In every business entity, there are certain expenses/losses which are related to the current accounting period but amount of which is not known with certainty because they are not yet incurred. It is necessary to make provision for such items for ascertaining true net profit.
For example, a trader who sells on credit basis knows that some of the debtors of the current period would default and would not pay or would pay only partially. It is necessary to take into account such an expected loss while calculating true and fair profit/loss according to the principle of Prudence or Conservatism. Therefore, the trader creates a Provision for Doubtful Debts to take care of expected loss at the time of realisation from debtors. In the same manner, Provision for repairs and renewals may also be created to provide for expected repair and renewal of the fixed assets.
Examples of provisions are:
- Provision for depreciation;
- Provision for bad and doubtful debts;
- Provision for taxation;
- Provision for discount on debtors; and
- Provision for repairs and renewals.
In the balance sheet, the amount of provision may be shown either:
By deducting it from the concerned asset on the assets side.
By showing it on the liabilities side of the balance sheet along with current liabilities, for example provision for taxes and provision for repairs and renewals.