One important activity as part of the Financial Closing Reporting Process is complying with the prudence accounting principle, meaning that the assets are not overstated, and the liabilities are not understated such as the entity’s financial statements represent a true and fair view of the entity’s financial position and results.
For this purpose, the management has to estimate the net realizable value of the inventories and the most probable collections of the receivables, and adjust accordingly, if necessary.
In the same manner, the entity will analyze if there are goods or services received/sold but for which the invoices were not received or issued yet, and for which the entity will accrue and consequently recognize the revenues or expenses in the year when they were incurred regardless of the moment of invoicing or payment.
As at the balance sheet date, the entity will analyze if there are events that either create a legal or constructive obligation, namely as obligating event and, therefore, results in an entity having no realistic alternative but to settle the obligation; or if the past practice creates a valid expectation on the part of a third party, namely as constructive obligation.
An entity must recognize a provision if, and only if:
The amount recognized as a provision should be the best estimate of the expense required to settle the present obligation at the balance sheet date, that is, the amount that an entity would rationally pay to settle the obligation at the balance sheet date or to transfer it to a third party.
The provisions should only be used for the purpose for which they were originally recognized. They should be reviewed at each balance sheet date and adjusted to reflect the current best estimate. If it is no longer probable that an outflow of resources will be required to settle the obligation, the provision should be reversed.
The most often obligations for which a provision might be booked are litigations, fines, penalties, decommissioning costs for fixed assets, restructuring, pensions, taxes, employees’ bonuses, or unused holidays.
A possible obligation (a contingent liability) is disclosed but not accrued. However, disclosure is not required if payment is remote.