RESERVE AND A PROVISION– ALL YOU NEED TO KNOW
A reserve is an appropriation of profits for a specific purpose. The most common reserve is a capital reserve, where funds are set aside to purchase fixed assets. By setting aside a reserve, the board of directors is segregating funds from the general operating usage of the company.
There is no actual need for a reserve, since there are rarely any legal restrictions on the use of funds that have been “reserved.” Instead, management simply makes note of its future cash needs, and budgets for them appropriately. Thus, a reserve may be referred to in the financial statements, but not even be recorded within a separate account in the accounting system.
“Any amount written off or retained by the way of providing depreciation or diminution in the value of assets or for providing any known liability of which the amount cannot be determined with substantial accuracy.”
A provision is the amount of an expense or reduction in the value of an asset that an entity elects to recognize now in its accounting system, before it has precise information about the exact amount of the expense or asset reduction. For example, an entity routinely records provisions for bad debts, sales allowances, and inventory obsolescence. Less common provisions are for severance payments, asset impairments, and reorganization costs.
“That portion of earnings, receipts or other surplus of an enterprise (whether capital or revenue) appropriated by the management for general or a specific purpose other than a provision for depreciation or diminution in the value of assets or for a known liability.”
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.
Meaning of Reserves
Reserve is an appropriation of profits; on the other hand, Provision is a charge against profit. Reserves are not meant to meet out contingencies or liabilities of a business. Reserve increases working capital of a company to strengthen the financial position.
There are two types of reserves −
- Capital Reserve − Capital reserve is not readily available for distribution as the dividends among the shareholders of the company, and it creates only out of capital profit of the company. It is like Premium on issue of shares or debentures and Profit prior to incorporation.
- Revenue Reserve − Revenue reserves are readily available for the distribution of profit as dividend to the shareholders of the company. Some of the examples of this are general reserve, staff welfare fund, dividend equalization reserve, debenture redemption reserve, contingency reserve, and investment fluctuation reserves.
Difference between provisions and reserves:
|Meaning||The portion set aside for meeting known liabilities or expenses whose probability is certain.||The portion set aside from the company’s profits to meet an unforeseen business event.|
|Nature||It is a charge against profits, which means that they are created even if there is no profit.||It is an appropriation of profits, which means that they are only created when the company is profitable.|
|Objective||Provisions are always made for a defined liability or expense.||Reserves may or may not be made for a defined purpose. Example- Debenture Redemption reserve/General reserve.|
|Purpose||Provisions are created to meet a specific liability and fulfill the requirement of the law.||Reserves are made to give strength to the financial position of the company.|
|Mode of Creation||It is created by debiting Profit and Loss Account.||It is created by debiting Profit and Loss Appropriation Account.|
|Necessity||It is mandatory to create provisions as per various laws.||It is not mandatory to create reserves. They are only created when the company has surplus profits.|
|Payment of Dividend||Dividends cannot be paid from provisions.||Dividends can be declared and paid from reserves to the shareholders.|
|Presentation in Balance Sheet||They are always shown on the liabilities side as a current liability or reduced from the concerned asset for which it is made.||Reserves are shown under the head of ‘Reserve and Surplus’ as the Owner’s Capital/Shareholders’ Fund on the liability side of the balance sheet.|
|Investment||The amount of provision can never be invested outside the business.||The amount of reserve can be invested outside the business, as in case of Debenture Redemption Reserve Investment|
|Utilisation||Provisions can only be used for the specific purpose for which they are created.||Reserves can be used to meet any unknown loss or liability.|