What it means
The purpose of a provision is to stop a business from looking more profitable than it really is. If you sell products in December carrying a two-year warranty, some of those products will fail, and the cost of fixing them genuinely belongs against December's sales rather than against a future year's.
Accounting standards allow a provision only when three conditions are met: there is a present obligation arising from a past event, an outflow of money is probable, and a reliable estimate can be made. If an outflow is merely possible rather than probable, the item is a contingent liability, disclosed in the notes but not recorded on the balance sheet.
Mechanically, creating a provision is one entry with two effects: an expense in the profit and loss account and a liability on the balance sheet. When the real cost lands, it is charged against the provision rather than against profit again, and any unused balance is released back to profit.
Provisions attract attention from auditors and analysts because they involve judgement, and judgement can be stretched. A management team having a bad year has an incentive to over-provide, creating what is sometimes called a cookie jar reserve that can be released to flatter a later year.
The word also carries an unrelated meaning in banking, where a loan loss provision is the amount a lender sets aside for borrowers expected to default. The principle is the same: recognise the likely cost when the risk is taken on, not when the borrower finally stops paying.
In practice
Real-world examples.
Example
A furniture retailer offering free returns within 60 days provisions for expected refunds at each year end, based on the proportion of recent sales that historically come back, so December's revenue is not overstated by goods that will be returned in January.
Example
A regional bank reviews its loan book and raises loan loss provisions by $4,000,000 after unemployment rises in its main market. Profit falls immediately even though no borrower has yet missed a payment.
Example
A manufacturer announcing the closure of a plant provisions for redundancy payments and site clean-up costs in the year the decision is announced and communicated, rather than spreading the pain across the two years it will take to complete the closure.
Think of it
“A provision is like setting aside money for car repairs. You know something will probably break eventually, so you put money aside now.
Formula
Calculation
Provision = Number of units at risk x Probability of the cost occurring x Estimated cost per occurrence
An appliance manufacturer sells 40,000 units during the year, each carrying a 12-month warranty. Based on several years of history, about 3% of units come back for repair, and the average repair costs $85 in parts and labour.
Expected claims = 40,000 x 3% = 1,200 units. Provision = 1,200 x $85 = $102,000.
The year-end entry is a warranty expense of $102,000 in the profit and loss account and a warranty provision of $102,000 as a liability, so the cost is matched to the year the sales were made.
During the following year, 950 units are actually returned at an average repair cost of $90, giving real spend of 950 x $90 = $85,500. That $85,500 is charged against the provision rather than against the new year's profit. The provision has $102,000 - $85,500 = $16,500 left, which is released back to profit as a credit once the warranty period has closed.Case study
Seen in the real world.
Kettleford Appliances is an illustrative, fictional manufacturer that had never recorded a warranty provision, simply expensing repairs as they happened. In a fast-growing year this made the numbers look excellent, because sales were rising quickly while the repair costs from those sales had not yet arrived.
When growth flattened, the pattern reversed painfully. Repairs from two years of heavy selling all landed in one quieter year, and the finance director had to explain a 30% fall in operating profit that had nothing to do with that year's trading.
The company adopted a straightforward provision based on its own claims history, roughly 3% of units at an average of $85 each. In this fictional example the reported profit became less flattering in the growth years and far less alarming afterwards, which is exactly what provisioning is meant to achieve.
Watch out
Common mistakes.
- Confusing a provision with a cash reserve. A provision is an accounting liability, not a ring-fenced bank account, so a company can carry a $102,000 provision and still have no cash set aside to meet it.
- Provisioning for costs the business has not yet committed to. Future operating losses and planned but unannounced restructuring do not qualify, because there is no present obligation from a past event.
- Leaving stale provisions on the balance sheet. If the obligation has passed or the estimate was too high, the unused balance must be released to profit rather than quietly carried forward.
Questions
People also ask.
What is the difference between a provision and an accrual?
An accrual is for a cost that is certain in amount and timing but not yet invoiced, while a provision covers a cost where the amount or timing is genuinely uncertain.
Does creating a provision reduce cash?
Not at the time it is created, because the cash only moves when the actual claim, settlement or redundancy payment is made, but it does reduce reported profit straight away.
Can a provision be reversed?
Yes, and it should be if the expected cost no longer applies or turns out lower than estimated, with the surplus credited back to the profit and loss account.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%