Provision

What it means

A provision is a liability of uncertain timing or amount that is nonetheless likely to arise: untaken holiday, litigation, warranty repairs, severance for a planned redundancy.

It differs from an estimated accrual in the degree of uncertainty: there the performance has happened and only the document is missing, here the performance is still expected. It differs from accruals and deferrals in that neither amount nor date is precisely known.

A provision is neither the reserve fund nor an impairment allowance. The reserve fund is part of equity set aside from profit, an allowance reduces the value of an asset such as a doubtful receivable, while a provision is external funding: an estimated liability shown among liabilities.

How it works in practice

It is created at the annual closing on a qualified estimate with a documented calculation: payroll data for holiday, counsel’s view on a dispute, warranty claim statistics. An unused provision is released to income.

Only provisions listed in the Income Tax Act are tax-deductible; the rest are non-deductible and added back in the return. In the books, though, they must be recognised where the conditions are met, whatever the tax treatment.

In a small s. r. o. the provisions most often calculated at closing are for untaken holiday including contributions, and for preparing the accounts and filing the tax return. We keep a calculation for each and compare it with the actual figure the next year, so the new estimate rests on real numbers.

What to watch out for

Failing to create provisions overstates profit and is one of the commonest audit observations. The opposite extreme is creating them to manage the result - both inspectors and auditors recognise that by the missing calculation.

A provision left untouched for years turns into hidden profit. The lawsuit ends in a settlement, but the provision stays on the books, results are understated for years, and on release it all shows up in a single year, often just at the due diligence before the company is sold.