Lets say you sold a product or service for Rs. 1,000 on credit. After a month the customer paid you Rs.500. So you still have Rs.500 left to collect in your accounts receivables. But after asking for the remaining money a few times you have given up hope that you will get the 500. In this case, you will "write-off" using a contra-account / provision to remove the 500 from the accounts receivable since you are not going to get it back.
Dec 04 2011 09:40 AM
So in the case of accounts receivables, provisions are used to directly reduce the accounts receivable and is not reported under liability. Such provisions are not reported on the income statement as an expense.
But sometimes there are provisions that are not tied to an asset - like money set aside for future legal cases etc - such provisions are reported as a liability and are expensed on the income statement.
Typically provisions are made in advance of the default actually happening, since companies and banks roily know what their default rates will be. Since these provisions are only assumptions of a future write off, no cash has left the company yet, so hence it is a non cash expense.
The current financial crisis is largely because some of the biggest banks had to write off massive amounts of bad debt originating from home loans.