A provision, in the accounting field, is a liability that consists of reserving a series of resources to meet a payment obligation expected in the future.
When the company has a future obligation or believes that it will have one (there is a high probability that it exists), it has to provision, that is, a provision is made. This means that it reserves a series of resources in the company for that future obligation and, therefore, does not spend them on other things. Provisions are usually made at the end of the year (depending on the country, but usually December 31) and it is usual that they are for an estimated amount (since the final amount is unknown).
Here is an example to better understand the concept: As of December 31, a company is part of a lawsuit for which a sentence has not yet been handed down. His lawyers have told him that it is very likely that he will lose it and have to pay court costs.
These court costs are an obligation to pay in the future. Therefore, the company must make a provision to ensure said disbursement, which will almost certainly occur.
Types of provision
Various classifications of provisions can be made. Here we focus on the type of expense that is provisioned and the term in which the provision will last.
According to the type of expense that is provisioned:
- Provision for an obligation incurred and not yet paid: It is a past obligation. For example, suppose that on December 1, we buy merchandise from a supplier and agree to a 6-month payment. As of December 31, we will make a provision for this debt with that supplier, since we have generated an obligation, but we have not paid it.
- Provision of an obligation not contracted (and therefore not paid), but foreseeable: It is a future obligation. For example: As of December 31 we know that during the month of February of the following year we will have to pay a certain tax. Although we do not know the specific amount, we must make a provision for an approximate amount, which will be used to meet that payment.
- Provision for impairment expenses: Although impairments are not obligations as such, they represent an expense for the company, so when the possibility of impairment is perceived (of an asset, a customer, etc.) must endow a provision.
According to the estimated duration of the provision:
- Short-term: When it is estimated that the obligation that we are provisioning will be fulfilled in the short term, that is, in less than 12 months. The provision will be included within current liabilities.
- Long-term: When it is estimated that the obligation that we are provisioning will be fulfilled in the long term, that is, in more than 12 months. The provision will be included within non-current liabilities.
Purpose of the provision. What if the forecast that we are provisioning is not fulfilled?
As we have commented previously, the objective of the provision is to cover an obligation or an expense that we will have to face in the future. Often these obligations or expenses are forecasts and, therefore, there is no total certainty that they will occur. What happens, then, if it does not occur? We will have to reverse the provision and, therefore, we will return to the initial situation prior to the provision. Ultimately, it would be as if we had not made any provision.
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