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2018

Understanding Provisions and Accounting Treatment of Provisions

Understanding Provisions and Accounting Treatment of Provisions

At the end of the financial year when books of accounts are closed, certain provisions need to be created. The practice of creating provisions is in line with Matching Principle of Accounting. According to Matching principle, expenses incurred in a financial year must be recorder in the same financial year to which it relates. However, sometimes the exact amount of expense is not known at the end of financial year. Provision is created in order to recognize such accrued expenses for which exact amount is not yet known. Hence, a Provision for expense basically recognizes the liability of an organisation towards expenses related to a financial year. Please refer to the below points to further understand provisions.

Provision is an account which recognizes a liability of an entity. Such liabilities are normally related to unpaid expenses. Hence, the recording of the liability in the balance sheet is matched to an expense account in the entity's P&L A/c.
The main purpose of a provision is to adjust the current year balance sheet and P&L A/c so that they reflect true and fair view of an entity's financial position. If expenses accrued in a financial year are recorder in the next year in which invoices are received, the statements of accounts would be misleading to the stakeholders.

Provisions and International Financial Reporting Standards (IFRS):
Guidelines pertaining to Provisions are prescribed in "IAS 37: Provisions, Contingent Liabilities and Contingent Assets" According to IFRS (IAS 37) Provision is defined as "A provision can be a liability of uncertain timing or amount. A liability, in turn, is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits"
When to create a Provision?

There are certain factors which must be kept in mind while determining when provision for certain expense should be created. Not all obligations can be treated as provisions.
An entity has a present obligation as a result of a past event occurred in relation to a financial year in which provision is to be created.
It is probable that obligation shall cause an outflow of monetary resources to settle such obligation in next financial year.
A reliable estimate can be made of the amount of the obligation at present.
The standard also provides for measurement methods of provisions. The standard requires that the entity recognizes a best estimate of the amounts needed to settle the obligation.
Accounting Treatment of Provisions:
As discussed, the purpose of creating provision is to recognize present obligation of an entity in relation to an expense whose benefits are received in the current financial year but exact amount of expense is not yet known. In accounting terms, a provision account is a current liability and shown on the Liability side of the balance sheet. Similarly, the expense for which provision is created is recognized in the same financial year and recorded on debit side of P&L Account.

 

  • Journal Entries for Provisions for Expenses at the end of Financial Year:

 

Date Particulars Dr. Cr. Under Group
31st March

Expense A/c
To Provision for Expense

Indirect Expense
Provision

 

  • Effect on respective Ledgers:

 

Expense Ledger
Particulars Debit Particulars Credit
To Provision for Expense By P&L Account
Provision for Expense Ledger

 

Provision for Expense Ledger
Particulars Debit Particulars Credit
By Expense
To Balance C/F

 

Profit & Loss Account
Particulars Debit Particulars Credit
To Expense
Balance Sheets
Liability Amount Assets Amount
 Provisions:
Provision for Expense 

 

  • Reverse Entry in next financial year:

 

Date Particulars Dr. Cr. Under Group
1st April

Provision for Expense A/c              Dr.  
To Expense

    Provision
    Indirect Expense

 

  • Entry when actual invoice is received for the expense:

 

Date Particulars Dr. Cr. Under Group
Date of Invoice

Expense A/c                        Dr. 
To Party

    Indirect Expense
    Sundry Creditors

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