Definition of Provisions

A provision is an amount that is set aside or reserved from a company's profits to cover potential or certain future losses or liabilities. It is considered one of the most important concepts in financial accounting and banking management, playing a vital role in ensuring the financial stability of institutions and protecting the rights of shareholders and creditors.

Accounting Concept of Provisions

In the accounting system, provisions represent a practical application of the prudence principle, which is one of the fundamental accounting principles that requires recognizing potential losses before they actually occur. When a company expects a loss or future obligation, it creates a provision to face this loss, ensuring that reported profits are not overstated and reflecting the true financial position of the institution.

Provisions are recorded as expenses in the income statement, reducing the net profit for the accounting period, while simultaneously appearing as liabilities in the balance sheet or as a reduction in the value of the related asset. This treatment ensures compliance with the matching principle in accounting, where expenses are matched with revenues in the same accounting period.

Types of Provisions

Provisions vary according to their purpose and the nature of the institution's business activity. Understanding these different types is essential for applying correct accounting treatment and making sound financial decisions:

1. Provision for Doubtful Debts

This is one of the most common types of provisions in commercial companies, created to cover expected losses from customers' inability to pay their dues. This provision is usually calculated as a percentage of total accounts receivable or credit sales, based on the company's historical experience and credit risk analysis.

2. Depreciation Provision

This provision is created to distribute the cost of fixed assets over their estimated useful life periods. Its purpose is to match the revenues of each accounting period with the appropriate portion of asset costs used in generating those revenues, ensuring accurate measurement of profitability.

3. End-of-Service Benefits Provision

Companies create this provision to meet their obligations toward employees upon termination of their service. This provision is calculated based on employee salaries, years of service, and labor law provisions applicable in the country.

4. Tax Provision

Created to meet the company's estimated tax obligations, especially when there are disputes with tax authorities or when there is uncertainty about the exact amount of tax due.

Methods of Calculating Provisions

1. Percentage Method

This method relies on applying a fixed percentage to a certain base such as sales or accounts receivable. This percentage is usually determined based on the company's historical experience and prevailing industry standards. Despite the simplicity of this method, it may not reflect the actual risk situation in each accounting period.

2. Individual Analysis Method

In this method, each case is studied individually to estimate the required provision amount. This approach is more accurate but requires more time and effort, and is suitable for large amounts or complex cases. Banks usually use this method for large or non-performing loans.

3. Advanced Statistical Methods

With the development of technology and big data, financial institutions have begun using complex statistical models to calculate provisions. These models take into account multiple factors such as economic conditions, customer characteristics, and payment history to estimate default probability with greater accuracy.

Impact of Provisions on Financial Statements

Provisions directly affect all the company's basic financial statements. In the income statement, provisions created during the period appear as expenses that reduce net profit, affecting profitability indicators such as return on assets and return on equity.

In the balance sheet, provisions affect both assets and liabilities. Provisions such as depreciation and doubtful debts reduce asset values, while other provisions such as end-of-service benefits appear as liabilities. This impact extends to all financial ratios related to the balance sheet such as liquidity ratios and financial leverage.

Regarding the cash flow statement, provisions have a distinctive impact as they are non-cash expenses at the time of creation. Therefore, they are added back to net profit when calculating operating cash flows, while actual use of the provision affects cash flows.

Management and Control of Provisions

Managing provisions requires a delicate balance between prudence and caution on one hand and avoiding overestimation on the other. Overestimating provisions may lead to artificial reduction in profits, harming shareholders' rights and affecting the company's market value. On the other hand, inadequate provisions expose the company to financial risks and mislead investors about the true financial position.

To ensure accuracy of provisions, companies establish clear policies and procedures for creating and reviewing provisions regularly. These policies include estimation criteria, required approval levels, and periodic review mechanisms. International accounting standards also require detailed disclosures about provisions in financial statements and their notes.

This change aims to improve transparency and financial stability through early recognition of potential losses. The standard requires using forward-looking information and complex probabilistic models to estimate expected losses, making the provision calculation process more complex but more accurate.

Importance of Provisions in Decision Making

Provisions play a crucial role in financial and strategic decision-making for institutions. For management, provisions provide a realistic picture of the company's obligations and financial risks, helping in liquidity planning, risk management, and making investment and expansion decisions.

For investors and financial analysts, reviewing provision policies and their evolution over time provides deep insight into the quality of company management and the extent of its conservatism in financial estimates. Sudden changes in provisions may indicate problems in business activity or changes in operational risks.