What you should know about provisions

As an accountant, it is important to understand all aspects of financial management. One of the most important tasks is the creation of accruals. In this article we explain what accruals are, why they are necessary, what to look out for and how to calculate them. We will also show you examples of how you can use accruals wisely.

What are provisions?

Provisions are balance sheet liabilities that are set aside for future obligations. This means that companies set aside money to cover possible expenses that may arise in the future. Accruals are reported on the liabilities side of the balance sheet and reduce equity. Examples of accruals are vacation and Christmas bonuses, warranty accruals, accruals for litigation and accruals for environmental damage.

Why do you need accruals?

Accruals are important to cover future obligations. For example, if a company has employees who receive vacation and Christmas bonuses, these amounts must be set aside to ensure that the company is able to meet these expenses. Accruals therefore serve to ensure long-term financial stability and continuity.

What should be considered when setting aside accruals?

There are some important factors to consider when setting aside provisions:

• Legal requirements: It is important to comply with legal requirements to avoid violations and penalties.
• Estimates: The creation of accruals is based on estimates. Therefore, it is important to be conservative in the estimation process and make realistic assumptions.
• Regular review: Provisions should be reviewed regularly to ensure they are still appropriate.

What can go wrong?

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There are a number of problems that can arise when setting up accruals:

• Overstatement: if accruals are set too high, this results in an excessive liability that reduces equity.
• Understatement: If accruals are understated, this can lead to financial difficulties when unexpected expenses are incurred.
• Non-compliance with legal requirements: If provisions are not set up in accordance with legal requirements, this can lead to high penalties.

How are provisions calculated?

The calculation of provisions is based on estimates and assumptions. There are various methods for calculating provisions, such as the annual average method or the accrual method.

The annual average method is one of the most common methods for calculating provisions. It involves estimating the expected expense for the coming year and comparing it to the actual expense for the previous year. The difference between the two values gives the amount of the provision. This method has the advantage that it is relatively simple and quick to perform and is a good approximation of the actual requirement.

The accrual method, on the other hand, is based on the timing of expenses and income. Under this method, costs incurred in a fiscal year are allocated to the fiscal years in which they were incurred. This method also allows accruals to be recognized for obligations that have not yet been settled in the current fiscal year but have already been incurred. However, this method requires a precise knowledge of the operating processes and careful documentation of the costs and obligations.‍

How are provisions calculated?

The calculation of provisions can be carried out differently depending on the type of provision. In general, however, the following steps must be carried out: Identification of the obligation: first, it must be determined for which obligation a provision is to be recognized. To do this, it is important to accurately document the business transactions that led to the obligation.

• Estimating the obligation: Once you have identified the obligation, you must estimate how high the associated costs are likely to be. It is important to consider all factors that may impact the obligation, such as litigation, warranty claims, or accruals for vacation and overtime.
• Determining the amount of the accrual: Once the obligation has been estimated, the amount to be included in the accrual must be determined. Care must be taken to ensure that the amount is reasonable, realistic and reflects the actual costs expected to be incurred.
• Updating the provision: Once the amount of the provision has been determined, the provision must be reviewed regularly and adjusted if necessary. This is important to ensure that the provision amount is always in line with current estimates and that the provision is correctly reported on the balance sheet.

Examples of provisions

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The following are some examples of provisions:

• Provisions for warranty obligations: When a company sells products or services that are subject to warranties, it must record a provision for the expected costs associated with fulfilling those warranties.
• Provisions for litigation: If a company is involved in litigation, it must establish a provision for the expected costs associated with that litigation.
• Vacation and overtime accruals: If a company provides vacation and overtime benefits to its employees, it must establish an accrual for the expected costs associated with those benefits.

Conclusion

Accruals are an important part of accounting and can have a significant impact on a company's financial position. Therefore, it is important that accountants thoroughly understand the rules and procedures for establishing accruals and, if necessary, seek professional assistance to ensure that they are doing so correctly. By carefully calculating and monitoring provisions, accountants can help ensure the company's financial stability and long-term success.

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