Accounting Provision

In accounting, a provision allows for the existence of a risk that is both measurable and probable, but also uncertain . The provision is directly linked to one of the basic principles of accounting: prudence . The accounting provision has a direct impact on the balance sheet, as it increases the company’s liabilities.

Accounting provision: definition

Directly linked to the accounting principle of prudence, an accounting provision is the recognition of a measurable, probable but uncertain risk. Indeed, we know neither its amount nor its maturity. A provision will impact the balance sheet and the company’s results in the year in which this provision is recognized, by increasing the company’s liabilities.

There are different provisions: for taxes, for risks or even for expenses. For example:

Dispute with a third party resulting in legal action,
Ongoing tax audit potentially leading to an adjustment,
renewal of fixed assets,
major works,
guarantee given to customers, etc.

Be careful not to confuse an accounting provision with a debt or accrued expense. The key difference arises from the nature and certainty of the obligation. Provisions are estimates for uncertain and future events, while payables and accrued expenses are concrete and current obligations.

What is the purpose of an accounting provision?

For a business owner, it is essential to consider provisions for risks and expenses within the framework of their business. Indeed, recording a provision will allow them to anticipate the various risks related to the company’s activity. This may involve, for example, an increase in expenses or a reduction in the value of an asset. It also allows them to smooth out an expense over time and to determine the impact of a future expense on the company’s annual accounts as soon as the expense becomes known.

Furthermore, this is part of an approach aimed at respecting the accounting principle of prudence necessary for accounting treatment that complies with the rules in force.

Why record an accounting provision?

Recording a provision allows you to anticipate risks related to your company’s business. If the risk materializes, you avoid being caught “off guard.”

Accounted for at the time of preparation of the annual accounts, the accounting provision is maintained or disappears, depending on the evolution of the risk.

If the risk materializes, the reversal of the debt recorded on the balance sheet offsets the expense incurred during the accounting period. This is why it is important to have properly assessed the risk when recording the provision.
If the risk has not materialized, but remains current, the provision is maintained on the balance sheet and may be adjusted if necessary.
If the risk disappears, the provision must be cancelled by a “reversal of provision”.

How to record an accounting provision?

As a general rule, accounting provisions are estimated and recorded at the end of the financial year when preparing the annual accounts (balance sheet, income statement and legal annex).

When a risk is recognized, a provision will indicate a probable future liability on the balance sheet liabilities and create an expense in the income statement. Several scenarios will then be possible if the risk occurs or disappears:

The risk arises: the assumption of the debt created on the balance sheet will offset the expense appearing in the income statement. Be careful, you now understand the importance of properly estimating the provision so that the impact on the financial year is zero.
The risk does not occur but remains present: the accounting provision remains in the balance sheet and is adjusted at the end of the accounting year in order to be as close as possible to reality.
The risk disappears: the provision must be cancelled via the “provision reversal” mechanism. This will have the effect of increasing the company’s exceptional result.

A provision generally constitutes an expense deductible from taxable income in the year it is recorded and a taxable income on the day it is reversed. There are, however, exceptions, for example:

provisions not admitted for tax purposes for risks linked to disputes whose outcome is uncertain or for unrealized depreciation of assets,
provisions for major repairs on fixed assets are often subject to specific rules,
regulated provisions (such as those for investments) which benefit from a special tax regime,
provisions made for retirement pensions or other similar obligations,
provisions for exceptional depreciation,
a provision made for a future event whose occurrence is uncertain, etc.

Focus: Provisions for depreciation

Impairment provisions are accounting adjustments used to reflect the decline in the value of a company’s assets. They are established when the carrying amount of an asset exceeds its recoverable or market value. Examples include:

Depreciation of fixed assets for durable goods used over the long term by the company (buildings, machinery, vehicles, etc.). It is incurred when these assets suffer a loss in value due to wear and tear, obsolescence, or a change in the economic environment.
Depreciation of inventories if their market value is lower than their production or purchase cost, due to a drop in demand, deterioration, or obsolescence of the stored products.
Depreciation of receivables if the risk of debtor insolvency increases or in the event of prolonged delay in payments, making their recovery uncertain.
Depreciation of investment securities in shares, bonds, or other financial instruments, when the market value of these securities falls sustainably below their purchase price.

We recommend that you work with a certified public accountant to manage your accounting. Only this professional will be able to guide you and provide a true and accurate picture of your company’s accounts.

Who can make accounting provisions?

The persons authorized to make accounting provisions are mainly:

individual entrepreneurs;
and companies subject to income tax in the industrial and commercial profits category or to corporation tax.

On the other hand, professionals exercising a liberal activity, falling under non-commercial profits and using cash accounting, cannot normally constitute provisions, due to the incompatibility of this method of compatibility with the constitution of provisions.

However, if these taxpayers opt for commercial accounting, they can then set aside provisions, but this possibility is limited to provisions for doubtful debts.

Why calculate accounting provisions?

The advantages of accounting provisions

Calculating accounting provisions meets accounting requirements:

anticipate risks by reflecting potential future losses or expenses in the company’s accounts;
respect the accounting principle of prudence which states that a company, in uncertainty, must always record estimates that anticipate losses in order to avoid overestimating its profits;
present the company’s financial situation faithfully.

The risk of provisions

Provisions can also present some risks:

make inaccurate estimates that may distort the company’s true financial situation;
manipulate results to artificially influence financial results.

What are the conditions for the validity of accounting provisions?

The conditions for the validity of accounting provisions can be divided into several aspects:

accounting conditions;
and tax conditions.

Accounting conditions for the validity of provisions

To be validated, the provisions must:

show that the company has an obligation to a third party through contracts, regulations, public commitments, etc. This obligation must exist at the closing date of the financial year, but it can come from a previous financial year (as long as it continues) and not from a future financial year;
result in an outflow of resources from the company for the benefit of the third party at the end of the financial year, without there being at least equivalent compensation;
be able to be reliably measured. If the amount of the outflow cannot be reliably measured, the provision is not recorded, but a note must be made in the notes.

Tax conditions for the validity of provisions

From a tax perspective, the conditions for validity are as follows:

the provisions must actually be recorded in the accounts for the accounting year concerned;
They must be recognized in anticipation of a loss or expense that is tax-deductible.
the nature and amount of the loss or charge must be clearly specified ;
the probability of the loss or expense occurring must result from particular circumstances ;
and the probability of the loss or expense must arise from events in progress at the closing date of the financial year

How to calculate accounting provisions?

The calculation of accounting provisions depends on the nature of the provision and the information available at a given time.

An accounting provision for risk and expense is recorded by creating:

a debt on the balance sheet liabilities;
and a charge in the income statement.

The provision stays on the balance sheet until the risk or expense is realized. Once realized, the provision becomes real, and a new expense shows up on the income statement through a provision reversal.

What happens to the provisions?

There are several situations when provisions are made:

If the loss or expense for which the provision was recorded occurs, the procedure starts by reversing the provision. This means the provision, no longer justified due to the actual loss or expense, is adjusted in the results. Then, the actual loss or expense incurred is subtracted from the result;
if the loss or expense does not materialise, the provision previously set aside becomes irrelevant (for example, a provision for doubtful debt settled by the customer). In this case, it must be reinstated in the profits for the financial year;
and finally, if the provision was constituted irregularly, that is to say if the substantive and/or formal conditions were not respected, then the provision must also be reinstated in the company’s results.

FAQ

How to cancel a provision in accounting?

To cancel a provision in accounting, note the reintegration of the provision in the accounts. Credit the provision account and debit the income statement when the anticipated loss or expense will not be realized

Why should provisions for risks and expenses be recorded?

The recognition of the provision for risks and charges is necessary for two reasons:

It allows you to predict financial risk and anticipate your financial vision.
It ensures compliance with the accounting principle of prudence and contributes to presenting a true and fair view of the company’s financial statements.

Read Also:

Accounting Provision: A Simple Guide