Here's the best way to recognise and disclose provisions
If you never thought about raising a provision on the last day of your financial period, you could be understating liabilities and reflecting the incorrect position on your financial statements. This could lead to a false impression for future investors or lenders.
This because mose businesses forget their balance sheet isn't just a representation of the entire year, but a snapshot of the last day of the financial year. It offeres feedback of all your assets, equity and liabilities on the last day of the financial year-end.
Engaging in transactions on or before the last day of the year could result in transactions not being accounted for and result in incorrect disclosure of financial information.
If you don't treat yours correctly, you could end up misstating the figures of your business, which is fraudulent.
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Let's look at what a provision represents.
A provision is a liability of uncertain timing or amount, it's characterised by that payment date, timing, and amount are not certain.
Here is the example that will give you a better understanding of how provisions work:
Peter creates the two accounts called Plastic expense and Provision liability
These transactions will affect the income statement and balance sheet and therefore the relevant accounts will be selected, debit the income statement account and credit the balance sheet account. Peter needs to buy plastic, which will give rise to an expense but he won't pay the expense before the end of his financial year. This will result in a liability in his books at the end of the year.
Peter processes the relevant transaction by debiting the Plastic expense account on the 27th of February 2014 with the amount of R5 000. (Note: The accruals principle of accounting states you need to record transactions in period in which they occur, whether or not payment has been made. In the case above the invoice has been received before year end, so the transactions should be recorded in the stated period.)
Peter then credits the Provision liability account with the R5 000, which he debited in the plastic expense account. (It's important to rememnber that a liability always needs to have a credit balance. It means Peter still owes money to a supplier. If the liability account has a debit balance it would mean the supplier would owe Peter money, then it wouldn't be a liability anymore, it would be an asset.)
At year-end on 28 February 2014, Peter is obligated to pay an amount of R5 000 to his supplier Mighty Plastics because of a past event that occurred. The amount of the transaction is clear but because of the fact the timing of the payment isn't sure at the end of February, a provision needs to be recognised.
Example of a provision
Peter's WorkOut, a supplier of gym equipment, on 31 January 2015 supplied weight lifting equipment worth R100 000 to Fit Body Gym. After using the equipment for less than a month, Fit Body received complaints from its staff and members the weight lifting equipment was faulty and one of its staff members has been badly injured because of this.
Fit Body Gym returned the equipment to Peter's and Peter's refused to accept the equipment. Fit Body Gym has filed a lawsuit against Peter's and is suing them for R75 000. At year end, 30 June 2014, the matter hasn't been resolved, still pending judgement. Peter's legal advisors are of the opinion they'll lose the case citing the fact they didn't perform quality checks on the equipment and will probably be found guilty of negligence and probably be liable to pay the full amount of R75 000 to Fit Body.
Factors to consider when accounting for a provision
1. Present obligation – Liable to pay damages to Fit Body for supplying faulty equipment.
2. Past event – Sale of equipment by Peter's Workout to Fit Body.
3. Probable outflow of resources embodying economic benefits – Payment of damages.
4. Reliable estimate of the obligation – Probable pay the full amount of R75 000.
Peter's Workout will recognise a provision in its Annual Financial Statements for the year ended 30 June 2014. DR Expenses – Damages (Income statement) R75 000
CR Provision – Fit Body (Statement of financial position) R75 000
Peter's Workout will also have to disclose the following information in the notes to the financial statements:
• The carrying amount at the beginning and end of the period;
• A brief description of the nature of the obligation and the expected timing of any resulting outflows of economic benefits;
• An indication of the uncertainties about the amount or timing of those outflows. Where necessary to provide adequate information of the amount required to settle an obligation; and
• An entity shall disclose the major assumptions made concerning future events.