In this web article we will also discuss:
1. Nature of Reserves or Provisions
2. Differences between reserves and provisions
3. Secret Reserves
Provisions are for known liability or losses, the amount of which cannot be determined with substantial accuracy. In order to ascertain, profit or loss as accurately as possible, it is necessary to make careful estimates of the amounts of such known liabilities or losses and charge these sums against revenue as representing losses or expenses of the period. The amounts so set aside are termed as ‘provisions’ .
Well, both interest and depreciation are an expense. But there is a small difference between the two. Interest is certain, the amount is accurate. It is a specific expense. Depreciation too is certain but the amount is estimated. Depreciation cannot be determined with accuracy. It depends upon the cost of the asset, its estimated life and estimated scrap value.
Since the life and the scrap value of the asset cannot be determined with accuracy, the amount of depreciation remains an estimate. Here depreciation is a provision. Every year some debts go bad. But no body can tell with accuracy as to how much debts will go bad. Bad debts are certain but the amount is not.
Since bad debts are certain, some amount must be kept aside to meet such a loss. But since the loss cannot be determined with accuracy, the amount set aside is an estimated amount. This is provision for bad debts.
Again every year, some discount is allowed to debtors for prompt payment, but no body can tell with accuracy as to how much debts will be collected promptly. Therefore, the amount of discount cannot be calculated with accuracy. Discount is certain but amount is not. The amount kept aside to meet the expense on account of discount can only be an estimate. It is called ‘provision for discount’.
Again, every year some amount is spent on repairs. But no body can tell with accuracy as to how much amount will be spent on repairs. Repairs are certain but the amount is not. Thus, some amount must be retained to meet the expenses on repairs. But since the amount cannot be determined accurately, the amount set aside is an estimated amount. This is ‘Provision for repairs’.
Provisions must be created, whether, there is any profit or not. They must be created even if there is a loss. Thus, one cannot find out profit or loss, without creating provisions. In short, two things are certain about provisions:
(a) they are essential
(b) they are estimated
