Tax provisions in the accounts

What are provisions in accounting terms?

Provisions in accounting terms are liabilities of uncertain timing or amount, created in connection with anticipated costs or losses. They are sometimes referred to as ‘tax provisions’, because from a tax law perspective, their creation does not usually have an immediate impact on the tax base (they constitute a balance sheet cost, but not a tax cost). This does not refer exclusively to deferred tax provisions (although a deferred tax provision is one type of provision created). The term ‘tax provisions’ generally refers to all provisions created in accordance with the Accounting Act, which are treated differently from ordinary operating costs for tax purposes.

According to the legal definition (Article 3(1)(21) of the Accounting Act), provisions are liabilities whose timing or amount is uncertain. A provision is therefore recognised when an entity has a present obligation (legal or constructive) arising from past events, and the settlement of that obligation in the future is likely to require an outflow of resources. Typical examples of such future obligations include:

• expected payments under guarantees and warranties,
• claims arising from ongoing legal disputes,
• costs of planned restructuring,
• future retirement severance payments.

A common feature is the high degree of probability that such a cost will arise and the possibility of reliably estimating it.

Obligation to create provisions – provisions of the Accounting Act

The Accounting Act imposes an obligation on entities to create provisions for future liabilities in strictly defined cases. Article 35d(1) of the Accounting Act stipulates that provisions shall be created for:

• certain or highly probable future liabilities, the amount of which can be reliably estimated, and in particular for losses arising from ongoing business transactions, including those arising from guarantees, sureties, credit operations and the effects of pending legal proceedings;
• future liabilities arising from restructuring, if the entity is required to carry out such restructuring under separate regulations or binding agreements have been concluded in this regard, and the restructuring plans allow the value of these future liabilities to be reliably estimated.

The creation of provisions is mandatory whenever, as at the balance sheet date, there is a present obligation that has not yet been fulfilled but is probable, and which will be borne by the entity in the future, provided that an approximate value can be attributed to it. The principle of prudent valuation requires that such a provision be recognised as an expense in the current period – otherwise, the financial result would be overstated. An entity should recognise provisions not only at the end of the financial year, but on an ongoing basis throughout the year, as soon as the circumstances justifying the creation of a provision arise (although the final deadline for recognition is the balance sheet date). The correct recognition of provisions is also a condition for the financial statements to meet the requirement of reliability and clarity (Article 4(1) of the Accounting Act).

Consequences of failing to recognise a mandatory provision

Failure to create a provision, despite the existence of grounds for doing so, may have serious consequences for the quality of financial reporting. Above all, it leads to an overstatement of the net financial result and an underestimation of liabilities on the balance sheet. As a result, the picture of the entity’s financial position is distorted – the company appears more profitable and has fewer liabilities than in reality. Such an omission breaches the principle of prudence and may be challenged during the audit of the financial statements by a statutory auditor.

In the long term, the absence of the required provision results in a sudden burden on the financial result when the obligation actually materialises – the entire cost previously deferred then impacts the result in a single instalment, rather than being spread over the periods to which it related. Furthermore**, management that has failed to create the mandatory provision risks being accused of preparing financial statements in breach of regulations** – in extreme cases**,** this may give rise to legal liability for misleading reporting.

Practical examples – when should a provision be recognised?

Below are typical situations in which an entity should recognise a provision for liabilities.

Provision for an ongoing legal dispute

A company is involved in legal proceedings with a former business partner who is claiming substantial damages. Lawyers assess that there is a high probability of losing the case and having to pay, for example, PLN 500,000. In such a situation, in accordance with the principle of prudence, the company should recognise a provision for the anticipated liability arising from this matter, charging it to other operating expenses for the current period. Failure to recognise a provision would distort the financial result – the company would report a profit which would most likely be reduced in the future if the case is lost.

Provision for warranty repairs

An electronics manufacturer sells its products with a 2-year warranty. At the end of the year, the company estimates that a certain percentage of the devices sold will be returned for servicing under warranty, which will generate repair costs (labour and spare parts) in the future. Based on historical data regarding failure rates, the company calculates the expected cost of these repairs, e.g. PLN 100,000, and creates a provision for warranty costs. As a result, costs relating to revenue from the sale of products will be recognised in the current financial year (fulfilling the matching principle), even though the actual expenditure will be incurred in subsequent years.

The above examples illustrate the principle that whenever there is a reasonable likelihood of a future expenditure affecting the current or past period, the entity should consider creating an appropriate provision. This ensures a true and fair view of the company’s financial position and prevents unexpected fluctuations in the financial result.

Tax provisions in the accounts – summary

Whenever there is a reasonable likelihood of a future expense charged to the current or previous period, an entity should consider creating an appropriate provision. This ensures a true and fair view of the company’s financial position and prevents unexpected fluctuations in the financial result. Issues relating to the creation of provisions are linked to the broader issue of tax settlements – correctly distinguishing between balance sheet cost and tax cost has a direct impact on the amount of a company’s public-law liabilities.

Author

Piotr Magda

Radca prawny, Senior Associate

The practice includes ongoing advice on administrative and tax law. He has extensive experience in handling judicial, administrative, tax and judicial-administrative proceedings concerning both individual clients and business entities, including that gained through many years of providing services to local government units and other units of the public finance sector.

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