by The concept of provisions is based on the prudence (conservatism) concept of accounting. It requires that all expected losses and liabilities should be recognized as soon as they are anticipated, while expected gains should not be recorded until realized. Provisions ensure that profits are not overstated and that financial statements reflect a realistic and cautious view of the company’s financial position.
Meaning of Provisions
Provisions are amounts set aside out of profits to meet a known liability or loss, the exact amount of which cannot be determined with certainty at the time of preparing accounts. These amounts are charged against profits and shown as liabilities or deductions from assets in the Balance Sheet.
Definitions of Provisions
- According to Accounting Standard (AS) 29,
“A provision is a liability which can be measured only by using a substantial degree of estimation.”
- According to R.N. Carter,
“A provision is an amount written off or retained to provide for depreciation, renewal, or diminution in value of assets or for any known liability the amount of which cannot be determined with accuracy.”
- According to William Pickles,
“Provision means any amount retained out of profits for providing for depreciation, renewals, or contingencies which are known to exist.”
Objectives of Provisions
- To Follow the Principle of Prudence
One of the main objectives of provisions is to follow the prudence or conservatism principle of accounting. This principle requires that expected losses and liabilities should be recognized as soon as they are anticipated, while unrealized gains should not be recorded. By creating provisions, companies avoid overstatement of profits and present a cautious and realistic financial position.
- To Ascertain True and Correct Profit
Provisions help in determining the true and correct profit of a business. Expected losses such as doubtful debts, depreciation, or tax liabilities are charged to the Profit and Loss Account in the same accounting period. Without provisions, profits may appear inflated, which can mislead stakeholders and result in incorrect financial decisions.
- To Ensure Proper Valuation of Assets
Another important objective of provisions is to ensure proper valuation of assets. Provisions for doubtful debts, depreciation, and discounts on debtors reduce asset values to their realistic or realizable amounts. This prevents overvaluation of assets in the Balance Sheet and helps in presenting an accurate picture of the company’s financial strength.
- To Provide for Known Liabilities
Provisions are created to account for known liabilities whose exact amount cannot be determined with certainty at the time of preparing accounts. Examples include provision for taxation, gratuity, and warranty claims. This objective ensures that liabilities are recognized in advance and financial statements reflect all obligations of the company.
- To Avoid Sudden Financial Burden in Future
By making provisions regularly, a company avoids sudden heavy financial burdens in future periods. Instead of charging the entire expense in one year, provisions spread the cost over relevant accounting periods. This helps in maintaining stability in profits and better financial planning.
- To Present a True and Fair View of Financial Statements
Provisions help in presenting a true and fair view of the financial position and performance of the company. They ensure that assets are not overstated and liabilities are not understated. This objective enhances the reliability, transparency, and credibility of financial statements prepared by the company.
- To Comply with Accounting Standards and Legal Requirements
Provisions ensure compliance with accounting standards such as AS 29 and statutory requirements under the Companies Act. Proper provisioning is mandatory for certain liabilities and employee benefits. This objective ensures uniformity in accounting practices and adherence to professional and legal norms.
- To Protect the Interests of Stakeholders
Provisions safeguard the interests of shareholders, creditors, employees, and other stakeholders. By recognizing expected losses and liabilities in advance, provisions prevent distribution of unreal profits and protect creditors against financial risks. This objective strengthens confidence in corporate financial reporting.
Types of Provisions
1. Provision for Doubtful Debts
Provision for Doubtful Debts is created to cover possible losses arising from debtors who may fail to pay their dues. Since it is uncertain which debtors will default, an estimated amount is provided based on past experience. This provision is charged to the Profit and Loss Account and deducted from Trade Receivables in the Balance Sheet. It ensures realistic valuation of debtors and prevents overstatement of assets and profits.
2. Provision for Bad Debts
Provision for Bad Debts is made to account for debts that are expected to become irrecoverable in the near future. Unlike bad debts written off, this provision is an estimate and not a confirmed loss. It is treated as an expense and charged against profits. This provision follows the prudence concept and safeguards the business against potential losses from credit sales.
3. Provision for Discount on Debtors
Provision for Discount on Debtors is created to meet the expected loss arising from discounts allowed to customers for early payment. Since such discounts reduce income, a provision is made in advance. This provision is charged to the Profit and Loss Account and deducted from debtors after adjusting for bad debts and provision for doubtful debts. It ensures correct valuation of receivables.
4. Provision for Taxation
Provision for Taxation is made to account for the estimated tax liability of the company for the accounting period. As the exact tax amount is determined later, an estimated provision is created and charged to profits. It is shown as a short-term provision under current liabilities in the Balance Sheet. This provision ensures that profits are not overstated and tax liability is recognized timely.
5. Provision for Depreciation
Provision for Depreciation is created to account for the wear and tear or obsolescence of fixed assets over their useful life. It represents the reduction in value of assets due to usage and passage of time. Depreciation is charged to the Profit and Loss Account and deducted from the asset value in the Balance Sheet, ensuring proper asset valuation.
6. Provision for Gratuity
Provision for Gratuity is made to meet the future liability of gratuity payable to employees upon retirement, resignation, or death. Since the amount becomes payable in future and cannot be determined exactly, a provision is created based on actuarial valuation. It is shown as a long-term provision and ensures compliance with employee benefit obligations.
7. Provision for Leave Encashment
Provision for Leave Encashment is created to account for the liability arising from unavailed leave accumulated by employees. Employees may encash their unused leave in the future, resulting in a financial obligation for the company. This provision is made based on estimation and charged to the Profit and Loss Account, ensuring recognition of employee-related liabilities.
8. Provision for Warranty Claims
Provision for Warranty Claims is made by companies that provide warranties on their products. Based on past experience, an estimated amount is set aside to meet future warranty-related expenses. This provision is charged against profits and shown as a liability in the Balance Sheet. It ensures accurate profit measurement and recognition of future obligations.
9. Provision for Contingent Liabilities (Recognizable)
Certain contingent liabilities, when they are probable and can be reasonably estimated, require provisioning. Examples include legal claims likely to be settled against the company. Such provisions are created to recognize expected losses and are disclosed in the Balance Sheet, ensuring transparency and prudence.
Journal Entries for Provisions
| Type of Provision | Debit (Dr.) | Credit (Cr.) |
|---|---|---|
| Provision for Doubtful Debts | Profit & Loss A/c | Provision for Doubtful Debts A/c |
| Provision for Bad Debts | Profit & Loss A/c | Provision for Bad Debts A/c |
| Provision for Discount on Debtors | Profit & Loss A/c | Provision for Discount on Debtors A/c |
| Provision for Taxation | Profit & Loss A/c | Provision for Taxation A/c |
| Provision for Depreciation | Profit & Loss A/c | Provision for Depreciation A/c |
| Provision for Gratuity | Profit & Loss A/c | Provision for Gratuity A/c |
| Provision for Leave Encashment | Profit & Loss A/c | Provision for Leave Encashment A/c |
| Provision for Warranty Claims | Profit & Loss A/c | Provision for Warranty Claims A/c |
| Provision for Contingent Liabilities (Recognized) | Profit & Loss A/c | Provision for Contingent Liabilities A/c |
| Provision for Repairs and Maintenance | Profit & Loss A/c | Provision for Repairs A/c |
| Provision for Proposed Dividend | Profit & Loss A/c | Provision for Dividend A/c |
Difference between Provisions, Adjustments and Reserves
| Basis of Difference | Provisions | Adjustments | Reserves |
|---|---|---|---|
| Meaning | Amount set aside to meet known liabilities or losses | Entries made to allocate income and expenses to correct period | Portion of profit retained for future use |
| Nature | Charge against profits | Accounting correction | Appropriation of profits |
| Purpose | To cover anticipated losses or liabilities | To ensure correct profit calculation | To strengthen financial position |
| Creation Time | Before determining profit | At the time of preparing final accounts | After profit is determined |
| Profit Impact | Reduces profit | May increase or decrease profit | Does not reduce profit |
| Accounting Concept | Prudence concept | Accrual and matching concepts | Profit retention concept |
| Compulsion | Generally compulsory | Mandatory for accuracy | Optional |
| Certainty of Amount | Estimated amount | Exact amount | Fixed by management |
| Legal Requirement | Often legally required | Not legally required but essential | Generally not legally required |
| Dividend Distribution | Not distributable | Not applicable | Generally distributable (except capital reserve) |
| Balance Sheet Treatment | Shown as liability or deduction from asset | Shown as asset or liability | Shown under Reserves & Surplus |
| Examples | Provision for tax, doubtful debts | Outstanding expenses, prepaid expenses | General reserve, capital reserve |
| Flexibility of Use | Used only for specific purpose | Used only for adjustment purpose | Can be used for general purposes |
| Objective | To avoid overstatement of profit | To present true and fair view | To provide financial stability |
| Effect on Financial Statements | Ensures realistic profit and asset valuation | Ensures accuracy of accounts | Improves solvency and strength |
