Provisions in Accounting: Every business organization is exposed to some common known expenses or losses the exact amount of which in the future period is unknown such as depreciation on fixed assets, payment of tax liability, default in payment by customers, etc. For the purpose of meeting such expenses or losses, a business may keep aside a certain amount every year.
The amount that is kept aside from the profits of an enterprise to meet the future ‘known’ liabilities is known as provision. It is created only for those liabilities, the amount of which cannot be ascertained precisely and accurately beforehand.
Therefore, if a provision is created for a liability whose amount is already known cannot be considered as a provision rather, it would be considered as a liability for the business. From this, it is clear that there lies a difference between a provision and a liability as the former is to provide for a future known liability whose amount is difficult to be determined while the latter is in itself a future known liability whose amount is already known. For example, a provision created for a tax liability of Rs 10,000 to be paid in the month of December is a liability and not a provision. This is because, here, the amount of liability is already known, therefore provision cannot be created for this liability.
This creation of provision is truly based on the intuitions and past experiences of a business. In other words, it is created on an estimated basis based on past performances. The unascertained liabilities in the form of provisions are kept aside which helps a business to sustain from future unexpected losses.
Provision is considered as an expense of a business that is charged from the profits by debiting it to the Profit and Loss Account. The underlying principle behind the creation of provision is the accounting principle of Conservatism which states that provides for all anticipated expenses or losses but does not provide for anticipated incomes or gains’. It should be noted that the creation of provision is compulsory even if the business does not have profits. The main rationale for making provisions is to provide a cushion to the future business performance against the uncertain and unforeseen losses that may arise from the past transactions. The creation of a provision helps in determining the true profits or losses during an accounting period.
As per Penguin Dictionary of Commerce ‘A provision is an amount written off or retained by way of providing depreciation, renewals, or diminution in the value of assets or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy’.
Examples of Provisions
The following are few examples of provisions.
- Provision for Doubtful Debts
- Provision for Discount on Debtors
- Provision for Taxation
- Provision for Depreciation
- Provision for Repairs and Renewals
Accounting Treatment
The amount of provisions is charged against profits by debiting it to the Profit and Loss Account. It is charged in the accounting period in which such provision is created. We know that provision is compulsory to be created therefore, it has to be created by the business even in case of losses.
Features of Provisions
The given below are some features of provision that can be derived from the above explanation.
- It is created to meet the future known liability the exact amount of which cannot be determined.
- It is an estimation based on past experiences and performances.
- It is compulsory to create irrespective of the fact whether there are profits or losses.
- It is a charge against profits and not an appropriation of profits.
Importance of Provisions
The following are the various purposes served by creating provisions.
Provide for Future Expenses or Losses: Provision is the amount kept aside out of profits to meet the future expected liabilities and losses. Therefore, it helps the business in meeting the expenses or losses that are expected to take place in the near future.
True Profits or Losses: The true profit or loss of a firm can be determined only when all the expenses or losses (whether they are paid/incurred or not are provided) i.e. debited to Profit and Loss Account. Provision is a charge against revenues or profits of a firm and therefore it helps in ascertaining the true profit or loss during an accounting period.
True and Fair Financial Position: By creating the provisions for anticipated expenses and losses the true financial position of an organization can be assessed at the end of an accounting period.
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