Provisions, Reserves and Specific Reserves
Provisions, Reserves and Specific Reserves
In short, a reserve is an appropriation of profit for a specific purpose, while a provision is a charge for an estimated expense. The basic difference between provision and reserve is that net profit is calculated only after giving effect to all provisions, whereas reserves are created only after reckoning profit. Click to see more...
Provision implies money set aside to cover an anticipated liability or loss. Reserves refer to withholding some amount for any use in future. Provision and reserves are two terms which are highly confused, but they carry different meanings.
Provisions
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.
Reserves
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.
It cannot be created unless there is a sufficient profit. Its creation is the discretion of management. In other words, it is not obligatory.
Specific Reserves
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.
Summary
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.
In spite of the above distinction between provision and reserve it may be noted that both of them are created out of the same source, i.e. revenue of the business. Again, if there be any surplus provision after meeting the liability or loss for which it was created, such surplus provision is as good as reserve. For example, a provision of Rs. 50000/- is created in this year for doubtful debts. But actual bad debts in the year comes to Rs. 40000/- only leaving a surplus provision of Rs. 10000/- (Rs.500 - Rs.400). This surplus will be credited to profit and loss account. In other words, it becomes payable to the owner of business like reserves.
