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Provision



Definition

In financial terms, a provision is an amount set aside to cover a probable future liability or loss in a company’s financial statements. It acts as a buffer to prepare for anticipated future costs. Provisions can cover various scenarios such as lawsuits, product warranties, or debt repayments, among others.

Phonetic

The phonetic spelling of the word “Provision” is /prəˈvɪʒən/.

Key Takeaways

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  1. Provision predominantly refers to a necessary measure taken in advance to deal with potential future scenarios. This could be financial (setting aside funds for future expenses), material (stocking up on necessary items), or strategic (planning for different potential outcomes).
  2. In financial accounting, a provision is a liability or an amount set aside to cover a prospective obligation or expenditure, such as a bad debt provision. Accounting provisions are recognized on the balance sheet and will reduce a company’s equity.
  3. Provisions should be made realistically and thoughtfully, with accurate predictions based on data and analysis. Over- or under-provisioning can lead to imbalances and problems in the future – over-provisioning ties up resources unnecessarily, while under-provisioning may leave one unprepared for future needs.

“`In addition to the financial sense, ‘provision’ can also refer to the supply of food and other necessary items, particularly in a legal context or in relation to soldiers, or to God’s protective care in religious contexts.

Importance

In business/finance, the term provision is extremely important as it is a measure taken by businesses for potential future liabilities. Provisions are amounts set aside to cover foreseeable future expenses or losses, such as product warranties, loan defaults, litigation, or restructuring costs. They are essential in prudent financial planning as they ensure that companies are prepared for negative financial impacts that are likely to happen. This anticipatory behavior aids in maintaining financial stability and minimizing the potential risks that can damage the firm’s fiscal health, thereby contributing to better risk management and financial predictability. This ensures investors and stakeholders about the transparency of a company’s future obligations and its ability to meet those financial responsibilities. It forms a crucial part of the balance sheet, providing a more accurate picture of an entity’s financial position by accounting for future outflows.

Explanation

A provision in finance or business is a vital tool used for planning purposes. Its primary purpose is to signal some form of anticipated liability or potential future loss that a company expects to incur. Provisions may stem from a variety of situations such as bad debts, product warranties, lawsuits, restructuring charges, or taxes. They essentially provide an avenue for firms to set aside a certain amount of funds to cater to these impending expenditures. By incorporating provisions into financial planning, businesses can avoid the sting of sudden financial burdens, as they would have allocated adequate resources to handle these situations.The usage of provisions also helps to uphold the principle of conservatism in accounting, which promotes the anticipation of potential losses but not gains. Thus, it is a financial safety net that ensures transparency and foresight in a company’s financial reporting. Provisions also play a major part in accurate representation of a company’s financial health. Without provisions, unforeseen expenditures could distort the financial reality of the business. Hence, by making provisions, companies create a more realistic depiction of their financial status while preparing for potential losses.

Examples

1. Bad Debt Provision: This is one of the most common provisions seen in businesses, especially in the finance and retail sector. Businesses, when providing credits to their clients or customers, often face circumstances where the clients are unable to repay the debt. In these situations, the businesses create a provision for bad debts, anticipating the potential losses that may occur due to the non-paying clients. This amount is kept aside to cover the expected loss from bad debts in a certain period.2. Provision for Depreciation: All physical assets like machinery, equipment, or property that businesses own have a certain useful life, and over time, the value of these assets depreciates. Businesses create a provision for depreciation to systematically write-off the cost of those tangible assets over their useful lives. It helps to spread their cost and thereby matching it to the revenues those assets help in generating.3. Warranty Provision: Many companies, especially in the manufacturing sector, provide warranties on their products. During the warranty period, if the product malfunctions or needs repairs, the company is responsible for providing the service free of charge. A provision for warranties is estimated and set aside at the time of the sale to cover these potential future costs. This helps businesses maintain their financial stability and ensures that the costs of warranty repairs and replacements do not eat into their profits unexpectedly.

Frequently Asked Questions(FAQ)

What is a provision in finance?

A provision in finance refers to the amount set aside to cover a probable future liability or loss in the company’s financial books.

Why are provisions important in business?

Provisions are important as they exhibit a company’s prudence in dealing with its future liabilities. By recording these losses in the current accounting period, the company ensures it neither overstates its income nor understates its liabilities.

How is a provision different from a reserve?

A provision is an amount set aside to cover a specific liability, while a reserve is an amount withheld from profit to guard against any generic risk or future uncertainty that the company cannot quantify at present.

How does a provision affect the company’s balance sheet?

A provision always reduces the profit of the company and is shown as a liability on the balance sheet, therefore, it reduces both the company’s net profit as well as the shareholders’ equity.

Who decides the amount of provision set aside?

The amount of provision is usually decided by the company’s management based on their assessment of the possible future liability and supplemented by professional or legal advice.

How frequently is the provision amount reviewed?

The provision amount should be reviewed at the end of each accounting period and adjusted to reflect the current best estimate. If it is no longer required, it should be reversed.

Can a provision be used for an expected loss?

Yes, a provision can be used to cover an anticipated loss. If the company predicts future losses (for instance, from a lawsuit or an uncollectible debt), it can establish a provision to cover these losses.

Are provisions and contingent liabilities the same?

No, provisions and contingent liabilities are not the same. While both deal with potential future obligations, provisions are recognized as liabilities on the balance sheet once the company anticipates the loss. Conversely, a contingent liability is recorded only when the future event causing the loss becomes likely and the amount can be reasonably estimated.

Related Finance Terms

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