What Is a Provision in Accounting?

Table of Contents

• Definition of Provisions
• Why Provisions Matter
• Legal vs Constructive Obligations
• Recognising and Measuring Provisions
• Example: Warranty Provision
• Contingent Liabilities and Assets
• In Practice

Definition of Provisions

In accounting, a provision is a type of liability. More specifically, it is a liability of uncertain timing or amount. Under IAS 37, a provision is recognised when there is a present obligation arising from a past event, settlement is probable, and the amount can be reliably estimated.

Why Provisions Matter

Before IAS 37, provisions were sometimes used to reduce profit in strong years and absorb costs in weaker years, creating artificial profit smoothing. IAS 37 limits this behaviour by linking provisions to genuine obligations rather than management discretion, improving transparency and comparability.

Legal vs Constructive Obligations

A legal obligation arises from a contract, law, or regulation. A constructive obligation arises from an entity’s actions, such as consistent past practice or public statements that create a valid expectation among stakeholders.

For example, an oil company may not be legally required to clean up every drilling site. However, if it has consistently done so and communicates that commitment publicly, stakeholders may reasonably expect the behaviour to continue. This expectation can create a constructive obligation.

Recognising and Measuring Provisions

A provision is recognised only when settlement is more likely than not, typically interpreted as a probability greater than 50%. Measurement then focuses on the best estimate of the expenditure required to settle the obligation at the reporting date.

When many similar items exist, an expected value approach may be used by weighting outcomes by probability. For single obligations, the most likely outcome is often used. If the time value of money is material, the provision should be discounted to present value and updated as assumptions change.

Example: Warranty Provision

Parker Co sells goods with a six-month warranty. Based on past experience, 75% of units have no defects, 20% require minor repairs costing $1 million in total, and 5% require major repairs costing $4 million in total.

This amount is recognised as a provision, increasing liabilities on the balance sheet and recording an expense in the income statement for the period.

Contingent Liabilities and Assets

Some obligations do not meet the recognition criteria because settlement is not probable or the amount cannot be measured reliably. These are described as contingent liabilities and are disclosed in the notes unless the likelihood of settlement is remote.

Contingent assets are treated more cautiously. They are disclosed only when an inflow of economic benefit becomes probable and are recognised only when that inflow becomes virtually certain.

In Practice

Provisions affect more than accounting presentation. They influence reported profit, key financial ratios, and how risk is perceived by investors and lenders. A rising warranty provision may signal quality issues, while environmental provisions often reflect regulatory or remediation risk.

For boards and senior decision-makers, the practical skill lies in understanding the assumptions behind the number: the nature of the obligation, probability judgements, estimation techniques, and whether discounting is appropriate. Provisions are where uncertainty and governance frequently intersect.