Provision vs. Reserve: Key Differences

Commerce

Provision vs. Reserve: Key Differences

Reviewed by:

Dimple Tiwari

Provision And Reserve Difference Introduction

As we all are aware that businessmen prepare their accounts on the basis of the going concern concept assuming that their business will continue for an indefinite period of time. Therefore, in order to ascertain the net profit of a business each year, businessmen not only consider current contingencies but also future contingencies. In reality, provision and reserve are the terms that are actually related to the future needs for which part of the current earnings has to be set aside. But there are few points of differences between provision and reserves which we will learn through this article.

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What Does The Term Provision Mean In Accounting?

Provision is an amount that is put away from the profit earned by the company to cover expected losses or expenses even though the specific amount might be unknown. A provision is considered as a form of saving, rather, it is identified as an upcoming liability.

Sometimes IFRS calls the provision a reserve, however, both the terms are not interchangeable. The provision aims to cover business liabilities that might occur in the near future whereas reserve is a part of business profit that is put away to enhance the financial position of a company through expansion or growth.

Needs For Provision In Business

Depreciation, renewal, or reduction in the asset value.
A disputed claim
Redemption of Liability
Writing off bad debts/doubtful debts
Contingent Liabilities
A known liability, for which amount cannot be determined with accuracy.
Specific loss on payment of taxes or realization of an asset

General Rules In Creation of Provision

Provision is created by debiting a profit and loss account.
Provision is created to meet liability that is known or for any specific contingencies. For example, provision for doubtful debts, provision for depreciation, etc.
A provision is created to meet the known liability or contingencies.
It is not available for distribution as a dividend among the shareholders.
A provision is set for a definite amount, and hence, a definite amount is set aside every year to meet the known contingencies.
A provision is generally represented on the liability side of the balance sheet.

What Does The Term Reserve Means In Accounting?

Reserves are also known as retained earnings. Retained earnings are defined as a part of the business profit that has been set aside to strengthen the financial position of a business. Reserves are often used to repay debts, purchase fixed assets, fund expansion, or payment of bonuses or dividends. In accounting, the different types of reserves have several purposes and come from distinct income streams, but two of the most common types of reserves are capital reserves and revenue reserves.

Types of Reserves

The two most common types of reserves are:

1.Revenue Reserves: Revenue reserves arise from a company’s net profit earned through normal, daily operations. The revenue reserves are generally employed by business for small or short-term purposes, business expansion, contingencies which are liabilities that could potentially occur. Revenue reserves are further categorized as:

General Reserve: General reserved by its name implies that is not laid aside for any specific purpose. It can be used to meet any future contingencies or unknown liability. It is not mandatory to create a general reserve. These reserves are created only when the company earns sufficient profit. The object of this reserve is to strengthen the financial position of the business. It is recorded on the debit side of the profit and loss appropriation account.
Specific Reserves: As the name suggests, specific reserves are set aside for a specific purpose. It is utilized for only that purpose for which it is created and not for the other purpose. Whether a business earns profit or losses, it is obligatory for it to create reserves for specific purposes. It is shown on the debit side of the P&L account.

2. Capital Reserves: A capital reserve is usually created out of a profit which is capital in nature such as capital gains, premium on issue of shares or debentures, profit prior to incorporation, profit on revaluation of asset or liabilities, etc. It should not be used to distribute a dividend among the shareholders. Instead, it is used to strengthen the financial position of the business, or to write off the capital loss or losses of abnormal nature.

Difference Between Provision And Reserve: Tabular Representation

Point of Difference	Reserves	Provision
Method of Creation	The reserves in the business are created by debiting profit and loss appropriation account	The provisions are created by debiting profit or loss account
Need	The creation of reserves depends upon the financial policy of business	The creation of provision is used as it depends upon the financial emergency of a business.
Objective	A reserve is a total of known liability	A provision is a total of unknown liability
Necessity For Creation	It is not necessary to create reserves as it totally relies on the business policy	The creation of provision is not compulsory.
Utilization	The amount can be utilized for any other purpose for which they are created because they represent undistributed profit.	The amount cannot be utilized for purposes other than for which it is created.
Nature	Reserves are an appropriation of profit. It implies that reserves are created only if the business earns profit, else no reserves are created.	Provisions are charged against profit. It implies if there is a loss in a business, provision is a must, and hence it is compulsory for the company to create provisions.
Feature	It strengthens the financial position of the business. Reserves are added to the amount of working capital.	Provisions are created to meet a specific loss on realization of assets or an accrued liability. It is also used for meeting out an unanticipated loss or liability.
Amount	The amount of reserve depends upon the management policy and judgments.	The amount of provision cannot be accurately determined at the date of the balance sheet, though the liability is known.
Available For Distribution of Dividend	It can be used to distribute dividends among the shareholders.	It cannot be used to distribute dividends among the shareholders.

Conclusion

In short, a reserve is an appropriation of profit or accumulated profit to strengthen the financial position of a business whereas provision is an amount that is kept aside to meet the expected loss/expense.

FAQs on Provision vs. Reserve: Key Differences

1. How are reserves recorded in accounting?

To record reserves, you need to first debit your retained earning account for the same amount you are allocating to the reserves. Then you will balance the debit with the equivalent credit by crediting the same account to the reserves account. For example, if your business has not updated the machinery in a while as you have to spend ₹ 25000 for its potential repairs. To do this, you simply need to debit the retained earning account for ₹ 25000 and credit the reserve account for the same amount i.e.₹ 25000, hence balancing your account.

2. How are provisions recorded in account?

Provisions are recorded as an expense in the income statement. Also, they are recorded on the balance sheet as a liability as they represent a future obligation where the liability amount can be reliably estimated but is not known for certain.

3. Is the amount of provision and reserves can be used for any other purpose?

The amount of provision cannot be used for any purpose other than for which it is created whereas the amount of reserves can be used for any purpose because they represent an undistributed profit.