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Short Storyline
Imagine you run a manufacturing company. You know that at the end of the year, you will need to pay a warranty claim of ₹50,000 for faulty products. Even though you haven’t paid yet, you set aside money now to cover this future expense.
This amount is called a provision, and it ensures that the company is financially prepared for expected costs. But how do we record provisions in accounting? 🤔
Let’s break it down step by step!
What is a Provision in Accounting?
A provision is an amount set aside from profits to cover an expected liability or future expense. Unlike accruals, provisions are recorded for uncertain future costs, where the exact amount or timing may not be fully known.
Real-Life Example
- A company sells electronics with a 1-year warranty.
- Based on past experience, 5% of products will require repairs, costing approximately ₹1,00,000 per year.
- The company records a provision of ₹1,00,000 as an expense in the current year, even before the actual repair costs occur.
✅ Recognizes expected future costs
✅ Reduces sudden financial shocks
✅ Follows the prudence principle
Key Features of Provisions
✅ Recorded as a liability because it represents a future obligation.
✅ Helps smooth out expenses over multiple periods.
✅ Follows the matching principle—expenses should match the revenue they help generate.
Types of Provisions in Accounting
| Type | Explanation | Example |
| Provision for Bad Debts | Money set aside for expected customer defaults | A business expects 2% of credit sales to become bad debt |
| Provision for Tax | Expected tax liabilities for the year | A company estimates ₹5,00,000 in taxes before final tax payment |
| Provision for Warranty | Anticipated costs of repairing faulty products | A mobile company expects to spend ₹2,00,000 on warranty claims |
| Provision for Depreciation | Estimated loss in asset value over time | A company sets aside ₹50,000 yearly for asset wear and tear |
| Provision for Legal Cases | Funds reserved for potential lawsuit costs | A company facing a customer lawsuit estimates ₹3,00,000 in legal fees |
Provision vs. Accrual: What’s the Difference?
| Feature | Provision | Accrual |
| Definition | Amount set aside for an expected future expense | Records expenses when incurred, even if unpaid |
| Uncertainty | Future cost is uncertain (estimate-based) | Future cost is certain (amount and timing known) |
| Example | ₹1,00,000 set aside for warranty claims | Electricity bill incurred in December, paid in January |
What is the Journal Entry for Provisions?
Example 1: Creating a Provision for Warranty
A company expects ₹50,000 in warranty claims at year-end.
Journal Entry (Provision Created)
Debit: Warranty Expense ₹50,000 (Expense recognized)
Credit: Provision for Warranty ₹50,000 (Liability created)
Narration: “Recorded ₹50,000 as a provision for expected warranty claims.”
Example 2: Using the Provision When the Expense Occurs
A company actually pays ₹30,000 in warranty claims the next year.
Journal Entry (When Provision is Used)
Debit: Provision for Warranty ₹30,000 (Reducing liability)
Credit: Cash/Bank ₹30,000 (Payment made)
Narration: “Paid ₹30,000 for warranty claims using the provision balance.”
If the actual expense is more than the provision, the extra amount is recorded as an additional expense.
Real-Life Example
A company expects a lawsuit settlement of ₹2,00,000 next year. To avoid sudden financial stress, it records a provision now.
- Recording the Provision (Current Year)
Debit: Legal Expense ₹2,00,000
Credit: Provision for Legal Case ₹2,00,000
- When Payment is Made (Next Year)
Debit: Provision for Legal Case ₹2,00,000
Credit: Cash/Bank ₹2,00,000
This ensures the expense is recognized before it happens, making financial statements more accurate.
Where Does Provision Appear in Financial Statements?
Balance Sheet (After Creating Provision)
Provisions appear under Liabilities as they represent amounts set aside for future expenses.
Balance Sheet
————————————–
Credit (Cr) | Debit (Dr)
————————————–
Liabilities | Assets
– Provision for Tax ₹5,00,000 | – Cash ₹10,00,000
————————————–
Profit & Loss Statement (Provision as an Expense)
Provisions are recorded under Operating Expenses, reducing net profit.
Profit & Loss Statement
————————————–
Credit (Cr) | Debit (Dr)
————————————–
Revenue | Expenses
– Sales Revenue ₹10,00,000 | – Provision for Tax ₹5,00,000
| – Rent Expense ₹1,00,000
————————————–
Net Profit: ₹4,00,000
————————————–
How to Calculate Provision?
Formula:
Provision = Expected Cost × Probability of Occurrence
Example Calculation:
- A company expects ₹50,000 warranty claims with a 90% chance of occurrence.
- Provision for Warranty = ₹50,000 × 90% = ₹45,000
Why Are Provisions Important?
✅ Prepares businesses for future expenses
✅ Prevents sudden financial shocks
✅ Ensures accurate financial reporting
Common Mistakes to Avoid
🚫 Underestimating provisions – Can lead to unexpected financial strain.
🚫 Recording provisions too late – Expenses may not match the correct financial year.
🚫 Overstating provisions – Can artificially reduce profits, misleading investors.
Relevant Accounting Standards (GAAP, IFRS, IAS)
- IAS 37 – Provisions, Contingent Liabilities & Assets
- IFRS 9 – Financial Instruments (For credit loss provisions)
- US GAAP (ASC 450) – Contingencies
For more details, check GAAP vs. IFRS Differences.
FAQs
1. Is Provision an Asset or a Liability?
✅ Liability – Represents future obligations the business expects to pay.
2. Where Does Provision Appear in the Profit & Loss Account?
Under Operating Expenses if related to business operations.
3. How Does Provision Affect Financial Statements?
- Increases expenses in the Profit & Loss Account.
- Creates a liability in the Balance Sheet.
4. What is the Difference Between Provision and Reserve?
| Feature | Provision | Reserve |
| Purpose | Covers expected liabilities | Retained earnings for business growth |
| Accounting Treatment | Expense | Equity |
5. Can Provisions Be Reversed?
✅ Yes, if a provision is no longer needed, it is reversed:
Debit: Provision Account ₹5,000
Credit: Other Income ₹5,000
Conclusion
Provisions help businesses prepare for future liabilities, ensuring that financial statements reflect realistic expenses. Whether for bad debts, warranties, or legal cases, correctly recording provisions improves financial planning and stability.