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Accounting for provisions

M.V. KALI PRASAD
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The accounting department merely makes an entry for the provisions as suggested by other departments.

M.V. KALI PRASAD
M.V. KALI PRASAD

A provision is an expenditure relating to a particular accounting period, but not falling due on the date of financial statements. Since the expenditure relates to a particular financial period, a provision needs to be made against the revenue generated in the said accounting period, failing which, the financial statements cannot be said to be showing a true and fair view. A provision can be an estimate as in the case of provision for doubtful debts or accurate as in the case of audit fee.

Provisions have to be properly calculated based on information available. Few provisions will be known from the information available after the date of the balance sheet.

Provision for income tax is calculated after the audit is completed and is sewn in to the financial statements to make the statements acceptable.

Some of the provisions are to be made based on a contract. Provision for audit fee is to be made based on the terms of engagement. A service contract such as maintenance contracts also have to be accounted based on the terms of the contract.

Some of the provisions are purely approximation based on past experience. When a computer or a TV is sold, the item comes with a manufacturer's warranty, which may extend beyond the date of the Balance sheet. How much of the liability is likely to arise after the date of balance sheet is an approximation.

Certain of the provisions are mandatory as in case of insurance companies which provide for unexpired risk.

ORIGIN OF PROVISIONS

It is the respective departments (and not the accounting department) which have to calculate the provisions to be made for the activities related to the respective department. Sales department has to make the estimate of sales tax to be paid. HR department has to calculate the provision to be made for bonus; Service department has to make the estimate of after sales service to be made to the goods sold etc.

The accounting department merely makes an entry for the provisions as suggested by the departments.

How much of a provision is to be made and whether it is justified are to be judged by taking in to account the other information available in support of the transaction. Arithmetical calculations, provisions of law, position of pending suits, perceptions of the management etc need to be considered while making a provision.

Banks do not pay interest on overdue deposits. But, if the deposit is renewed on a subsequent date, interest can be paid for the intervening period.

If a deposit matured say, during December, 2010 and it is not renewed till March 31, 2011, the bank would not be justified in making a provision for interest on overdue deposit for the period December 2010 to March 2011. If the depositor renews the deposit some time during April 2011, the payment of interest from December 2010 to the date of renewal arises on the date of renewal.

However, considering that the amount is kept deposited with the bank for the intervening period, the Reserve Bank of India has issued certain guidelines for making a provision under these circumstances.

ACCOUNTING TREATMENT

A provision can be created only for an expenditure which accrues, and not for an expenditure which arises. Liability to pay insurance premium arises on the due date and it does not accrue over a period of time. It would be improper to make a provision for it..

Provisions are brought into existence by way of a journal entry at the end of the year. Making provisions is a part of the year-end procedures. As against the common belief that provisions are a charge against profit, they can as well be an appropriation out of profits as in the case of proposed dividends.

A provision may be made against an anticipated expenditure or against an anticipated loss. A provision for anticipated expenditure is to be disclosed under the head ‘current liabilities and provisions' whereas a provision for an anticipated loss (provision for doubtful debts) is to be shown as a deduction from the asset which is likely to result in a loss.

This is the logic behind disclosing provision for doubtful debts as a deduction from ‘sundry debtors' and not under the head ‘current liabilities and provisions'.

Once a provision is made, the relevant loss or expenditure has to be debited to the provision account. It is not a sound accounting policy to reverse the entry for provision and record the expenditure in the subsequent accounting period.

As discussed above, if a provision is made by a bank for interest on overdue deposits, the provision needs to be carried in the financial statements and any such interest paid upon renewal is to be debited to such provision account only.

It would not be proper to reverse the entry every month and debit interest account on renewal of the deposit. An excess provision not any more required can be written back to the profit and loss account (as in the case of provision for doubtful debts) or to the general reserve (as in the case of proposed dividends) depending upon the nature of the provision.

Where accrual basis of accounting is followed, a provision would be admissible as a deduction in so far as it relates to expenditure (provision for audit fee). But a provision for an anticipated loss has to be considered on a case-to-case basis. A provision for doubtful debts is not admissible as a deduction.

AUDIT OF PROVISIONS

An auditor has to be satisfied on the following grounds:

The provision is permissible under law and is required to be made;

Certain of the expenditure requiring a provision but not provided for does not escape the attention of the management as well as the auditor;

The provision is justified as on the date of the financial statements;

Quantification of the provision;

Proper accounting treatment, whether it has to be a charge or an appropriation out of profit;

Disclosure of the provision; and

Adequacy of the provision to ensure that there is no excess provision or under-provision.

(This article was published on April 17, 2011)
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