Difference between accrual and provision.

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Accruals and Provisions are concepts in Financial Accounting that are used in different types of situations. Provisions are done for expenses that have not been occurred yet, while Accruals are funds kept aside to clear the unpaid dues. In this article, we will have a detailed look at how Accruals and Provisions are used in Accounting.

What is Accrual in Accounting?

The Accrual Principle is a concept in Accounting where the financial transactions are recorded during the same time period in which they occur, however the actual cash flow may occur at a later stage. For example, suppose a company supplies goods worth $50,000 in the first quarter of financial year, but the company receives the payment in the second quarter. In such a case, if we apply the Accrual Principle, then the company will record this financial transaction in its books in the first quarter itself.

The Accrual Principle is useful when it is important to match the revenues against the expenses when a financial transaction occurs, regardless of when the payment is received.

Why is it Necessary to Apply the Accrual Principle?

Most of the large companies do business on credit. They supply the goods and services in advance for which the payments are received over a period of time. Recording such transactions when the payment is actually received may project an inaccurate picture of the financial position.

As most of these large companies are listed entities, they have the obligation to declare their financial position every quarter, as accurately as possible. In every quarterly result, they record the revenue, the profit generated, the gross profit margin, their assets and liabilities, etc. Cash accounting is quite inefficient in measuring these factors and show how a business performed in a particular period. Cash Accounting has no provision to account for payments that will be received in future. Hence, such companies must adopt the Accrual Principle of Accounting.

When the companies need to measure their performance in a particular fiscal year or a quarter, they must record the expenses when the goods are purchased and revenues when the goods are supplied. Hence, they have to use the Accrual principle of accounting.

Limitations of the Accrual Principle

In case of a default, the Accrual Principle can get complicated. Let's take an example. Suppose ABC Corp. supplies goods to XYZ Corp on credit, for which the payments are to be received in the next 90 days. ABC Corp. records this transaction in its books. Unfortunately, XYZ Corp is not able to keep its obligation and defaults on the payment. In this situation, ABC Corp has amount receivable in its books which is not going to come. This is a significant accounting problem because it presents an incorrect financial picture of the company.

What is Provisioning in Accounting?

A Provision is the amount which kept aside to cover future expenses. It is a separate fund which is kept aside to cover certain expenses. Note that a provision is not a reserve. Examples of Provisioning include Guarantees, Deferred tax, Restructuring liabilities, Depreciation, Sales allowances, etc.

A provision can be recognised if it meets the following criteria −

  • An entity which has a current obligation due to past events.

  • It may be cash outflow to settle obligation.

The main objective of provisioning is to make the balance sheet more accurate in an accounting period or financial year. Accountants use provisioning to present correct financial statements, predict losses and liabilities, and meet known losses and liabilities.

Companies do tax provisions to meet their income tax requirements. Tax deductions include depreciation, allowances, interest expenses etc. After some calculations, the firm determines its amount to be allocated on its books in a provision known as tax provisions.

Difference between Accrual and Provision

The following table highlights the major differences between Accrual and Provision −

AccrualProvision
Records expenses incurred but payment yet to made.Records expense that have not yet been incurred.
Existence of liability is certain.Existence of a liability is not entirely certain.
Works on matching concept.Works on prudence concept.
Each revenue reporting should match equal expense in a period.Business should never anticipate profit, but should make all provision for any future loss that going to occur.
Made on basis of actual documentary evidence.Made on the basis of estimation/information from credible source/less substantial documentary on probably occurrence of loss.
Accrual amount is realized and certain.Provision amount is not certain.
Amount of accrual is a specific amount.Anticipated amount is an estimation one.
Quantified with accuracy.Not necessarily be accurately quantified.
May or may not increase income all the time.Results in decline profits.
Examples include prepaid expenses, insurance premium,etc.Examples include depreciation provision, provision for bad debt, etc.

Conclusion

A Provision is an amount that is set aside to cover a probable future expense. Note the word "probable" because these expenses have not been incurred yet. Accruals, on the other hand, refer to the recognition of expenses and revenue that have been incurred and not yet paid.

raja
Updated on 27-Jul-2022 10:17:55

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