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Accrued Expenses vs. Provisions: An Overview
In accounting, accrued expenses and provisions are separated by their respective degrees of certainty. All accrued expenses have already been incurred but are not yet paid. By contrast, provisions are allocated toward probable, but not certain, future obligations. They act like a rainy-day fund, based on educated guesses about future expenses.
It’s very difficult to draw clear lines between accrued liabilities, provisions, and contingent liabilities. In many respects, the characterization of an expense obligation as either accrual or provision can depend on the company’s interpretations.
Key Takeaways
- In accounting, accrued expenses and provisions are separated by their respective degrees of certainty.
- An accrued expense is one that is known to be due in the future with certainty. The expense has already occurred but not yet been paid.
- Companies elect to make provisions for future obligations whose specific amount or date is unknown.
- Banks account for unpaid loans by making loan loss provisions.
Accrued Expenses
All accruals are divided into either expenses or revenues. An accrued expense is one that is known to be due in the future with certainty. In a publicly listed corporation’s financial statement, there is an accrued expense for the interest that is paid to shareholders each quarter.
When companies buy and sell from each other, they frequently do so on credit. A credit transaction occurs when an entity purchases merchandise or services from another but does not pay immediately. The unpaid expenses incurred by a company for which no invoice has been received from its suppliers or vendors are referred to as accrued expenses. Other forms of accrued expenses include interest payments on loans, services received, wages and salaries incurred, and taxes incurred, all for which invoices have not been received and payments have not yet been made.
Interest payable on the owner’s equity is a known figure. It can be estimated well ahead of time, and money can be set aside for it in a very specific fashion. The accrued expense is listed in the ledger until payment is actually distributed to the shareholders.
Provisions
Provisions provide protection and specify deadlines for actions. Provisions can be found in the laws of a country, in loan documents, and in investment-grade bonds and stocks. For example, the anti-greenmail provision contained within some companies’ charters protects shareholders from the board passing stock buybacks. Although most shareholders favor stock buybacks, some buybacks allow board members to sell their stock to the company at inflated premiums.
Provisions are far less certain than accruals. Companies elect to make them for future obligations whose specific amount or date of incurrence is unknown. The provisions basically act like a hedge against possible losses that would impact business operations.
There are general guidelines that should be met before a provision can be justified in the financial statement. The entity must have an obligation at the reporting date; that is, the present obligation must exist. The amount of the obligation needs to be reliably estimated. Most importantly, the event must be near-certain, or at least highly probable.
Special Considerations
Provisions for banks work a little differently than they do for corporations. Banks make loans to borrowers, which come with a risk that the loan will not be paid back. To protect against this, banks make loan loss provisions. Loan loss provisions work similarly to the provisions that corporations make, in that banks set aside a loan loss provision as an expense. Loan loss provisions cover loans that have not been paid back or when monthly loan payments have not been met.