Provisions in accounting help businesses to be more accurate in their financial position. This will help them make smarter business decisions, and also give investors a clear picture of how the company is doing financially. For example, if a company sells products with warranties, it may have a provision to cover the cost of repairs and renewals. These provisions are flexible, allowing management to adjust them as needed.
To determine how much money to set aside for these expenses, businesses need to determine the likelihood that the company will incur an obligation in the future. They look at their historical experiences, recent financial statements, and industry averages. Based on this information, they estimate how much revenue will become uncollectible in the future. This amount is then recorded as a liability on the balance sheet and an expense on the income statement.
Provisions are separate from reserves and savings. While reserves are set aside to meet specific expenses, provisions are generally set aside as part of a company’s profit. Reserves are set aside for specific expenses, and are often highly liquid. A homeowner’s association, for instance, may have a reserve fund to cover building repairs. In addition to being highly liquid, the funds in a reserve fund allow for flexibility over timing and cost.
Aside from accruals, other types of provisions in accounting include income tax, pension liabilities, asset impairment, and inventory obsolescence. Provisioning can be a tricky part of the accounting process, and a basic accounting system won’t make the process very simple. Thankfully, many accounting software packages make provisioning much simpler. For example, Tally can handle sales-related provisioning, and it also helps accountants analyze the data and make estimates more accurately.
Another common type of provision is bad debt. This is an amount of accounts receivable that the business estimates will not be collected. Businesses usually estimate this amount based on industry averages and previous accounting periods. Another type of provision is a guarantee. This occurs when one business assumes financial liability for another. This is common if the company has an interest in a business’ success.
Provisions are an important part of the financial picture. They help an organization forecast the future. For example, a bank will set aside money for loan losses. If the loan is not paid, the company will incur a loss. This type of provision is also known as loan loss provisions. In addition to loan losses, loan provisions are created for bad debt and other loan-related issues.