What is the Treatment of Provision in Cash Flow Statement?

Managing cash and cash equivalent resources is crucial for companies to stay liquid. This liquidity also brings many benefits, such as quicker transactions, more flexibility, better opportunities, etc. Similarly, most investors prefer investments that can illustrate better cash management. These investors obtain information about how companies manage their operations through financial statements. For most companies, these include four critical reports.

Three financial statements use the accrual principle to report operations. While this method allows for better consistency and comparability, it can also have drawbacks. The primary disadvantage of using this principle is that it does not focus on cash flows. While it promotes better presentation and reporting, some investors may find it confusing. However, accounting standards address that issue through the cash flow statement.

The cash flow statement reports a company’s cash inflows and outflows for a specific period. In other words, it presents how much cash it spends and generates from various areas. The cash flow statement does not follow the accrual concept. It shows the cash aspects of each transaction without considering its accounting sides.

Nonetheless, some items may become a part of the cash flow statement that don’t involve cash receipts or payments. Also known as non-cash items, the cash flow statement adjusts them beforehand. One of these items may include provisions. Before discussing its cash flow adjustment, it is crucial to understand what these are.

What is a Provision?

Accounting principles require companies to recognize expenses once incurred. These principles do not consider when a company pays for those expenses. On the other hand, the same applies to revenues or income. However, the recognition criteria for those items are stricter. Companies can recognize expenses for future expected losses or costs. However, they cannot increase their revenues based on forecasts.

The conservatism or prudence concept in accounting allows companies to create provisions. Essentially, a provision is an expense recognized for future costs or liabilities. Companies recognize this expense to set funds aside from profits for this express purpose. This way, they can help liabilities and obligations in the future. On top of that, recognizing provisions also allow companies to match expenses with the related revenues.

Primarily, a provision refers to funds set aside from company profits for future costs. These costs may relate to obligations from past events. In accounting, provisions are crucial in allowing companies to report an accurate picture in their financial statements. However, accounting standards dictate when a company can record a provision. More specifically, IAS 37 Provisions, Contingent Liabilities and Contingent Assets guide companies on the area.

Companies create a provision account that holds the liability for the expected costs or losses. This account constitutes a liability for the company as it can result in outflows of economic benefits in the future. On top of that, it also generates from past obligations. Consequently, this account falls under liabilities in the balance sheet. On the other side, companies also record an expense for the same amount. This expense becomes a part of the income statement.

Overall, a provision is an amount recognized for future expenses or losses. Similarly, it represents the liabilities that companies record in the balance sheet for those expenses. This way, provisions impact the income statement and the balance sheet. While these items represent funds aside for future use, they may not include a cash flow initially. Therefore, the treatment of provision in the cash flow statement may be complex.

What is the treatment of Provision in Cash Flow Statement?

When companies expect the future expense to occur, they may create a provision. For example, warranties may warrant companies to estimate future costs and record them. Consequently, companies must increase their expenses in the income statement. In contrast, they must also increase their liabilities. This process does not involve any flows from cash and cash equivalent balances.

The first treatment of provisions in the cash flow statement is removing its non-cash impact. This process is critical when reporting cash flows under the indirect method of the cash flow statement. Usually, provisions are a part of the non-cash item adjustments made under this format. When companies bring net profits over from the income statement, they may include non-cash expenses. By adding them back, companies can remove the impact.

However, provisions do not constitute creating liabilities and expenses only. These expected costs may realize in the future. When it happens, companies may incur cash outflows. Therefore, they must include it in the cash flow statement to treat provisions. However, they must establish that the compensation occurred through cash and cash equivalent resources. For non-monetary reimbursements, the cash flow statement won’t need adjustments.

Therefore, the second treatment for provisions in the cash flow statement is reporting actual cash flows. Usually, these provisions cause companies to pay amounts to other parties. These amounts are in cash or occur through cash equivalent resources. Therefore, they constitute cash outflows. Companies must record these in the cash flow statement. This process occurs by calculating the increase or decrease in the liability in the balance sheet.

Both treatments for provisions occurs under cash flows from operating activities. The first appears after the net profits as a non-cash adjustment. In contrast, the second treatment is a part of the increase or decrease calculations. These calculations also include other current assets and liabilities. However, these calculations can cause inflows or outflows for provisions.

Example of Provision in Cash Flow Statement

The treatment of provision in the cash flow statement occurs through cash flows from operating activities. As mentioned above, the first part includes removing the expense from the net profits. Since these expenses are not cash items, including them in the cash flow statement is not applicable. Companies add the total amount from the income statement in this process.

The other treatment of provision in the cash flow statement also occurs through operating activities. However, it does not obtain figures from the income statement. Instead, it calculates the difference between the provision liability from the balance sheet. It gets those figures from the current year and the previous year’s values in that statement. When reporting this balance, it may either include an increase or decrease.

If the provision balance in the balance sheet has decreased, it will constitute a cash outflow. A reduction in this amount usually implies the company has paid to settle the provision. They must report it in the cash flow statement as outflows from operating activities. In some cases, companies may also reduce the balance through other compensations. Consequently, they must not include it in the cash flow statement.

If the provision balance in the balance sheet has increased, it will constitute a cash inflow. However, the increase in the balance occurs through an increase in expenses. Companies may have already adjusted for them in the income statement. In those cases, companies must not include them in operating activities.

Overall, an example of the treatment of provision in the cash flow statement is below.

Conclusion

A provision represents funds set aside for future expenses or losses. Companies recognize these items under the IAS 37 accounting standard. Although they represent funds, they do not constitute actual cash flows. There are two treatments of a provision in the cash flow statement. Both treatments are a part of the cash flows from operating activities.