[Commerce Class Notes] on Difference Between Provision and Reserve Pdf for Exam

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.