Definition: Provisions refer to the practice of retaining an estimated fund out of the profit by the firm so as to cover an uncertain anticipated loss or to reduce the value of the asset in the future. It is a liability whose time of occurrence and the amount is not known. Liability here means liability for expenses. The funds are set aside for a particular purpose only and it must be used for the same.
As per the matching concept of accounting, the expenses and revenues of business need to be recognized in the same financial year in which they arise, to make the financial statements more accurate. The provisions form part of both, Balance Sheet as well as the Income Statement. Provision for Doubtful Debts, Provision for Depreciation, Provision for Discount on Debtors, etc. are examples of Provision.
Now the question arises – When the provision is recognized?
Well, a provision is recognized when:
- A present obligation arises from a past event
- There is a possibility that to settle the obligation, the outflow of resources representing economic benefits will be needed.
- A reliable estimation of the amount of the liability can be made.
Characteristics of Provisions
As per the Convention of Conservatism, provisions must be created for all identifiable liabilities, expenses, and losses. Also, probable losses occurring due to contingencies need to be provided for. It is characterized by:
- Provision is a charge against profit
- It is not an asset, rather it will reduce the net assets of the firm.
- It is provided for an expected contingency, that may arise in the future like Liability for a disputed claim.
- Follows matching convention, i.e. all the actual and estimated current year’s losses need to be adjusted against the current year’s revenues or profits.
- The value of provision cannot be ascertained with significant accuracy.
- Reflects true current year’s profit.
- It is provided to meet known losses or outstanding liability
It must be noted that if a provision is made in excess of the amount which the directors think is reasonably necessary for the purpose, the excess amount should be treated as a reserve and not as a provision.
Classification of Provisions
Provisions are broadly classified into two categories:
On the basis of Assets and Liabilities
- Based on assets:
- Depreciation of Assets
- Renewal of Assets
- Reduction in the value of Assets
- Based on Liabilities
- Expected Contingencies
- Outstanding Liabilities
On the basis of Objectives
Accounting Treatment of Provisions
Provisions are a charge against profit. And so to create the profit and loss account is debited for a specific and known contingency or any expected loss. For this purpose a definite sum is charged every year out of the current year’s profit, to meet the contingency or loss. Therefore, it is posted on the debit side of the Profit and Loss Account. Additionally, these are shown at the asset side of the Balance Sheet, by reducing the amount of provision from the amount of the concerned asset.
For example Provision for Discount on Debtors and Provision for Doubtful Debts appear as a deduction from debtors. Similarly, Provision for Depreciation appears as a deduction from Plant and Machinery.
However, it can also be shown on the liabilities side like provision for taxation or provision for creditors.
Needs of Provision
Provision is created for:
- Depreciation, renewal, or diminution in the asset’s value
- Disputed claim
- Writing off bad or doubtful debts
- Specific loss on realization of an asset or on tax payment
- Contingent liabilities
- Known liability whose amount cannot be ascertained with substantial accuracy.
- Redeeming liability
Rules for Creation of Provisions
There are certain rules for the creation of provisions, which must be followed strictly, these are:
- It can be provided by debiting the profit and loss account.
- The provisions are made to cover the loss arising due to the known liability or any contingency.
- Provisions are not associated with profits, as they can be created without referring to the profitability position of the company. Meaning that it can be created even when the company has incurred a loss in a particular financial year.
- The amount set aside for provision, cannot be distributed as dividends among shareholders.
- For the creation of provision, a fixed sum is retained every year to cover the contingency.
- To meet the expected contingency or anticipated liability, the creation of a provision is necessary.
- It appears on the liabilities side of the balance sheet.
A Word from Business Jargons
Provision is the amount written off or kept separately to provide for depreciation, renewal, or heavy repair of assets or for any known liability whose amount cannot be ascertained with considerable accuracy. However, if the amount can be ascertained with a considerable degree of accuracy, then liability is created and not a provision such as liability for outstanding rent or salary.