Accounts of any business are prepared on the basis of the going concern concept assuming that their business will continue for an indefinite period. Hence, in order to ascertain the net profit for each year, businessmen need to take into account not only the current contingencies but future contingencies also. In fact, provisions and reserves are
such considerations which actually relate to the future needs for which a part of the current earnings has to be set aside.
After studying this lesson you will be able to understand the meaning and need of provision and rules in creation of provisions.
PROVISION : Meaning and Need
As you know in our daily routine life we make various arrangements for the future expected needs. For example, if your father wants to give you higher education such as Engineering, Doctorate, or any other professional course, he will need a lot of money. Now the question arises how would your father be able to arrange such an amount? Yes, you are thinking right, he will start saving money from today and every year he will do the same. 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/ expenses, these are planned to be managed in advance from the current year’s profits/ surplus. The amount which is kept separately to meet such expected losses/expenses is called a Provision. If an amount is payable in the future and the amount is certain, it is a liability. For
example, October month’s rent, totaling ` 2,000. is payable on 31st October. The enterprise will debit Rent Account and Credit Rent Outstanding Account as it is a definite 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:
i) Depreciation, renewal or reduction in the value of assets.
ii) A known liability, the amount of which cannot be determined with substantial accuracy.
iii) A disputed claim.
iv) Specific loss on realization of an asset or on payment of taxes.
v) Redeeming the liability.
vi) Writing off bad-debts/doubtful debts.
vii) Contingent liabilities.
General rules in the creation of Provisions:
i) It is created by debiting the profit and loss account.
ii) It is created to meet a known liability or a specific contingency, e.g. ‘Provision for bad and doubtful debts’ and ‘provision for depreciation’ etc.
iii) A provision is created irrespective of whether there is profit or loss in the business.
iv) It is not available for distribution as dividend among shareholders.
v) A provision is made for a definite amount and, therefore, a definite sum is set aside
every year to meet the known contingency.
vi) Making of a provision is must to meet known liability or contingency.
vii) The provision is generally shown on the liability side of the balance sheet.