While studying the balance sheet, students often might have noticed an entry known as provisions, which was listed on the liabilities side of a balance sheet. This article will help you in understanding the concept of a provision in accounting and the need for the creation of such a provision.
Provision Definition
Provisions in accounting refer to the amount that is generally put aside from the profit in order to meet a probable future expense or a reduction in the asset value although the exact amount is unknown.
Provision cannot be seen as savings, but it can be regarded as a way of recognising any upcoming or future liabilities.
Most of the time, provision is treated as a reserve, but reserve and provision are not interchangeable. A provision is set up to cover probable future liabilities while a reserve is a part of the profit that is set aside for assisting the company’s growth and expansion.
Provisions in Accounting
It is stated in the matching principle that it is mandatory to report all expenses incurred in a financial year along with the revenue earned. This is essential as it will become misleading if cost belonging to a certain year is recorded in previous or future balance sheets.
Provisions, therefore, balance the current year balance to become more accurate by ensuring expenses are included along with revenues in the same accounting period.
Examples of Provisions in accounting
Bad debt is one of the most common types of provisions. It is calculated to cover the cost of debts that are expected to remain unpaid during an accounting period.
The other examples of provisions are
- Doubtful debts
- Depreciation
- Pension
- Restructuring liabilities
- Income taxes
- Guarantee (product warranties)
Requirements for creating provision
A provision can be created due to a number of factors. However, there are certain requirements that must be met before a financial obligation can be considered as a provision.
The following requirements are mentioned below:
- The organisation should perform a detailed amount of regulatory measurement for the obligation, and it should be performed by the management.
- An obligation must be determined as such, it is probable to occur, but not certain to occur. It should have more than 50% chance of occurring.
- The obligation must result in a decrease in the financial position of the business.
Accounting Treatment of Provision
Accounting treatment of provision can be understood with the example of presenting a written off bad debt in the account books.
Bad debt expense A/c Dr 50000
To Bad debt provision A/c 50000
This concludes the concept of Provisions in accounting. For more such insightful articles on various concepts of Commerce for students, stay tuned to BYJU’S.
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