The word ‘Provision’ is used to denote an amount written off against or set aside out of profits. It is created to provide for a known liability the amount of which can only be estimated or for a diminution in the value of an asset.
Thus regarding Provisions, there are some important facts that we should remember :
It is a charge against profits and not an appropriation of profits. It should be provided whether there is a profit or loss.
The amount cannot be accurately calculated and can only be estimated.
It is provided for meeting a expected loss or liability and to show the assets and liabilities at their true values.
It is created with a definite objective but the amount charged for it depends upon assumptions or anticipations. For example, liability to pay tax is known liability. A Provision for Taxation is created to meet such liability. But how much should be provided depends on suitable assumptions.
Examples of some common Provisions:
1. Provision for Bad and Doubtful Debts;
2. Provision for Depreciation;
3. Provision for Discounts;
4. Provision for Taxation;
5. Provision for any liability against a disputed claim etc.
Provision for Discount on Creditors:
Sometimes in problems of accountancy, it is seen that few people create a Provision for Discount on Creditors on the anticipation that the creditors will allow some discounts at the time of receiving payments. However this assumption is not appropriate as per the Doctrine of Conservatism where only losses should be anticipated and not profits.
Provision should be created carefully and correctly. Over or under provisioning is bound to affect the annual profits/losses adversely. A Provision is a necessity in the process of measurement of income. But the correctness of its amount decides the correctness of its profit or loss.
Reserve is that part of the profits of the business which is not distributed among the owners of the business and retained within the business. Its purpose is to strengthen the financial position of the business and to meet unforeseen losses.
Thus regarding Reserves, there are some important facts that we should remember:
1. It is an appropriation of profit;
2. It is retained in the business for meeting future needs of unknown nature;
3. It may be used for payment of dividends (except Capital Reserve);
4. It makes a business financially strong.
Watch the video to get an insight and understanding:
Types of Reserves:
Reserves are of two types, namely:
a. Capital Reserves; and
b. Revenue Reserves.
This type of Reserve is created out of profits not arising out of normal trading activities of a business. They are not available for payment of dividends (except in some special cases). A Capital Reserve is generally created out of:
1. Profits from sale or revaluation of fixed assets;
2. Profits made on forfeiture and reissue of shares;
3. Pre-incorporation profits of a company etc..
Capital Reserves are used for the following purposes:
1. To issue bonus shares;
2. To write off premium on redemption of Preference Shares/ Debentures;
3. To write off fictitious assets;
4. To write of expenses/losses on the issue of securities etc..
This type of Reserve is created out of profits arising out of normal trading activities of a business and is available for distribution as dividend. General Reserve, Investment Fluctuation Reserve, Asset Replacement Reserve are common examples of Revenue reserves. They are used for the following purposes:
1. Meeting unknown liabilities, contingencies and losses;
2. Strengthen the financial position of the business;
3. Provide for the cost of replacement of assets;
4. To keep the dividend rate stable in spite of fluctuation in annual profits etc..
Reserves and Reserve Funds
Normally the amount of a Reserve is retained within the business and is locked up in general assets. However it becomes difficult to realise ready cash against such reserves in cases of emergency. So where a reserve is to be maintained for a specific purpose and some ready money is required for the said purpose, the amount of the reserve is invested outside the business in highly liquid securities which are readily marketable. Such kind of reserves which are represented by investments are called Reserve Funds. At the times of need, the investments can be sold and the money can be realised for the specific purpose.
Difference between Reserves and Provisions: The table below lists the main differences between the Reserves and Provisions:
Point of Distinction
Created to face unknown expenses, losses or liabilities that may arise in the future
Created to provide for a known loss, expense or liability whose amount is not known with certainty and can only be estimated.
How it is created?
It is an appropriation of Profit and can only be created if there is any profit in a financial year. The Profit and Loss Appropriation Account is debited for creation of Reserves.
It is a charge against revenue and needs to be created whether there is profit or not. The Profit and Loss Account is debited for creation of the Provisions.
It is created to strengthen the financial position or strength of a business entity. Except in very few cases, it is not mandatorily required to create a reserve.
Provisions are required to be created to depict the true and fair view of the accounting records. Thus provisions are created as per the requirement of the accounting principles (mainly Doctrine of Conservatism)
Reserves are shown in the liability side of the Balance Sheet under the head ‘Reserves and Surplus’
Provisions are usually shown as a deduction from the respective assets in the asset side of the Balance Sheet (e.g. Provision for Depreciation). However in certain cases they are shown in the liability side of the Balance Sheet under the head ‘Current Liabilities’ (e.g. Provision for Taxation)
Free Reserves can be distributed among the shareholders or owners as dividend.
Provisions cannot be distributed among the owners as dividend.
I hope this article helped you to understand the concept of Reserves and Provisions and the distinction between them. Do comment below if you have any suggestions or important facts to add to the above. Hope to see you in my next article. Happy Reading 😉