As a freelancer or small business owner, one of your main responsibilities will be planning (and sticking to!) a budget. But how do you budget for an upcoming expense if you aren’t entirely sure when it will occur, or how much it will cost? The answer: you would create a provision.
A provision in accounting is a liability without a fixed timing or amount. When you create a provision, you are setting aside a certain amount to cover anticipated future expenses, before knowing exactly how much it will cost, or exactly when it would occur.
According to the matching principle, revenue generated in a specific accounting period must be matched against the expenses occurred within the same period. By creating a provision, you are ensuring that the cost will be expensed and recognised in the correct accounting period.
When would I create a provision?
When planning a budget or reviewing your finances, you may find that you have financial obligations which will not be settled until a future accounting period, even though they are the result of activity from the current or past financial year.
For example, you hire a decorator to renovate your office. You signed a contract before the work begun but will not know for certain how much the work will cost until it has been completed in a few months time.
What are the different kinds of provision?
One of the most common types of provisions is a provision for bad debts. Also known as a provision for doubtful debts, this type of provision estimates the amount of bad debt based on past experience. ‘Bad debt’ refers to any payments, or accounts receivable, that are unlikely or impossible to collect. A bad debt provision therefore covers sales which may never be recovered.
Some of the other main types of provisions include:
- A provision for taxation
- A provision for depreciation
- A provision for repairs, upgrades or renewals.
How can I create a provision?
Bad debt is an unfortunately reality for many freelancers, sole traders, and small business owners. Although there are many ways to chase late payments from customers, sometimes bad debt just can’t be avoiding. But while you can’t always rely on your customers, you can rely on your accounting software.
With Debitoor accounting and invoicing software, you can process bad debt as an expense. You can also track depreciation of assets, and get an overview of your company cashflow.