In accounting, the matching principle states that expenses should be reported in the same financial year as the correlating revenues. This is because costs that belong to a certain year can become misleading if accounted for in previous or future financial years.
Provisions therefore adjust the current year balance to be more accurate by ensuring that costs are recognised in the same accounting period as the relevant expenses.
Provisions are recognised on the balance sheet and are also expensed on the income statement.
Accounting rules require a company to review its operating data periodically and ensure that loans and customer receivable amounts are accurate. These rules include generally accepted accounting principles and international financial reporting standards.
Definition
In accounting parlance, a provision is an estimation that senior management makes in anticipation of a customer's default on a loan or account receivable.
Significance
Recording loss provisions is important because it helps department heads manage credit risk appropriately in operating activities. Credit risk is the loss expectation resulting from a business partner's inability to pay a loan when due.
Bad debt is customer receivables that are noncollectable. To record a bad debt provision, an accountant debits the bad debt expense and credits the allowance for doubtful items account.
Loan Loss
A company records loan loss provisions similar to bad debt. To record a loan loss provision, an accountant debits the loss provision account and credits the note receivable account.
Provision Reporting
Generally accepted accounting principles and international financial reporting standards require a company to report the allowance for doubtful items in the balance sheet and bad debt in the statement of profit and loss.
Types of provision in accounting
The most common type of provision is a provision for bad debt. A provision for bad debt is one that has been calculated to cover the debts encountered during an accounting period that are not expected to be paid.
This provision is usually included in the budget created by a company and can be estimated based on past experience with bad debt amounts as well as industry averages.
Other common kinds of provisions in accounting include:
- Restructuring Liabilities
- Provisions for bad debts
- Guarantees
- Depreciation
- Accruals
- Pension
How to create a provision
There are a number of factors that could cause a company to create provisions; however, there are certain requirements that must be fulfilled before a financial obligation can be viewed as a provision. These include:
The company must perform a reliable amount of regulatory measurement of the obligation. The measurement must be undertaken by company management.
It must be probable that the obligation results in a financial drag on economic resources.
An obligation must be a result of events that will advance the balance sheet date and could result in a legal or constructive obligation.
An obligation must be determined to be probable, but not certain. It must be estimated to have a more than 50% probability of occurring.
Tax and provisions
The way a provision is handled for tax purposes depends on whether it is a general provision or a specific provision.
A general provision is not allowed as a tax deduction. A specific provision - in which specific debts are identified - is allowed as a tax deduction if there is documentary evidence to indicate that these debts are unlikely to be paid.
Provisions and Debitoor
With Debitoor invoicing software, managing your cashflow has never been easier. Built for freelancers, sole traders, and small businesses, Debitoor grows with your company.
When you create an expense with Debitoor offers a ‘bad debt’ category for expenses, where you can record provisions for lost income. With our larger plans, you can also enter and track depreciation of assets.
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