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. ●
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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.