Provisions in GmbH Accounting

GmbH (Gesellschaft mit beschränkter Haftung) is a common business structure in Switzerland, especially for small and medium-sized enterprises (SMEs). As with any business, accurate accounting is an essential part of managing a GmbH, and provisions form an important component of accounting. This article will explore what provisions are, their properties, types, and accounting effects, as well as how they can be used to optimise taxes.

What are Provisions?

Provisions are one of the special features of accounting for a GmbH / AG. Provisions are liabilities that are created in a company’s books to account for specific future expenses and/or liabilities that are highly likely to occur. The key point to understand about provisions is that they are a way to account for definite future expenses or obligations, where the amount or legal status is not yet certain. Examples include provisions for bad debts, warranty costs, inventory damage, tax provisions, etc.

The main feature that these examples have in common is that they are all costs that the company will almost certainly have to bear, yet the amount is not yet known. Therefore, the amounts assigned to the provisions are based on estimates made by the management and are reviewed periodically to ensure that they are still valid. Depending on the specific type of provisions in question, the amount can be estimated with varying degrees of accuracy.

The purpose of creating provisions is to ensure that the financial statements of a company accurately reflect its financial situation, including known future expenses. Accounting for provisions also helps the company adequately prepare for such future costs.

Properties of Provisions

The primary property of a provision is that it is created to account for specific liabilities and expenses that are expected to occur in the future, on the basis of a past or current event or obligation. The amount assigned to the provision is based on the best estimate of the future cost of the liability or expense. Provisions are not created for possible future expenses that are unlikely to occur (see the comparison between “provisions” and “reserves” below).

In essence, a provision is similar to an ordinary liability, except that there is still a degree of uncertainty with respect to one or more of the following elements of the obligation:

• The amount of the obligation,
• The exact cause of the obligation (the company may assign a general cause of the obligation, such as “litigation costs”, but the specifics will only become apparent when it comes into force),
• The date upon which the payout will be due,
• The time at which the obligation becomes binding,

Provisions are subject to the principle of prudence, which requires that they are neither overstated nor understated.

What is the difference between provisions and reserves?

Many confuse the concepts of provisions and reserves, but they are distinct accounting terms which cannot be used interchangeably. Provisions, as we have discussed, are reported to account for a known or likely obligation as a result of past or current circumstances. The exact future payout amount, or timing of the payout, is not yet known, so it is recorded as a present liability in the balance sheet based on best estimates of the obligation.

Reserves, on the other hand, are funds which a company sets aside as a buffer against unexpected or unknown future expenses, losses, or even to fund capital ventures and other expenditures. They are not tied to a specific known obligation and are not reported as a liability on the balance sheet. A reserve fund is usually made up of liquid assets such as cash and cash equivalents. It strengthens the company’s financial position and provides the ability to deal with unexpected liabilities and losses.

What is the difference between provisions and accrued expenses?

Provisions should also be clearly differentiated from accrued expenses. Provisions are used to account for probable future expenses where there is still uncertainty over the amount and timing, whereas an accrued expense is a specific term used to denote an expense which has been incurred but not yet paid. In the case of accrued expenses, the amount and timing of the future payout is known with certainty.

For example, a GmbH may incur a utility bill in the month of December but only pay it in January. In this case, the bill would be recorded as an accrued expense in December, which represents a current liability in the balance sheet.

Types of Provisions

There are several types of provisions that a GmbH can create to account for expected expenses and liabilities. These provisions can be broadly separated into two types: expense provisions and debt provisions.

Expense provisions vs debt provisions

Expense provisions are created to account for future expenses that are expected to occur. Examples include provisions for tax obligations, pension accruals, currency risks, litigation risks, and uncertain liabilities. Expense provisions are based on the best estimate of the future cost of the expense or liability.

Debt provisions are created to account for the potential losses from bad debts or unpaid loans. They are usually referred to in the balance sheet as “provision for bad debts” or “allowance for bad debts”. The estimate of debt provisions is based on the expected loss from the non-payment of debts.

Let us now examine some specific types of provisions which fall under the category of expense provisions:

Provisions for Tax Obligations

Provisions for tax obligations are created to account for the expected tax liability of a company. It fulfils the properties of a provision in that it involves a definite future payout, but the exact amount is not yet determined. As such, a GmbH is required to create tax provisions for any known or anticipated tax obligations, in accordance with best estimates of the final tax liability to be paid. Tax provisions can be created for direct taxes, such as income tax, and indirect taxes, such as value-added tax (VAT).

Provisions for Pension Accruals

In Switzerland, it is often the case that retirement provisions are organised through employer contributions to independent pension funds (which would be considered a salary benefit). However, it can also be the case that the employer directly pays retirement benefits to the pensioner. In this case, companies are required to create pension accrual provisions for their employees under the Swiss Pension Fund Law (BVG).

Essentially, this is a difference between using an independent pension fund versus maintaining internal pension provisions. In the case that there is no legally independent pension fund, the liability of future pension payouts to recipients are usually reported as “provisions for pension obligations” in the balance sheet.

It is important to note that these provisions are specifically required in the case of defined benefit pension plans, whereby the pensioner is guaranteed defined pension benefits until death. In this case, the provision amount is calculated as the discounted (present) value of the expected future payouts.

Other Types of Provisions

There are various other types of expense provisions which a GmbH may commonly create. Examples include provisions for:

• Currency risks: Provisions for potential losses due to currency fluctuations,
• Litigation risks: Provisions for potential losses from legal proceedings,
• Environmental costs: Provisions for the estimated costs of environmental remediation arising out of damage caused by past or current business activities,
• Restructuring: Provisions for the costs of restructuring or reorganizing the company,
• Onerous contracts and other uncertain liabilities.

Why are provisions made and then reversed again?

Provisions are made to account for probable future expenses or losses that a company may incur. As time passes, the actual expenses are incurred and paid out. At this time, the company’s asset value is reduced to cover the incurred expenses, while the need for the provision reduces (in the case of partial payout) or disappears entirely (in the case of full payout of the obligation) and this therefore results in a decrease in liabilities. The net effect on equity will depend on whether the amount set aside as provisions for the expense is greater than, equal to, or less than the actual payout amount.

In addition, as time passes more information is gathered and the timing and amount of future expenses or losses becomes clearer and more accurately predictable. Therefore, the company should continuously update the value of provisions to reflect the best estimates based on the most up-to-date information and knowledge currently available. This may result in either an increase, decrease, or complete disappearance of certain provisions from the balance sheet.

Let us now look at three case examples to illustrate the accounting effects when the provision amount is equal to, less than, or greater than, the actual payout amount:

Case 1: Provision Amount = Payout Amount

Let us assume that a GmbH has a legal case pending against it, and it is estimated that the company will have to pay a settlement of CHF 150,000. This is just an estimation, and the final outcome is still uncertain. The company decides to create a provision for the estimated settlement amount in its financial statements.

At the end of the year, the case is settled, and the company has to pay out the full CHF 150,000. In this case, the provision amount is equal to the payout amount. CHF 150,000 is deducted from the company’s cash balance to pay the settlement and at the same time the provision is reversed resulting in a decrease of CHF 150,000 in liabilities. As the two amounts exactly cancel each other, there is no impact on the income statement, and the net effect on equity is also zero.

Case 2: Provision Amount < Payout Amount

Let us take the same scenario, except that in this case the settlement amount ends up being CHF 200,000. This amount is greater than the original provisions which were set aside. Hence, there will be an outflow of CHF 200,000 in cash and a simultaneous decrease of CHF 150,000 in liabilities as the provision is reversed. The shortfall of CHF 50,000 is recorded as a decrease in the company’s net income on the income statement, and results in a net decrease of CHF 50,000 in equity as retained earnings decrease.

Case 3: Provision Amount > Payout Amount

Finally, let’s assume that the settlement amount ends up only being CHF 100,000. This amount is less than the original provisions which were set aside. Hence, there will be an outflow of CHF 100,000 in cash and a simultaneous decrease of CHF 150,000 in liabilities as the provision is reversed. The surplus of CHF 50,000 is recorded as an increase in the company’s net income on the income statement, and results in a net increase of CHF 50,000 in equity as retained earnings increase.

Accounting Effects of Provisions

Some of the accounting effects of provisions were illustrated in the above cases, but let us summarise the effects of provisions on the balance sheet and income statement:

Provisions on the Balance Sheet

Provisions are recorded as liabilities on the balance sheet and therefore reduce the company’s equity. This reflects the fact that the company has a present obligation to pay a future expense. Once the expense is actually incurred, the provision is reversed (either partially or completely), which results in a decrease in the previously recorded liability.

Effect on the Income Statement

Provisions also have an impact on the company’s income statement. When a provision is created, it is typically recorded as an expense on the company’s income statement for that period. For example, if a company sets up a provision for bad debts of CHF 10,000, the amount would be recorded as an expense on its income statement. When the actual bad debts are incurred and the amount is therefore known, there may be an additional entry to the income statement in accordance with the difference between the actual amount and the provision amount.

• If the actual amount is equal to the provision amount, no additional entry is made to the income statement.
• If the actual amount is greater than the provision, the shortfall is recorded in the income statement as an additional expense.
• If the actual amount is less than the provision, the surplus is recorded in the income statement as an increase in net income.

How are Taxes Optimised with Provisions?

Provisions can help to reduce a company’s tax obligations if they are deemed to be tax deductible. According to Swiss tax law, the provision of a GmbH may be tax-deductible if it meets the following criteria:

• It is created for a specific event that has already occurred or is highly likely to occur in the future.
• The amount of the provision can be estimated with reasonable accuracy.
• The provision is necessary to comply with legal or contractual obligations, or to ensure the future profitability of the business.

It is important to note that the deductibility of provisions depends on the specific type of provision and the circumstances in which it is created. Ultimately, it depends on the laws and regulations of the canton in which the company is based, and the final decision lies with the relevant tax authorities. Companies should consult with tax professionals to determine the specific tax treatment of provisions in their particular situation.