Provision (accounting): Difference between revisions

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In financial accounting, a provision is an account which records a present liability of an entity to another entity. The recording of the liability affects both the current liability side of an entity's Balance Sheet as well as an appropriate expense account in the entity's Profit and Loss Statement.

In U.S. GAAP, a provision is an expense, while in IFRS, International Financial Reporting Standards, it is a liability. So, in the U.S., Provision for Income Taxes means the same thing as Income Tax Expense, while under IFRS, Provision for Income Taxes means Liability for Income Taxes Payable. Another examples is provisions for warranty costs [expense in the US and liability in IFRS]. Sometimes in IFRS, but not in US GAAP, the term reserve is used instead of term provision; such a use, however, is inconsistent with the terminology suggested by International Accounting Standards Board.^{[citation needed]} Reserve, which seems to be one of the most confusing terms in accounting, has the connotation of a debit balance to non-professionals but in accounting always means an account with a credit balance. Reserve for Warranties means estimated liability for future warranty repairs and replacements, NOT a pool of cash set aside for the firm to use in making repairs.

Provision: In IFRS, but not US GAAP, a present obligation which satisfies the rest of the definition of a liability, even if the amount of the obligation has to be estimated.

Provision can also be defined as the "liability of uncertain timing and uncertain amount" (Framework)

Provisions are defined under the AS-29 of Indian Accounting Standards

Provision under IFRS

In the IFRS, the treatment of provisions (as well as contingent assets and liabilities) is regulated by IAS 37.

Definition

A provision is defined as a liability of uncertain timing or amount. A liability, in turn, is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.^[1]

Recognition

A provision shall be recognized if the following criteria are fulfilled:

• an entity has a present obligation as a result of a past event;
• `it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation;
• a reliable estimate can be made of the amount of the obligation.^[2]

Typical examples for generally recognized provisions are onerous contracts, provisions for litigation and other legal claims, warranty provisions, decommissioning provisions, or environmental provisions.

More precisely, a provision has to be recognized if an obligating event creates a legal or constructive obligation that results in an entity having no realistic alternative to settling the obligation. A legal obligation may derive from a contract (through its explicit or implicit terms), legislation or some other operation of low. A constructive obligation derives from an entity's actions where by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity will accept certain responsibilities and other parties have valid expectations that the entity will discharge its responsibilities.

No provision, however, is recognized for costs that need to be incurred to operate in the future. Also, an obligation always involves another party to whom the obligation is owed (even if this party is unknown).^[3]

Executory and Onerous Contracts

An executory contract is defined as a contract under which neither party has performed any of its obligations (e.g. delivering an object and paying for that object) or both parties have partially performed their obligations to an equal extent. In case of an executory contract, IAS 37 does not apply and neither an asset nor a liability is recorded. However, a provision needs to be recognized if the executory contract becomes onerous to the entity. An onerous contract is defined as a contract in which the unavoidable costs resulting from the entity meeting its contractual obligations exceed the economic benefits expected to be received under that contract.^[4]

Restructuring

A restructuring is defined as programme that is planned and controlled by management, and materially changes either the scope of a business undertaken by an entity, or the manner in which that business is conducted.^[5] If a restructuring is anticipated, it leads to the recognition of a provision. However, that provision is subject to some specific restrictions: A restructuring provision does not include costs such as the retraining or relocating of continuing staff, marketing, or investment in new systems and distribution networks. This is because these expenditures relate to the future conduct of the business and are thus not liabilities for restructuring to be recognized at the end of the reporting period.^[6]

References

See also

• Balance sheet
• Income statement
• International Financial Reporting Standards
• IAS 37: Provisions, Contingent Liabilities and Contingent Assets

External Links

• IAS B: IAS 37 - Provisions, Contingent Liabilities and Contingent Assets