Provisions: The Basics Explained Simply

Provisions: The Basics Explained Simply

Business owners deal with various liabilities in their day-to-day operations. It is quite normal that the exact amount and timing of not all liabilities are clear. To be as well-prepared as possible for these uncertain liabilities, provisions are set aside in advance. Learn in this article what business owners need to know about provisions. Expert advice from a tax advisor:

What are provisions?

Provisions are uncertain liabilities. They are uncertain because the amount, timing, or very existence of the liability is not certain. A provision is set aside as a preventive measure to protect against impending costs.

Provisions may only be established if the reason for the liability lies in the past fiscal year. As a business owner, you may only establish a provision if you already have verifiable grounds for doing so. So, if there is only a vague risk that liabilities will arise, you may not simply create provisions.

Provisions are often confused with reserves. However, reserves are not liabilities (debt) but financial reserves (equity). Put simply, provisions “already belong” to the person to whom you will owe money in the future. Reserves are intended for your own financial security.

Types of Provisions

The German Commercial Code (HGB) precisely regulates for which liabilities provisions may be created. These rules can be found in Section 249(1) HGB. Your company must create provisions for the following liabilities:

1. Liability provisions

Liability provisions arise when your company has a legal obligation to a contractual partner. Possible liability provisions include:

• Provisions for litigation costs for ongoing court proceedings
• Provisions for anticipated losses from pending transactions
• Pension provisions
• Tax provisions

2. Expense provisions

Provisions for expenses arise independently of contractual partners. They are established based on a voluntary commitment. Possible provisions for expenses include:

Provisions on the balance sheet

Provisions are liabilities and therefore no longer form part of the company’s assets. Consequently, they must be recorded on the liability side. In the balance sheet, provisions are clearly distinguished from certain liabilities as contingent liabilities. Both are classified as debt capital.

When established, the expense account is debited. The provision account is credited accordingly.

According to Section 266(3) of the German Commercial Code (HGB), provisions are classified into three categories:

1. Provisions for pensions and similar obligations

2. Tax provisions

3. Other provisions

Reversing provisions

Provisions may only be reversed if the reason for the provision no longer applies or the amount of the liability has been determined. Four possible scenarios may occur:

Option 1: The actual liability is lower than expected, and the provision was consequently overstated. This results in a surplus balance. This is recorded as operating income and increases profit.

Option 2: The actual liability is higher than expected. The provision was underestimated. The company must cover the remaining amount. This is treated as an operating expense. A loss results.

Option 3: The provision and the actual liability are identical. The reversal is neutral, with no additional income or loss.

Option 4: The reason for the provision no longer applies. Therefore, no expense is recognized. The entire provision amount is recognized as operating income.

Practical Tip

As your tax advisor in Düsseldorf and Oberhausen, we advise business owners on various tax matters. The topic of provisions also frequently causes problems and raises questions for companies. Provisions may seem simple at first glance, but they should not be treated lightly. In-depth consultation with a tax advisor is therefore always recommended. Our team of tax advisors specializes in various industries and would be happy to advise your company based on your specific circumstances. Please feel free to contact us.