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
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. What is the difference between provision and reserve account?
Provision accounts and reserve accounts are tools used in accounting but serve different purposes. A provision is created to cover a known liability or asset reduction, like bad debts, while a reserve is an amount set aside from profits for general or specific future use, without any certain obligation. Provisions are charged directly to profit and loss, whereas reserves are appropriations from profits.
Understanding this distinction helps in accurate financial reporting and ensures compliance with accounting principles.
2. Are provisions the same as reserves?
No, provisions and reserves are not the same in accounting, even though both involve setting aside amounts from profits. Provisions are made for specific, anticipated expenses or losses, such as provision for doubtful debts or warranty obligations. In contrast, reserves are created by retaining a portion of profits to strengthen the financial position or support business needs, such as a general reserve or dividend equalization reserve. Both are important for accurate financial management, but they address different purposes and situations.
3. What are reserves with an example?
In accounting, reserves refer to profits set aside for specific or general purposes, supporting business stability and growth. For example, a company may transfer part of its annual profit to a general reserve to strengthen its financial position, or create an investment reserve to purchase fixed assets in the future. These amounts are separate from routine business expenses and help companies manage risks effectively. Thus, reserves act as a financial cushion, preparing businesses for unexpected events or planned projects.
4. What are provisions and reserves in trial balance?
Provisions and reserves appear differently on a trial balance due to their distinct roles. A provision for expenses, such as provision for bad debts, is shown on the liability side or deducted from the respective asset. In contrast, reserves like the general reserve appear on the liability side of the trial balance, as they represent appropriations from profits retained in the business for future use. Recognizing both elements in trial balance helps present a more accurate financial position of a company.
5. Why are provisions created in accounting?
Provisions are created to account for expected future losses or liabilities that are probable but uncertain in amount or timing. They help businesses follow the prudence principle, which ensures that expenses and losses are recognized as soon as they are foreseen. Common reasons for creating provisions include:
- Covering bad debts
- Meeting future warranty claims
- Managing pending legal obligations
6. How are reserves used in business?
Reserves serve as a safety net for businesses, allowing them to face unexpected losses or invest in opportunities. For example, a capital reserve can be used for projects like equipment upgrades, while a general reserve helps meet unforeseen obligations. Unlike provisions, reserves are not meant for specific liabilities but can be used according to management's discretion. By building reserves, companies can maintain financial health and support long-term business goals.
7. Can a company operate without creating provisions or reserves?
Technically, a company can operate without making provisions or reserves, but this approach involves considerable risk. Without provisions, potential losses may suddenly impact profits when they occur, instead of being prepared for over time. Similarly, lacking reserves means there is no financial buffer for future growth or emergencies. Most sound accounting practices recommend creating both to promote stability and protect stakeholders' interests.
8. Are reserves mandatory as per accounting standards?
Generally, creating reserves is not mandatory under most accounting standards except when specific regulations require them, such as a capital redemption reserve in the case of share buybacks. However, creating reserves is a good practice for risk management and future planning. Provisions, on the other hand, are often mandatory to comply with the prudence concept if future liabilities can be reasonably estimated. Therefore, while reserves are optional and strategic, provisions are a required part of accurate accounting.
