Difference between provision and reserve

Difference between Provision and Reserve

While a provision is a charge against profits, a reserve is an appropriation of profits. In this blog post, we have discussed the differences between the two.

What is a Provision?

It is a widely established accounting principle that when calculating income for an accounting year, all potential losses and expenses must be considered. As a result, we normally account for depreciation on fixed assets as well as repairs, renewal, and so on. Similarly, there may be liabilities/losses whose amounts cannot be determined with reasonable certainty such as dispute claims for damages, bad debts, and so on. Before calculating the net profit, we must charge their expected amounts to the Profit and Loss Account. This charge is known as “Provision”.

A provision is to be made in respect of a liability that is certain to be incurred but the exact amount is unknown.

It is charged on an estimate basis in the Profit and Loss Account.

It should be apparent that a provision need not be made if the amount of a known liability can be established with reasonable precision. In that case, there won’t be any need to make a provision or arrangement for such liability. Because it shall be recorded as a liability itself.

What is a Reserve?

A portion of the profit may be set aside and kept within the business in order to address future needs like growth and expansion or to meet unforeseen expenses like workers’ compensation.

This amount set aside from profits is known as a reserve. It is not a charge on the profits; rather, it is an appropriation of the profits.

When times are tough, the business uses the amount of profits so retained. Reserves are not charged to the profit and loss account since they are neither expenses nor losses; rather, they are debited to the profit and loss appropriation account, which is created after the profit and loss account.

Utilization of reserves is also known as “ploughing back of profits”. Also, where the amount of reserve is invested outside the business, it is referred to as “Reserve Fund”.

Types of reserves

Reserves can be mainly of three types:

1. General reserves or revenue reserves:

If the objective of the reserve is to meet any unanticipated contingency (unknown liability) in the future, the reserve is referred to as a “General Reserve”. These are kept in order to strengthen the enterprise’s financial position. These reserves are also known as Revenue Reserves.

2. Specific reserves:

Reserves that are designated specifically for a particular purpose and can only be used for that purpose are known as specific reserves. Examples of Specific Reserves are “Dividend Equalization Reserve” and “Reserve for Replacement of Asset.”

3. Capital reserves:

In addition to the regular profits, the business also makes capital profits from a variety of sources. Capital reserves are those that are built up from capital profits such as Profit on sale of any fixed asset, Profit on revaluation of assets, and Profit prior to incorporation of the company. Capital reserves can be utilized for writing off capital losses.

What is the difference between Provision and Reserve?

The following points can be used to set out the difference between a reserve and a provision:

1. Treatment against profits

  • Provision is a charge on profits, which means that provision must be made regardless of whether the business enterprise is profitable or losing money.
  • A reserve is an appropriation of profits and not a charge on the profits. It is to be created out of adequate profits only.

2. Debited to

  • Provisions are created by debiting the profit and loss account whereas reserves are created through the profit and loss appropriation account.

3. Purpose

  • Reserves are created to enhance and strengthen the financial position of the business enterprise. It helps a business to face unforeseen liabilities.
  • Whereas a provision is created to meet a known liability, the amount of which cannot be calculated accurately.

4. Investment outside the business

  • A company may invest reserves outside the business but provisions cannot be invested outside the business.

5. Necessity

  • The creation of provision is necessary as per law and generally accepted accounting principles in order to account for known liabilities.
  • The creation of reserves is usually not necessary. They are made as a matter of prudence.

6. Effect on Net profit and taxable profits

  • The creation of provisions reduces the amount of net profit. Hence, it reduces taxable profits.
  • The creation of a reserve reduces the divisible profits but not the net profit. Since it is created from profit after tax, therefore, it has no effect on taxable profits.

7. Examples

  • Examples of provisions can be Provision for Depreciation on assets, Provision for Repairs and Renewals of assets, Provision for Taxation, Provision for Discount on Debtors, Provision for Bad and doubtful Debts, etc.
  • Examples of reserves are General Reserves, Dividend Equalization Reserve, etc.

8. Disclosure

  • Reserves are shown under the head “Reserves and Surplus” on the liabilities side of the balance sheet after capital.
  • On the other hand, a provision is shown either (a) by way of deduction from the concerned item on the asset side for which it is created, or (b) on the liabilities side along with current liabilities.

9. Dividend distribution

  • Provisions cannot be used for the distribution of dividends among shareholders but general reserves can be used for dividend distribution.

Key Takeaways: Comparison Table differentiating Provision and Reserve

PurposeTo meet a known liability such as liability for depreciation/renewal of assets.To meet unexpected contingencies likely to arise in future
UtilizationOnly to meet the specific purpose for which provision was madeCan be utilized for a future liability or loss
TreatmentCharge against profitsAppropriation of profits
In case of no profitsNeed to be made even if there are no profitsOnly when there are sufficient profits
Net profitMust be debited before arriving at the figure of net profitCreated from net profit after tax; represents undistributed profits
DividendCannot be used for payment of dividendCan be used for the payment of dividends (except in some cases)
InvestmentCannot be invested outside the businessIt may be invested outside the business
NecessityNeeded in order to ascertain the true profit/loss in compliance with Prudence or Conservatism conceptDiscretion of the management
ExamplesProvision for Depreciation on assets, Provision for Repairs and Renewals of assets, Provision for Taxation, etc.General Reserves, Reserves for Expansion, Reserve for Equalization of Dividends, etc.
Difference between Provision and Reserve

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