The compilation of these Depreciation, Provision and Reserves Notes makes students exam preparation simpler and organised.
If you have ever studied a balance sheet, you must have come across an item of provisions. It is listed on the liabilities side of the balance sheet. As easy as it sounds, it is not simple to understand the concept. You ought to understand this term and the purpose why we make use of it in accounts. Let us understand what the provisions are.
What is a Provision?
A provision is usually an amount that is set aside from a company’s profits, usually to cover an expected liability or a decrease in the value of an asset, even though the specific amount of the same might be unknown. A provision should not be understood as a form of savings, instead, it is a recognition of an upcoming liability, in advance.
Reserves, another common accounting term, and provisions are strictly not interchangeable terms. Whereas a provision is intended to cover upcoming liabilities, a reserve is a part of a business’s profit, set aside to improve the company’s financial position through growth or expansion.
Providing a Provision in Accounting
In accounting terms, the matching principle states that the expenses should be ideally reported in the same financial year as the correlating revenues. This is because the costs that belong to a certain year can become misleading if accounted for in the previous or the future financial years.
Provisions, therefore, adjust the current year balance to be more accurate by ensuring that costs are recognized in the same accounting period as the relevant expenses. Provisions are recognized in the balance sheet and are also expensed on the income statement.
Types of Provisions in Accounting
The most common type of provision is a provision for bad debt. A provision for bad debt is one that has been calculated to cover the debts encountered during an accounting period that is not expected to be paid.
This provision is usually included in the budget which is created by a company and can be estimated based on past experience with bad debt amounts as well as industry averages. A general provision is not allowed as a tax deduction. A specific provision in which specific debts are identified is usually allowed as a tax deduction if there is documentary evidence to indicate that these debts are unlikely to be paid.
The Other common kinds of provisions in accounting include:
- Restructuring Liabilities
- Provisions for bad debts
How can Provision be Created?
There are a number of factors that cause a company to create provisions. There are certain requirements that must be fulfilled before a financial obligation can be viewed as a provision. These include:
- The company must perform a reliable amount of regulatory measures of the obligation.
- It must be probable that the obligation results in a financial drag on economic resources.
Through a journal entry, depict how a written off bad debt provision will be recorded in the books of accounts.
The entry is as follows:
Pass a journal entry for the provision of Audit Expenses for the year.
The journal entry is