Provision

A provision is how the accounts recognise a cost that has been incurred in substance before it has been settled in cash: restructuring programmes, warranty obligations, environmental clean up, litigation where a loss is probable.

Recognition requires a present obligation from a past event, a probable outflow, and a reliable estimate. Where an outflow is possible but not probable, the item is disclosed as a contingent liability and stays off the balance sheet entirely, which is why the notes matter as much as the face of the accounts.

Because the amount is an estimate, provisions are a classic tool for managing earnings. Over providing in a bad year creates a cushion that can be released into profit later, a pattern sometimes called big bath accounting. A sequence of provision releases boosting operating profit is worth investigating.

In a transaction, large or long dated provisions such as pensions, decommissioning and environmental liabilities are often treated as debt like items in the enterprise to equity bridge, because a buyer inherits a real future cash obligation.

The genuinely operating ones, warranty being the obvious case, are left inside working capital instead, since they are a recurring cost of trading rather than a financing item.