Recognition Of Provisions And Their Impact On Capital Structure And Profitability

While assessing the sustainability of an entity the main indicators are its profit and solvency. A profitable entity is able to use its assets effectively and earn an expected return for the owners. In addition to the capital contributed by the owners, entities also raise borrowed capital, as a result of which the liabilities will increase. As a rule, the amount of liabilities and their due dates are known, however, provisions are estimated liabilities, where the outflow of resources is probable but the amount has to be estimated. When provisions are recognised, both liabilities and expenses will increase, thus it will affect the capital structure and profit. An increase in expenses will have an impact on the profit and profitability ratios. A survey on the impact of recognising provisions was performed based on the annual reports of the Top 100 successful companies in Estonia in 2018, which revealed that provisions account for a very small proportion of liabilities. Usually entities have recognised both short-term and long-term provisions, which have been created in relation to environment protection and onerous contracts based on the industry specifics. As provisions account for an average of 5% of liabilities, the impact of capitalising provisions on the capital structure and gearing was minimum. The decrease in profit caused by recognising provisions does not have a significant impact on the return on assets. However, the average return on equity was lower for those companies that had capitalised provisions. Thus, capitalisation of provisions has decreased the solvency of these companies that did capitalise them. In conclusion, recognising provisions has an impact on different profitability ratios through changes in the capital structure. Therefore, considering the impact of provisions is important while assessing an entity’s sustainability.