Valuation allowances and provisions: when to create them

Valuation allowances and provisions are among the tools that help the accounts give a true picture of reality. They take into account risks and future liabilities that have not yet materialised but can be realistically and demonstrably anticipated.

Why we create them

The purpose of valuation allowances and provisions is to apply the prudence principle. A company should not report higher assets or profit than actually exist when it is clear that their value is threatened by a risk or that a future expense is looming.

Thanks to them, the financial statements reflect reality better and do not mislead those who rely on them, that is, owners, banks and business partners.

What valuation allowances are

A valuation allowance reduces the value of an asset that has temporarily lost value. A typical example is an overdue receivable where there is a risk that the customer will not pay it.

If the risk later disappears, for example because the customer does pay after all, the valuation allowance is reversed. It is therefore a temporary adjustment of value, not a permanent write-off.

• doubtful overdue receivables
• impairment of inventory
• a temporary decline in the value of assets

What provisions are

A provision is a future liability that is probable, but whose exact amount or timing is not yet certain. It is created so that the cost is charged to the period to which it relates in substance, rather than to the later period in which it is actually paid.

• a provision for untaken annual leave
• a provision for warranty repairs
• a provision for pending lawsuits

The difference between them

A valuation allowance relates to a specific asset and reduces its value. A provision, on the other hand, relates to a liability, that is, a future expense of the company.

Both, however, are based on a realistic and demonstrable assumption, not on arbitrary judgement. They must not be used to reduce profit deliberately without justification.

What to watch out for

Always substantiate and document their creation so that it holds up in an audit. Also distinguish between the accounting and the tax treatment, because not every item created is automatically recognised for tax purposes.

Check the specific conditions for tax deductibility for the period in question, and in more complex cases consult an accountant.

Releasing and using a provision

A provision does not last forever. When the liability for which it was created actually arises, the provision is used to cover it. If the risk disappears or the provision proves unnecessary, it is released.

Similarly, a valuation allowance is adjusted as circumstances develop. If the debtor does pay the receivable after all, the valuation allowance is reversed, because the reason for its existence no longer applies. This principle ensures that the financial statements always reflect the current reality.

Why it matters

Correctly created valuation allowances and provisions give owners and creditors alike a truer picture of the company. Ignoring risks can make profit look better than it really is.

• a truer picture of assets and liabilities
• application of the prudence principle
• a better basis for owners’ decisions

Documentation and audit

You must be able to justify every valuation allowance and every provision. An audit examines whether creating it was justified and whether it corresponded to the actual risk or liability at the time.

That is why you should keep supporting documents for them, for example a list of overdue receivables or an estimate of future costs. Well-documented valuation allowances and provisions hold up in an audit and also give the company’s management a credible picture of its risks.

Related articles: Accruals and deferrals of costs and revenues simply explained, Cloud in accounting: benefits, risks and what to watch out for, Receivables and payables ledger: how to keep it efficiently.

Frequently asked questions

What is the difference between a valuation allowance and a provision?

A valuation allowance reduces the value of a specific asset, for example a doubtful receivable. A provision relates to a probable future liability where neither the exact amount nor the timing is certain. Both tools are based on the prudence principle.

Are valuation allowances and provisions always tax-deductible?

No. Some of them are tax-deductible only if statutory conditions are met; others are for accounting purposes only. That is why it is worth assessing them with an accountant and documenting their creation properly. Check the current conditions for the period in question.