In accounting, accrued expenses and provisions are financial obligations differentiated by their respective degrees of certainty.
All accrued expenses have already been incurred but have not yet been paid. They are certain. By contrast, provisions are funds allocated toward probable, but uncertain, future obligations. They are a kind of a rainy-day fund, built on educated guesses about future expenses. It can be difficult to draw clear lines between accrued liabilities and provisions. In some respects, the characterization of an expense obligation as either accrued or a provision can depend on a company’s interpretation of the expense.
All accruals are divided into either expenses or revenues. An accrued expense is a cost that has been incurred. It is certain that payment for it is due in the future. For example, in a publicly listed corporation’s financial statements, there is an accrued expense amount for the interest that is paid to bondholders each quarter. The company knows exactly how much it must pay and when it must pay it.
Interest payable on bonds is a known figure. It can be calculated well ahead of time, and money can be set aside for it in a very specific fashion. The accrued expense is listed in the ledger until payment is actually distributed to the bondholders. When companies buy and sell from each other, they frequently do so on credit. A credit transaction occurs when an entity purchases merchandise or services from another but does not pay immediately.
The unpaid expenses incurred by a company for which no invoice has been received from its suppliers or vendors are referred to as accrued expenses. Other forms of accrued expenses include interest payments on loans, services received, wages and salaries incurred, and taxes incurred. For all these, no invoices have been received and no payments have been made yet. Accrued expenses and provisions are accounted for as current liabilities on the balance sheet and as expenses on the income statement.
Understanding Provisions
Provisions are similar to a rainy day fund for a business. They are funds purposefully set aside to pay for anticipated but uncertain expenses.
For example, if a company’s clients don’t pay their bills or someone defaults on a loan, money put aside as provisions could be used to cover these losses. Likewise, provisions could be set aside to pay for probable income taxes.
Companies elect to make provisions for future obligations whose specific amounts or dates of incurrence are unknown. Provisions are like a hedge against possible losses that would impact business operations.
Guidelines for Recognizing Provisions
General guidelines should be met before a provision can be justified and recorded. For example, the potential liability must be a constructive obligation or a legal obligation. It must be expected to make a financial impact on a company (such as a loss of value or funds).
In addition, provisions must represent probable outflows. Otherwise they would be contingent liabilities. The reported amount must be a reasonable estimate of what may be spent to settle the obligation at the end of the reporting period.
Important Considerations
Provisions for banks work a little differently than they do for corporations. Banks make loans to borrowers, which involve the risk that a loan will not be paid back. To protect against this, banks make loan loss provisions.
Money set aside for loan loss provisions covers loans that have not been paid back or monthly loan payments that have not been made. Like corporations, banks recognize a loan loss provision as an expense.
Why Do Provisions Matter?
They matter because they allow companies to plan ahead for probable future expenses. They can lessen the financial impact of these expenses because money has been set aside for them.
What Happens to a Provision if It’s Not Needed?
Per proper accounting practice, companies should reduce amounts of provisions if the expenses don’t occur.
Are Provisions as Common as Accrued Expenses?
Typically, no. Accrued expenses are actual expenses and are a normal part of doing business. They’re recorded frequently. Provisions represent probable but not necessarily definite future expenses. So, they may or may not occur. Also, certain conditions must be met before a company can even establish a provision. Source