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 primary difference between a provision and a reserve in accounting?
The primary difference lies in their fundamental purpose and accounting treatment. A provision is a charge against profit created to meet a known liability or a probable loss, the exact amount of which cannot be determined with certainty. In contrast, a reserve is an appropriation of profit set aside to strengthen the company's financial position, meet future contingencies, or fund growth. Provisions are mandatory to ascertain the true profit, while reserves are created at the discretion of the management.
2. Why is it necessary for a business to create provisions?
Creating provisions is essential to adhere to key accounting principles and present a true and fair view of the financial statements. It follows the Prudence Principle (or Conservatism), which requires businesses to account for all anticipated losses but not for anticipated profits. It also supports the Matching Principle by ensuring that expenses (even if estimated) are matched with the revenues of the period in which they are incurred, leading to an accurate calculation of net profit.
3. Can you give a common example of a provision and a reserve?
Certainly. A common example of a provision is the 'Provision for Doubtful Debts', created to cover potential losses from customers who may not pay their dues. An example of a reserve is the 'General Reserve', which is an amount set aside from profits without any specific purpose, intended to be used for future business needs or to cover unexpected losses.
4. How do provisions and reserves affect a company's net profit and Balance Sheet?
Provisions directly impact the net profit, while reserves are created after its calculation. Here’s how:
- Provisions: A provision is treated as an expense and is debited to the Profit & Loss Account. This reduces the net profit for the accounting period. On the Balance Sheet, it is either shown as a liability or as a deduction from the concerned asset.
- Reserves: A reserve is an appropriation of profit, meaning it is created from the net profit available for distribution. It is debited to the Profit & Loss Appropriation Account. Thus, it does not reduce the calculated net profit but reduces the profit available for dividends. On the Balance Sheet, it is shown under the head 'Reserves and Surplus' on the liabilities side. You can find more details in the Class 11 Accountancy Chapter 7 notes.
5. Can the funds set aside for a provision be used for any other purpose?
No, the amount set aside for a provision is for a specific, anticipated liability. For example, 'Provision for Warranty Claims' can only be used to settle warranty claims from customers. Using it for any other purpose, like distributing dividends or covering a different type of loss, would violate accounting principles and misrepresent the company's financial health. Reserves, particularly General Reserves, offer more flexibility.
6. What is the difference between a provision and a contingent liability?
A provision is created when a liability is probable and its amount can be reliably estimated. It is recorded as a liability in the Balance Sheet. In contrast, a contingent liability is a possible obligation that depends on the outcome of an uncertain future event. Since its occurrence is not probable or its amount cannot be estimated, it is not recorded in the books. Instead, it is disclosed as a note to the financial statements, for example, a pending lawsuit against the company.
7. What are the main types of reserves a company can create as per the CBSE syllabus?
According to the Class 11 Accountancy syllabus, reserves are broadly classified into two main categories:
- Revenue Reserves: These are created out of profits earned from the normal operating activities of the business. They can be further divided into General Reserve (no specific purpose) and Specific Reserves (e.g., Debenture Redemption Reserve, Dividend Equalisation Reserve).
- Capital Reserves: These are created out of capital profits, which are non-operating gains. Examples include profit on the sale of fixed assets or premium received on the issue of shares. For more practice, you can refer to important questions for Class 11 Accountancy Chapter 7.
8. Is it possible for a company to have high reserves but low cash?
Yes, it is entirely possible. Reserves represent accumulated profits that have been retained in the business rather than distributed as dividends. These retained profits are not necessarily held as cash. They are often reinvested back into the business to purchase fixed assets, finance working capital, or expand operations. Therefore, a company's Balance Sheet can show significant reserves under 'Reserves and Surplus' while its 'Cash and Bank Balances' might be low.
