A provision is an amount that you put in aside in your accounts to cover a future liability.
The purpose of a provision is to make a current year’s balance more accurate, as there may be costs which could, to some extent, be accounted for in either the current or previous financial year. These costs that distinctly belong to a specific year could be misleading if accounted for in the future.
A provision is not a form of saving, even though it is an amount that is put aside for a future plausible cost or obligation. Provisions resulting impact is a reduction in the company's equity.
When accounting, provisions are recognized on the balance sheet and then expensed on the income statement.
On the other hand, a specific reserve is created for some definite purpose out of the profits of the company. The purpose may be anything connected with the business which the Article of Association or, the directors want to be provided for, such as dividend equalization, replacement of fixed assets, expansion of the organization, Income-tax liability for future foreign exchange fluctuation etc.
Though the concerned amounts are carried under the earmarked heads, these are available for distribution as dividend on the recommendation of directors but subject to the approval of shareholders, since these are created by appropriation of profits.
To create any specific reserve, existence of profit is essential. Some of the specific reserves may be required under the contractual obligations or legal compulsion, for example:
- funds for redemption of debentures and
- development rebate reserve.
Thus provisions are amounts set apart to meet specific liabilities. These must be provided for regardless of the fact whether or not any profit has been earned by the concern. While to create any specific reserve, existence of profit is essential.