Financial institutions such as banks, insurance firms, hedge funds or brokerages record provision expenses in their accounting ledgers to reflect the possibility that they may not recover full payment of loans from borrowers. These provisions help the lender to present an accurate picture of its financial strength.
When circumstances arise that make it doubtful that a borrower will be able to repay a loan properly, the lender may reduce the loan value in its ledgers to reflect the probability of loss. This is done not by actually changing the receivable due, but by recording a provision for that portion of the debt the lender considers in jeopardy.
Recording a provision expense allows a bank to report accurate asset values in financial reports while simultaneously reporting accurate loan balances. A loan represents an asset to a lender. Incorrect loan values affect working capital calculations. Working capital indicates a company's short-term cash levels and equals current assets minus current debt. If a lender learns that a borrower may not be able to pay off a loan satisfactorily, it must indicate that fact in its ledger so that it doesn't work with working capital figures that are misleading.
To record a provision expense, an accountant debits the provision expense account and credits the loan receivable account. Provision expense often is called bad debt or doubtful accounts expense. The accountant reports provision expenses in the statement of profit and loss, otherwise known as the statement of income.
