Provisions

What are provisions?

Provisions are amounts set aside for obligations that are probable in principle but whose amount or due date is not yet fixed.

The difference from liabilities: for those, basis, amount and due date are fixed. For provisions, at least one of them is open.

Under the German Commercial Code (Handelsgesetzbuch, HGB) they are in principle mandatory, not optional. Anyone who does not set aside a provision for a probable obligation reports a profit that is too high.

The most important types

• Pension provisions for commitments to employees or managing directors. The largest and most complex item, to be valued actuarially.
• Warranty provisions for future rectification work arising from services already performed.
• Litigation provisions for ongoing legal disputes, including costs.
• Tax provisions for taxes not yet assessed, including from ongoing tax audits.
• Holiday and bonus provisions for untaken holiday and promised variable pay.
• Archiving and closing costs for the retention of records and the preparation of the annual financial statements.

The last four items are forgotten most often

They are small in each case and add up. A company with 40 employees and an average of eight outstanding holiday days at year-end carries a holiday provision in the mid five-figure range, which is simply missing from many interim reports.

This is precisely why the annual result regularly deviates from the sum of the monthly reports, and precisely why the known items belong in monthly accruals.

How they are valued

Under the HGB, at the amount that is necessary according to prudent commercial judgement. Provisions with a remaining term of more than one year must be discounted, at the rate published by the German Federal Bank (Bundesbank).

For pension provisions, the commercial and tax balance sheets regularly differ because different interest rates apply. The difference can be considerable and belongs in the reconciliation.

What interests investors about them

Two things:

1. Are they complete? A provision that is too low raises the reported profit and is corrected in the review, which lowers the valuation.
2. Are they genuine? Conversely, excessive provisions are added back again in the adjustment. Both attract attention.

Particular attention goes to pension commitments to shareholder-managing directors. They are a long-term obligation, they reduce the enterprise value, and in a sale they are often a negotiating point of their own, because a buyer does not want to take them over.

Common mistakes

1. Not accruing holiday and bonuses during the year. Makes every month look better than it is.
2. Not providing for litigation risks. An ongoing proceeding should be valued, even if the outcome is open.
3. Forgetting discounting. Required for long-term provisions.
4. Not having pension commitments reviewed. In a sale they are regularly a stumbling block and need a solution before negotiations begin.
5. Forgetting to release. If the reason falls away, the provision must be released. That then increases profit.

Frequently asked questions

Do provisions reduce tax?

To the extent that they are recognised for tax purposes, yes. Not all provisions required under commercial law can be recognised for tax purposes: provisions for anticipated losses, for example, cannot.

How do they differ from reserves?

Provisions are debt capital for obligations to third parties. Reserves are equity, that is, retained profit.

What happens to a pension commitment in a sale?

It has to be resolved. Usual routes are a severance payment, transfer to an external pension provider or remaining with the seller. Each route has tax consequences and needs lead time.

The Roemer Capital view

Before every transaction, Roemer Capital checks the provisions for completeness before the buyer does. The reason is unpleasantly simple: every missing provision that is found in the review lowers the adjusted profit and is multiplied by the multiple. A forgotten item of EUR 60,000 therefore costs EUR 420,000 of purchase price at a factor of 7.