Release of a provision

What it means

Releasing a provision means cancelling all or part of a provision when the reason for it disappears or the cost is actually incurred. The provision is used against the actual cost and any unused balance is released to income.

There is a difference between using a provision, when it is consumed by the cost it was made for, such as paying the audit invoice, and releasing an unneeded provision, when it turns out the cost will not arise, such as after winning a lawsuit. The two are booked differently and affect profit differently.

Provisions must be reviewed at every annual closing. If the estimate has changed, the provision is adjusted: increased by an additional charge or reduced by a partial release. The aim is for the accounts to give a fair picture of expected obligations.

How it works in practice

With a provision for closing and audit costs, the provision is used when the accountant's or auditor's invoice arrives and any difference is booked. A bonus provision is used when bonuses are paid, and if less is paid, the remainder is released.

With a litigation provision, once the dispute ends the provision is used for the payment or, if the case is won, released in full to income. A release increases profit in the year it occurs, so it is explained in the notes to the financial statements.

For tax, it matters whether creating the provision was deductible. If it was not and was added back to the tax base, its release is deducted from the base to avoid double taxation. For deductible provisions, a release is taxable income.

What to watch out for

Keeping provisions that are no longer justified distorts profit and can be used to shift profit artificially between years. Auditors and tax authorities pay attention to old provisions that have not moved.

Mishandling releases in the tax return is a common mistake. Without a record of which provisions were tax-deductible and which were not, a company may pay tax twice or, conversely, reduce its tax base without entitlement.