The term Provision means the setting aside of an estimated amount to meet known liability or loss the amount of which may not be exactly ascertained.
It is a charge against profit to meet certain known liabilities or contingencies. Charge against profit means that the amount should be provided for even if there is no profit.
For the purpose of making provision, the amount of provision to be made is debited to the profit and loss account in order to ascertain the correct profit.
Examples of provisions:
1. Provisions for income tax.
2. Provisions for sale tax.
3. Provisions liability for the disputed claim.
4. Provisions for Depreciation.
5. Provisions for repairs and renewals.
6. Provisions for a discount on debtors.
Features of Provisions:
A) Provisions are made to meet a known liability.
B) Although the liability is known, the amount of such liability cannot be determined with reasonable accuracy.
C) Provisions are a charge against profits and such the creation of provision reduces the profits or increases the loss of the year in which it is created.
The loss when actually occurs is adjusted against such provisions and thus the profit of the year in which such loss occurs is not affected.
D) Provision is created even if there is Loss.
Importance of Provisions:
1. To ascertain the true net profit of the business: For the purpose of ascertaining the true profit of a business.
It is necessary that all expenses pertaining to that year, whether paid or not, must be debited to profit and loss account.
2. To ascertain the true financial position of the business: In order to see the balance sheet discloses the true and fair view of the financial position of the business.
It is necessary that provision is made for all the anticipated losses and expenses.
3) To provide for known losses in the future: Provisions are made to provide funds for meeting those losses which are likely to occur in the near future such as provision for bad debt, provision for taxation likely to arise from a pending suit and such offers.
4) For Proper allocation of expenses: Provision is also required to be made for the proper allocation of expenses.
For example Total amount to be spent over on an average basis because the number of expenses in earlier years would be comparatively lower than that of the later years.
Different Types of Provisions:
1) The amount is written off or retained by way of providing for Depreciation.
2) The amount retained by way of providing for any known liability the amount of which cannot be determined with substantial accuracy.
Nature of Balance of Provision and reserve account:
Any reserve or provision account usually show a credit balance. But there is only one exception i.e Reserve For a discount on creditors Account which shows debit balance.
Accounting Treatment of Provisions:
Provisions are charged against profit. Provisions are created by debiting profit and loss account for specific and known contingency or expected loss.
For example Provisions for discount on debtors and provisions for taxation etc.
A definite sum is charged every year out of profit and loss account to meet the known contingency. Provisions account should be compulsorily posted at the debit side of profit and loss account, whether the firm earns a profit or suffers a loss.
The Provision against any assets is generally shown as a deduction from concerned assets in the balance sheet.
For example: Provisions for doubtful debts and provisions for discount on debtors. They are shown as deduction from debtors on the assets side of the balance sheet.
The provisions for doubtful debts has generally has old balance. The old proviosns is deducted from the total of bad debts and new provision at the debit side of the profit and loss account.
In case of old provisions exceed the total of bad debts and new provision, the treatment should preferably be made at the credit side of profit and loss account, where the total of bad debts and new provisions should be deducted from old provisions.