We all know about the two types of liabilities – contingent liability and provision. But do you know what’s the difference between them? The provision means an amount set aside for a risk that may occur in the future. On the other hand, a contingent liability is an obligation that results from something uncertain or unexpected. In this article, I’ll walk you through the complete difference between provision and contingent liability.
What is Provision?
When it comes to business, the term “provision” has a number of different meanings. In general, a provision is an amount set aside for a specific purpose. A business entity creates provisions to meet specific future commitments. For example, a company might make a provision for repairs to its factory equipment.
In accounting, a provision is an estimated liability that a company has incurred but has not yet paid. Provisions are typically recorded on the balance sheet as part of the “current liabilities” section.
The amount kept aside in a provision account is known as the “provisional sum.” This sum is not always an accurate estimate of the actual liability, but it is the best estimate that can be made at the time. As more information becomes available, the provisional sum may be revised upward or downward.
Some provisions are made for expected losses, such as those resulting from bad debts or product returns. In these cases, the amount set aside is based on historical experience and is not contingent on any future event.
Characteristics of Provision
The six characteristics are given as follows.
- A business entity creates provisions to meet specific future commitments.
- The provision amount is based on an estimate.
- The amount set aside in a provision for expected losses is based on historical experience.
- The provision is recorded as a liability on the balance sheet.
- The provision may be revised as new information becomes available.
What is Contingent Liability?
A contingent liability is a potential future obligation that depends on the occurrence or non-occurrence of one or more uncertain events. A company may have a contingent liability arising from past events, such as pending litigation, or from future events, such as product warranties.
Contingent liabilities are not recorded in the financial statements because it is not possible to estimate the amount of loss, if any, that might ultimately be incurred. However, companies are required to disclose contingent liabilities in the notes to the financial statements.
The two conditions in which the contingent liability could be recorded are:
- When the likelihood of the obligation is probable and the amount can be reasonably estimated.
- When the obligation is remote and the amount cannot be reasonably estimated
Characteristics of Contingent Liability
The two main characteristics of contingent liability are given below:
- They are not recorded in the financial statements
- Contingent liabilities are only disclosed in the financial statements’ notes.
The following table exactly compares provision vs contingent liability.
4 key Differences Between Provision and Contingent Liability
The four major differences between provision and contingent are as follows.
- A provision is an amount that a company sets aside as an estimate of its liability. On the other hand, a contingent liability is a potential future obligation that depends on the occurrence or non-occurrence of an uncertain event.
- Provisions are recorded in the balance sheet as current liabilities, while contingent liabilities are not recorded in the balance sheet but are disclosed in the notes to the financial statements.
- While provisions are created when there is a present obligation and the amount can be reasonably estimated, contingent liabilities are created when there is a potential future obligation but the amount cannot be reasonably estimated.
- The recognition of provisions and contingent liabilities may affect different accounting ratios, such as the debt-to-equity ratio and the working capital ratio.
As you can see from the above table, there are several key differences between provision and contingent liabilities. The most important distinction is that a provision is an estimated loss that has already occurred, while a contingent liability is a potential future loss. Provisions are recorded on the balance sheet as current or long-term liabilities. On the other hand, contingent liabilities are not recorded unless and until they become actual losses.
Overall, it’s important to be aware of both types of liabilities when managing your finances. By understanding the distinction between them, you can make better decisions about how to protect yourself from potential losses in the future.
You Can Also Read: More About Provision