The term “provision” is used extensively in financial accounting activities. Business owners, for example, often use provisions to better predict their future profits. To effectively use provisions, though, you must first familiarize yourself with this term and what it means.
Overview of Provisions
In accounting, a provision is a record of a probable liability in the future. If you believe your business will owe money in the future, you can record it as a provision. At the same time, you can go ahead and set aside money to cover the liability if it occurs.
Like conventional liabilities, provisions are recorded on a balance sheet. They are placed alongside other liabilities and assets, allowing businesses to better forecast their future profits.
You can think of a provision as a liability in which neither the amount nor due date are certain.
Provisions can be defined by the following characteristics:
- Financial obligation from a previous sale or transaction
- Probability that the business will owe money for the sale or transaction at a future date
- The business can make a reliable estimate regarding the amount of the future liability
- The business accepts the financial obligation to cover the future liability
The Purpose of Provisions
The reason business owners use provisions is to predict their future prospects with greater accuracy. Without provisions, business owners may overlook future liabilities if they don’t know the details about those liabilities. And if they don’t record these future liabilities on their balance sheet, business owners could be hit with unforeseen expenses that hurts their ability to grow their organization. Provisions allow business owners to keep a detailed record of all their liabilities, including probable future liabilities.
Provision vs Accrued Expense: What’s the Difference?
Some business owners assume that provisions are the same as accrued expenses, but this isn’t necessarily true. Accrued expenses are expenses that a business has incurred but hasn’t paid, whereas provisions are probable liabilities in the future. Therefore, the difference between these two accounting terms is that accrued expenses have already been incurred, while provisions have not been incurred.
To recap, a provision is a probable future liability that’s recorded on a business’s balance sheet. It’s used to better predict a business’s financial health by ensuring that uncertain liabilities are accounted for. Hopefully, this gives you a better idea of provisions and how they are used.
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