Meanings of Provisions

Meanings of Provisions

Provisions are made for expenses that are known at the time of posting according to the reason for which they arise, but not their amount or their due date. The purpose of a provision is to post expenses in the accounting period in which they are caused, even though the actual payment is made later.

The term “provisions” – definition

If you are not sure what the amount of a liability is, you need to record such dubious liabilities as a provision in the annual financial statements . Provisions are fictitious liabilities (contingent liabilities), the formation of which is associated with a fictitious expense.

When creating provisions, you must observe the principle of commercial prudence (Section 252, Paragraph 1, Item 4 of the German Commercial Code). According to German commercial law, companies are obliged to report liabilities with their settlement amount (Section 253 (1) sentence 2 HGB) – i.e. the amount that you have to spend to settle a liability.

Uncertain commitment

According to polyhobbies.com, the prerequisite for the creation of a provision is that your company has an uncertain obligation to a third party. The necessary uncertainty can relate to the amount, origin or existence of the liability. In the case of liabilities that are subject to suspensive or dissolving conditions, the uncertainty that the condition will occur leads to the formation of a provision.

An uncertainty regarding the due date of a liability is irrelevant according to the principles of the HGB. However, if your company prepares its annual financial statements in accordance with the accounting regulations of the International Accounting Standard (IAS), a provision is mandatory even if there is uncertainty about the due date.

The booking of a provision requires that

  • the dubious liability arose before the balance sheet date .
  • you estimate the compliance effort as realistically as possible.

Accrual based on periods

By means of a provision, you can delimit a transaction that has an effect on profit or loss.

  • The creation of a provision leads to an expense posting that is immediately recognized in profit or loss. The company’s profit is reduced by the amount of the accrued provision (or an already existing loss increases).
  • However, the reduction in profit or increase in loss will only be realized in a future balance sheet period as soon as the liability becomes due.

The difference between provisions and reserves

Provisions and reserves are shown equally on the liabilities side of the balance sheet, but have completely different functions. A provision is part of borrowed capital , as it is set up for a specific purpose with regard to future liabilities. Reserves, on the other hand, belong to the equity of a company (case groups: retained earnings and capital reserves).

Provisions – from formation to dissolution

Basic requirements for the creation of provisions

Provisions may only be set up if

  • there is a liability that exists according to the legal basis (a mere business risk is not sufficient).
  • the liability arose in the year in which the provision was created.

In addition, the company making provisions is obliged to estimate the amount of the provision to the best of its ability.

Passivation obligation and ban on passivation

Section 249 (1) of the German Commercial Code (HGB) names certain expenses for which you have to set up a provision (obligation to passivate). This includes

  • uncertain liabilities
  • impending losses from pending transactions
  • neglected expenses for maintenance
  • omitted expenses for overburden removal
  • Warranties without legal obligation

You have to pay interest on provisions that are more than one year old (Section 253 (2) HGB).

You may not set up any provisions for purposes other than those listed in Section 249 (1) HGB (ban on passivation, Section 249 (2) sentence 1 HGB).

Provisions for accounting according to IAS and HGB

In the case of accounting in accordance with the German Commercial Code (HGB), you may have to set up provisions (due to the principle of prudence in German commercial law, Section 252 (1) No. 4 HGB) if the probability that a cost risk will materialize is less than 50 percent.

A claim is deemed to be “likely” if, based on the objective situation on the balance sheet date and the circumstances known or discernible up until the balance sheet was drawn up, a claim from an obligation can be seriously expected. When assessing the likelihood of a claim, you must not assume the most pessimistic development possibility. “Probability” assumes that a larger number of reasons speak in favor of instead of against the claim.

If, on the other hand, you use the International Accounting Standards (IAS), the probability of the cost event occurring must be over 50 percent (“more likely than not”) in order to justify the creation of a provision.

Posting rate when creating provisions

Posting record: expense account for provisions

(Examples: Expenses for operating materials in provisions for potential losses, tax expenses in tax provisions)

Release provisions

The reversal of accruals is only permissible under commercial law if the reason for their creation no longer applies (Section 249 (2) sentence 2 HGB). Please note the tax law requirement to release provisions if the reason for their formation no longer applies.

Posting rate when reversing provisions

“Drawdown” or “use” of a provision means that the provision is used to settle a liability. In this case, you resolve the restitution and ask the liability with a ( passive exchange ).

Posting record : provision to payables stock account

Hidden reserves contained in the balance sheet item lead to “other operating income” when provisions are released (Section 275 Paragraph 2 Number 4 HGB).

Posting rate for the release of hidden reserves: Provision for other operating income

If, on the other hand, it turns out, when a risk is realized, that provisions have been set up in too low an amount, “other operating expenses” are also posted (Section 275 (2) No. 8 HGB).

Posting rate: Other operating expenses for provisions

Provisions to liabilities stock account

Closing the provision accounts

The individual provision accounts are closed via SBK (closing balance account): Example: process costs provision to the closing balance account

Provision