In daily routine life, the events which are about to happen in the future are planned in the present with the help of available resources. In the same way these things are followed in a business also. When there are certain expected losses or expenses, these are planned to be managed in advance from the current year’s profits or surplus. The amount which is kept separately to meet such expected losses or expenses is called a Provision.
If an amount is payable in the future and the amount is certain, it is a liability. However, if the amount in respect of a liability or expected loss is not certain, an estimated amount is set aside by debiting the Profit and Loss Account. The amount so set aside is known as a Provision. Thus, Provision means an estimated amount to meet an uncertain loss or expense in future. Some of the examples of Provisions are - Provision for Doubtful Debts on Debtors, Provision for Discount on Debtors, Provision for Depreciation.
Needs of Provision
Provisions are provided for:
- Depreciation, renewal or reduction in the value of assets.
- A known liability, the amount of which cannot be determined with substantial accuracy.
- A disputed claim.
- Specific loss on realization of an asset or on payment of taxes.
- Redeeming the liability.
- Writing off bad-debts/doubtful debts.
- Contingent liabilities.
General Rules in Creation of Provisions
- It is created by debiting the profit and loss account.
- It is created to meet a known liability or a specific contingency. For example, 'Provision for bad and doubtful debts’ and ‘provision for depreciation’.
- A provision is created irrespective of whether there is profit or loss in the business.
- It is not available for distribution as dividend among shareholders.
- A provision is made for a definite amount and, therefore, a definite sum is set aside every year to meet the known contingency.
- Making of a provision is must to meet known liability or contingency.
- The provision is generally shown on the liability side of the balance sheet.