Provisions in Accounting – Meaning, Accounting Treatment, and Example

A provision in accounting refers to an amount that has been set aside from the profits of the business in order to meet an unanticipated loss. All business units set aside some part of their current year’s profits in order to “provide” for some certain unforeseen financial crunch that may arise in the next operating cycle. They are created following the prudence concept of accounting, which states that a business should account/provide for all possible contingencies and potential losses.

Example: As per the estimations, a firm believes that 20% of their Debtors may not pay their dues. So, the firm can make a provision for bad debts in the books to cover them.

It is shown as a current liability on the liabilities side of the balance sheet and recorded as expenses in the income statement. Provisions are tax-deductible expenses, which means that, while calculating profit before tax (PBT), it should be taken as an expense. While making cash flows, provisions should not be taken as there is no cash outflow/inflow.

Different kinds of provisions are usually created for meeting different kinds of contingencies. A few examples are:

1. Provision for Bad Debts
2. Provision for Income Tax
3. Provision for Depreciation
4. Provision for Repairs and Maintenance
5. Provision for Pension
6. Provision for Restructuring liabilities

Accounting Treatment of Provisions

1. In Profit and Loss Account:

Since a provision is a charge against profit, the amount for which a provision is created is debited to the profit and loss account. The following Journal entry is passed while creating a provision:

2. In Balance Sheet:

In the Balance Sheet, provisions may be recorded in any one of the following two ways:

A. as a deduction from the amount of the concerned asset, such as provision for doubtful debts and provision for depreciation.

B. as a current liability on the liabilities side of the balance sheet, like provision for income tax, provision for repairs, etc.

Illustration:

The following extract of trial balance of Madden Ltd. is provided along with additional information:

Additional Information:

1. Debtors amounting to ₹10,000 proved bad.

2. Provision for bad debts to be made at 4%.

Pass the necessary Journal entries and show the relevant extract of Balance Sheet in the books of Madden Ltd.

Solution:

Working Note:

Provision for bad debts= 4% of (₹2,00,000 – ₹10,000) = 4% of ₹1,90,000 = ₹7,600