What is Reserve?
Reserves are funds set aside from profits (retained earnings) for a specific purpose or for general future needs. They are used to strengthen the financial position of the company or prepare for future planned expenses. For example, a company may create a reserve for business expansion, equipment replacement, or as a contingency against future uncertainties. Reserves can be freely used by the company and are considered part of the company’s profit.
There are two main types of reserves: revenue reserves, which can be distributed as dividends, and capital reserves, which generally cannot be distributed as dividends and often originate from profits from non-operating activities.
What is Provision?
Provisions, on the other hand, are amounts set aside to cover a likely future liability or reduction in the value of an asset whose exact amount is uncertain but can be estimated with reasonable accuracy. Provisions are recognized as liabilities on the balance sheet.
Examples of provisions include allowance for bad debts (uncollectible accounts receivable), provision for warranties (where a company expects to pay for repairs or replacements under warranty), or provision for income taxes (where the company expects to pay taxes on its income).
The creation of provisions is governed by the principle of conservatism in accounting, which states that potential losses should be recorded as soon as they are expected, while potential gains should only be recorded when they are realized.
Reserve vs Provision: Key Differences
| Criteria | Reserve | Provision |
|---|---|---|
| Definition | Reserves are appropriations of profits set aside for specific purposes or contingencies. | Provisions are liabilities or expenses that are recognized on the balance sheet when there is uncertainty about their timing or amount. |
| Purpose | Reserves are created to strengthen the financial position of the company or to meet specific future needs. | Provisions are made to account for potential future liabilities or losses that are probable but uncertain in terms of timing or amount. |
| Nature | Reserves are not necessarily tied to specific liabilities; they are more discretionary and can be used for various purposes. | Provisions are specific and recognized based on estimated future obligations or losses. |
| Legal Requirement | Reserves are not required by law, and their creation is typically a management decision. | Provisions are often made in accordance with accounting standards and may be required by law. |
| Reversibility | Reserves may be reversible, meaning they can be utilized for other purposes or released back to the income statement if the need diminishes. | Provisions are usually only reversed when the uncertainty is resolved, and it becomes certain that the obligation will not materialize. |
| Disclosure | Reserves may or may not be separately disclosed in the financial statements; it depends on the accounting policies of the company. | Provisions are generally disclosed in the financial statements, providing details about the nature and amount of the obligation. |
| Examples | Examples of reserves include general reserves, contingency reserves, and dividend equalization reserves. | Examples of provisions include bad debt provisions, warranty provisions, and restructuring provisions. |
| Impact on Profit | Creating a reserve does not directly impact the income statement; it is more of an allocation of profits for a specific purpose. | Recognizing a provision directly reduces the profit in the income statement, reflecting the anticipated future expense. |
Reserve and Provision: Key Takeaways
- Reserve is used to cover short-term cash needs whereas provision is used to cover probable losses.
- Reserve is effected at the time of raising funds whereas provision is made during the year based on need.
- Reserve and provision are both classified under liabilities in the books of accounts.
- All the reserves are charged to revenue or expense except reserve for depreciation in fixed assets.
- Provision can be created after a loss, whereas reserves should be created before an expected loss.
- When a company wants to raise funds, it raises a reserve and not a provision. A company cannot raise a provision from another business entity where it has provided funds as per agreement unless mutually agreed upon otherwise.
- A provision can be classified under income with a corresponding entry in the income statement whereas reserve is not recognized as income.
- The accounting cost of provisions can be deducted from profit to arrive at net profit.
- Provision for depreciation is created for the expected removal of fixed assets over some time and is recognized as an expense if the fixed asset is not expected to be utilized beyond a certain period.
- Provisions should be original/created from the entity’s resources and should not be raised from another business entity where the funds have been provided for some other purpose.
- Provisions are subject to other provisions recorded on other related accounts such as accrued salaries, accrued interest, inventory discounts, etc.