Let us make in-depth study of the concept, objectives and types of provisions.
Provision means setting aside a part of the profits for meeting a liability in future, the amount of which is not known accurately at the time of finalization of financial statements. In any business, there may be some expected or unexpected eventualities which must be met by the businessmen without delaying them further. So based on the convention of conservatism, it is necessary for every business enterprise to conduct the business prudently. For this purpose, necessary provisions and reserves are to be created at the time of preparation of financial statements.
Provision is to be made in respect of a liability, which is certain to be incurred, but its exact amount is not known. If the exact amount can be known, it becomes a liability and not provision. ‘Provision for Legal Damages’, ‘Provision for Depreciation’, ‘Provision for Taxation’, ‘Provision for Doubtful Debts’, and ‘Provision for Discount on Debtors’ are few examples of provisions.
Provision is a charge against the profits, which means that irrespective of the fact whether business enterprise is earning sufficient profit or not, provision has to be made in the financial statements. Even in the case when the business enterprise is suffering heavy losses, provisions are to be made. It is worth mentioning that creation of provision does not affect flow of cash because it is an internal transaction.
According to Part III, Schedule VI of the Companies Act, 1956, ‘provision’ means “any amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets, or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy”.
Thus, the basic objectives of providing provisions are:
(i) To meet depreciation, renewals or diminution in the value of assets like investments;
(ii) To meet expected contingency e.g. ‘Provision for Bad Debts’, ‘Provision for Discount on Debtors’ etc.
(iii) To meet known liability, amount of which is not certain e.g. ‘Provision for Repairs and Renewals’, ‘Provision for Taxation’ etc.
Objectives of Provisions:
1. For Ascertainment of True Net Profit:
For ascertaining true net profit of the business, expenses pertaining to that year, paid or outstanding must be shown in Profit and Loss Account. In addition a provision should also be created for those expenses or liabilities for which the exact amount is unknown or cannot be ascertained accurately. For example provision created for doubtful debts, provision for discount on debtors etc.
2. For Ascertainment of True Financial Position:
The business must make adequate provisions for all expenses and losses, only then the Balance sheet will depict the true and fair view of the financial position of business.
3. To Provide for Known Losses in the Future:
For meeting a liability in future, the amount for which is unknown, steps should be taken to set, aside a part of profits. For example, provision for taxation, provision for repairs, provision for bad-debts etc.
4. For Uniform Charge on Income Statements:
For equal distribution of expenses and losses in all the years so that proper analysis can be made, provisions are required to be created. For example, Rs. 10,000 was to be incurred during the entire life of the machine, estimated life of which was 10 years.
In this case, instead of debiting Rs. 10,000 in a single year, it should be divided and debited in 10 years in such a way that Profit and Loss Account shall be burdened according to the benefits derived from usage of the machine during 10 years.
Types of Provisions:
Depending upon the need, size and nature of the operations of the business, different types of provisions are maintained by the business enterprise. Usually, a business enterprise creates ‘Provision for Doubtful Debts’, and ‘Provision for Discount on Debtors’.
(a) Provision for Doubtful Debts:
Generally, there are debts which cannot be recovered from the debtors due to various reasons such as death, insolvency or non-traceability of some debtors etc. The debtors from whom amount cannot be recovered are treated in the books of accounts as bad and termed as bad debts.
However, at the end of the financial year, there may be certain debts, which are not bad as yet but they are likely to be bad, reasons being malafide or bad intention of debtors. Sometimes due to non-availability of debtors, too old debts become time barred, hence, amount from such debtors is not likely to be recovered.
Keeping in view the convention of conservatism, adequate amount from the current year’s profit is set aside in a separate account known as ‘Provision for Doubtful Debts A/c’. Based on the experience and trend of recovery from the debtors, usually a percentage on debtors is fixed.
(b) Provision for Discount on Debtors:
To motivate and inspire for making immediate payment usually a scheme for discount is offered to the good debtors (i.e., receiving less than what is due from them). Such discount, being an expense, is debited to Profit and Loss Account. At the end of the financial year, business enterprise, based on its experience, anticipates the amount of debtors who may avail themselves of such discount. For this purpose a ‘Provision for Discount on Debtors A/c’ is created in which e anticipated amount of loss on account of discount on debtors is to be set aside.