Accruals and provisions made simple

When balancing the books, provisions should be treated as a liability on your balance sheet. Creating provisions ensures your company has enough money to pay future liabilities (e.g. payment of pensions, legal fees, transferals of property, etc.). The company is usually aware of these expenses in advance, but the exact level and cost might not be known until they are calculated later. In other words, provisions are simply financial reserves that a company makes in order to meet future payments and other liabilities.

All liabilities to third parties or imminent losses from ‘pending transactions’ must be included in the balance sheet in the financial statements. Provisions must be reversed on the balance sheet when the liability no longer exists. Find out more about how to record and cancel accruals and provisions here.

At the end of the financial year, companies must calculate their total turnover by means of double-entry accounting and communicate the result to HM Revenue and Customs. In addition to your annual tax declaration, the authorities also require you to report your company’s income and expenses within the annual accounts. The rate of income tax you pay is then decided according to the size of the profit margin.

Provisions are also part of the balance sheet, or more specifically, they represent an impairment of equity, meaning they reduce the company’s profit. This is enormously important for your tax balance; if your profit decreases, you will end up paying less tax. Creating and dissolving provisions is therefore logical, even if it is time consuming; without this, you would have to pay more tax at the end of the financial year.

We’ll use pension payments as an example to illustrate the economic benefits of provisions. If you employ staff in your company, the tax office requires a transfer of the resulting income tax and the employee’s share of the pension insurance. The tax burden is then carried by the employee, rather than the company. As the employer, all you have to do is deduct the salary tax rate directly from employees’ salary and pay it to the tax office.

Creating provisions thus helps employers retain a more precise overview equity and profit, as well as contractual obligations that will arise in the future, which will be paid to third parties. 

There are two basic types of accruals:

• Accruals that have occurred due to an obligation to a third party (i.e. accrued liabilities, imminent losses)
• Accruals based on an economic obligation to oneself with no specific obligation towards a third party (expense accruals)

While accrued liabilities are fully subject to the payment obligations, companies may only charge expenses for specific items, such as maintenance costs or removal of waste. You may not, however, make provisions for expenses that are not tax deductible.

Unlike bad debt provisions, expense accruals are treated as a voluntary commitment. This special type of accrual includes maintenance, salaries, and interest payable.

Deferred maintenance

When it comes to maintenance the following rule applies: if repairs or maintenance measures are to be postponed, the loss of use incurred must be attributed to the period in which it was established. If, for example, a warehouse renovation has been postponed until the following year, you can add the provisions in the balance sheet for the current calendar year. Exercise caution here: Maintenance works must be carried out within the period stated on the balance sheet.

Removal of overburden

An example of deferred maintenance in practice is the removal of overburden. In mining, there is a rule: if you need to reduce individual layers of rock (known as overburden), they must be re-filled into that surface. For this to take place at a later time (i.e. after the balance sheet date), the law requires provisions.