Provisions

A provision takes into account an expected liability. A company will create a provision in the current period when the likely liability becomes apparent, thus reducing the reported profit.

As an example, consider a company which sells on credit. At the year end it has debtors of £1,000,000 and, on past experience, expects to fail to recover about 5% of customer's debts. The company will create a provision (provision for doubtful debtors) by reducing this year's profits by £50,000 and reducing the amount of due debtors in the balance sheet by £50,000.

Suppose the company has £800,000 worth of debtors the next year. The amount it needs to provide is £40,000 (5% × £800,000). This will increase that year's profit by £100 (while the balance sheet item will reduce from £500 to £400).

One problem with provisions is that they can be used to smooth profits. A company can make make provisions than usual in a good year (reducing that year's profits) and reverse them in a bad year (boosting that year's profits). Accounting standards have been tightened in order to make this harder.