Provision in Accounting Meaning
The provision in accounting refers to an amount or obligation set aside by the business for present and future obligations. By their very nature, provisions are estimates of probable loss related to the future for events undertaken in the past and present. Provisions are calculated by following predefined regulatory guidelines by Banks and Financial Institutions; however, they can be undertaken by any business against bad debts or any other future liability.
- Always associated with a future liability that is uncertain and cannot be fully quantified;
- It always leads to a reduction in profits for the business.
- It represents a liability for the business and forms part of the liability side in the balance sheet.
- It is done following certain regulatory guidelines (like Banks do provision under BASEL guidelines) or as per historical business practice (in case of other business).
- It is undertaken in those cases where it is a probable case that outflow of funds will happen or certain receivables will face delinquency.
Types of Provision in Accounting
There are different types of provisions created in the ordinary course of business. Some are confined to a particular business, while some are across business types. Here are the most common types –
- Provision for Bad DebtsProvision For Bad DebtsA bad debt provision refers to the reserve made by a company to set aside an amount computed as a specific percentage of overall doubtful or bad debts that has to be written off in the next year.: This includes provisions mark by business against bad debtsBad DebtsBad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other obligation. in the normal course of business based on historic averages.
- Warranty: This includes provisions made by the business for warranty extended by the business.
- Taxation: This includes provision arising out of tax liability as computed by a business based on Income earnedIncome EarnedEarned income is any amount earned by an individual, such as a salary, wages, or employee compensation. It can also be an individual's income through their own business. following Income Tax Rules.
- Asset Class: This type of provision creation is confined to Bank and Financial InstitutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. , where a certain percentage of outstanding loan value is apportioned as Provision. The amount of percentage to be apportioned varies and increases as an Asset (i.e. Loan) defaults and move from standard category to substandard category, doubtful, and loss asset.
How to Create a Provision in Accounting?
It is a two-step process, namely:
- Determine the amount of provision, which is again dependent upon various factors and varies for Industry and business across different jurisdictions.
- Accounting treatment of the provision amount calculated in step 1, which involves debiting of provision expenses from the Income Statement and creation of a liability account under the Balance SheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. for the business.
Let’s explain the two steps with the help of a hypothetical example.
ABC Bank has provided a Term Loan to XYZ amounting to $100000, which requires a periodic monthly payment of $1200. XYZ has not paid the dues for the last three months and accordingly the ABC Bank has classified the account as Non-Performing Asset (NPA) and created a provision on the said Term loan equivalent to 20% of the amount of loan, i.e. 20% of $100000 which is $ 20000.
Thus as per step one, the amount of provision is $20000.
Now, this amount of $20000 is debitedDebitedDebit is an entry in the books of accounts, which either increases the assets or decreases the liabilities. According to the double-entry system, the total debits should always be equal to the total credits. under Income Statement, and a separate provision account is created in the Balance Sheet equivalent to the same amount.
A company selling Air conditioners with a year warranty has to set aside a certain amount as provisions for any claims that may arise during the warranty period. The company determines the Provision amount based on the past claims data for such air conditioners. This amount is debited from the Income StatementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements., thereby reducing the profits. At the end of the year, if the actual claims are less than the amount of provision, the balance amount is reversed back, thereby relinquishing the Provision Liability.
Bank A has granted the following three loans with the details as mentioned below:
Bank A will have to create a provision of 20% on the amount outstanding on each of the above loans as payment has gone past the due date over 90 days thereby classifying them into Non-performing Assets.
Thus Bank A will create a Provision of $56000 by debiting its Income Statement and creating liability under the head Provisions in the Balance Sheet Account.
How to Use Provision?
Provision act as a cushion against future liabilities or on the happening of uncertain events. Instead of impacting the Income Statement in one go, provision help business to create a sinking fundSinking FundSinking funds are a portion of a company's preferred stock or bond indenture set aside for the purpose of repaying debt or replacing a wasting asset at a later date. This is a great tool for achieving an organization's predetermined goals and objectives. type liability account in the Balance Sheet to navigate against such events.
Every business is prone to bad debts, tax liability and so on and these expenses cannot be reliably estimated at the beginning itself, and that’s how provision comes into play by helping businesses better manage such unforeseen but certain events.
When to set aside Provision?
Provision can be set aside when the actual event against which providers are created crystallize. Also, it can be reversed if the actual liability turns out to be less than what was provisioned. It can happen when there is higher than expected recovery, lower than expected claims, and so on.
This article has been a guide to Provisions in accounting and its meaning. Here we discuss how to create it along with examples and its most common types. You may learn more about financing from the following articles –