reporting Standards), Provisions are considered as Liability whereas GAAP (Generally Accepted Accounting Principles) recognizes provisions as a expense
Why Provisions ?
Legal obligation: It is action which is enforceable by law. For example, If the entity is asked to replace a machinery or reconstruct a building.
Constructive Obligation: The obligation which is predicted which is to be constructed compulsorily for which the entity has accepted it responsibility.
Provisions are created so that there is no due on the date of the balance sheet and to make sure all the accounts match and balance properly.
Like our mothers do, She won’t buy groceries in huge quantities. She purchases based on the consumption of the previous month. Similarly, that’s how an accountant creates provision.
When it comes to fees. It’s not an amount that a company owns. When a member fails to pay, The amount is adjusted on the liability side of the balance sheet.
When it comes to debtors, Debtors hold money, which the business owns. Therefore, it’s an asset. This way we can decide by which the provisions are categorized under loses and expenditure.
Short term provisions
Short term provisions are a current liability. They are the provisions for liabilities which are paid within the date of the balance sheet or the operating cycle. It last longs approximately for one year
- Provisions for employee benefits,
- Provision for expenses,
- Provision for tax, proposed dividend,
- Provisions for doubtful debts,
- Provisions for tax,
- Provision for discount on debts,
- Provisions for bad debts,
- Provisions for repairs etc..
Long term Provisions
Long term Provisions are non-current liability. They are the provisions made for the liabilities which arise after the date of balance sheet or an operating Cycle. The provisions which exist more than 12months.
- Provisions for depreciation,
- Provisions for renewal,
- Provisions for Inventory obsolescence,
- Provisions for sales allowance,
- Provision for warrant,
- Provision for retirement benefit,
- Provisions for guarantees, warranties,
- Provision for earned leave,
- Provisions for gratuity etc..
Provision for pension is made for a person who is about to retire, for which we should pay after the current year and the provision for warranty which will occur after the current accounting year.
All the due amounts are adjusted with the respective accounts and disclosed as a single amount in the balance sheet. The provisions for expenditure is made on the liability side and for loss, it’s by deducing from the respective asset.
In case if the predictions are not matched and the provisions are left they are returned to general reserve, if it is from provisions for dividends or else returned back to profit and loss Account in case if the provision for bad and doubtful debts are left.
Disclosure of Provisions in a company’s balance sheet
In the Balance Sheet Of ABC & CO
|Short term provisions||X|
|Long term provisions||X|
The balance to be shown on the balance sheet.
Provisions disclose how far a company is ready to meet its unforeseen occurrences. The company should recognize and be ready to meet the contingencies with sufficient balance. It’s always better to have sufficient and reliable provisions aside. This could be used to manipulate profits in the balance sheet. They manipulate in order not to provide them with extraordinary bonuses to the employees. So they plough some into the provision of next year’s expense.