Every business has expenses – all types of expenses occurring for different purposes and at different stages of the business. Correct accounting for expenses is important to ensure that the financial statements reflect the true and fair position of a company’s financial position.
This article looks at meaning of and differences between two types of accounting for expenses – accruals and provisions.
Definitions and meanings
Accrual
An accrual means accounting for a liability that is certain and due but yet to be actually paid. Accrual essentially means accounting for an expense that has been incurred but has yet to be settled by a business.
Example –M/s XYZ has purchased raw material for his factory for M/s ABC on 1 January 2020. The raw materials have been received by the factory against which M/s ABC has raised a bill for USD 1,000 on M/s XYZ. M/s XYZ has a credit period of 30 days to make payment for the raw materials purchased.
The accounting entry in the books will be:
Purchases a/c….1,000 [Dr]
M/s ABC (creditor) 1,000 [Cr]
(Being accrual entry accounted for purchase of raw material)
M/s XYZ will make an accrual entry in his books, accounting for the purchase on 1 January 2020 itself even though he has 30 days to make payment as the liability for payment has been incurred on 1 January itself.
Accrual entries are generally accounted for in the books of accounts on the basis of a specific document – this can be a bill from the vendor indicating services/goods provided or can be an agreement documenting amounts payable on completion of certain time periods or other milestones.
Accrual entries are made only in mercantile system of accounting.
Provision
A provision means accounting for a liability or a loss that is uncertain but possible or probable. There may be several circumstances which can result in an additional expense or a loss for the business. These circumstances may not be predictable with certainty but owing to the possibility of a loss occurring, a provision is created in the books in line with the accounting principle of prudence.
Example – M/s XYZ has a long outstanding debtor – M/s ABC that stands in the books. There is considerable speculation in the market that the business of M/s ABC has crashed and thus they may be unable to pay his dues. Till the time it can be said with certainty that the dues will be defaulted on, a provision can be made in the books of M/s XYZ for the probable loss.
The accounting entry in the books will be:
Provision for doubtful debts [Dr] (debited to P&L a/c)
Provision against debtor’s [Cr] (liability created in balance sheet)
(Being provision for doubtful debts against outstanding dues of M/s ABC created in the books)
Since provisions are made on a probable basis that an incident may or may not occur, they may not be able to quantified with certainty. Therefore, they are often accounted for on the basis of some reliable estimate.
Difference between accrual and provision:
The difference between accrual and provision has been detailed below:
1. Meaning
- Accruals involve recording of expenses that have been incurred but payment for which is yet to be made by the transacting entity.
- Provision involves recording of expenses or losses that have not yet been incurred but they may be incurred on the occurrence or non-occurrence of certain events.
2. Certainty of liability
- Existence of a liability is certain in the case of accruals. It is only that the actual settlement is pending and thus the same are accrued in the books.
- Existence of liability in the case of provisions is not entirely certain but is probable and is depending on the occurrence or non-occurrence of certain events.
3. Quantification accuracy
- Accruals can generally be quantified with accuracy as the expenses have actually been incurred.
- Provisions may not necessarily be accurately quantifiable in the absence of complete information and are thus often based on estimation.
4. Principle of accounting
- Accruals are accounted for as per the ‘matching’ concept principle of accounting – in which expenses must be accounted for and matched with the incomes and the period to which they pertain.
- Provisions are accounted for as per the ‘prudence’ concept of accounting –in which incomes should not be overestimated and expenses should not be underestimated.
5. Basis of accounting
- Accruals are generally made on the basis of actual documentary evidence such as bills, invoices, agreements etc.
- Provisions are generally made on the basis of less substantial documentary evidence but on the basis of estimates or on the basis of information from relatively credible sources on the probable occurrence of a loss.
6. Followed by
- Accrual entries are typically followed by payment entries.
- Provision entries may either be followed by actual accrual entries when the liability becomes certain or by reversal entries if the liability does not actually crystallize.
7. Examples
- Accruals include accounting for several expenses such as purchase of materials, payment of utility expenses such as rent, electricity, professional fees etc.
- Provisions include accounting for probable losses such as provision for doubtful debts, provision for impairment of assets etc.
Conclusion – accrual vs provision:
While there are several points of differences between accruals and provisions, both are accounted for only in mercantile system of accounting and not in cash basis of accounting. Accruals are made almost daily to account for various expenses incurred by a business whereas provisions are only made when certain special circumstances indicate the probability of a loss occurring.
