Provision and Reserves

Reserves

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 a 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.

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.

In short, a reserve is an appropriation of profit for a specific purpose, while a provision is a charge for an estimated expense.

Provision

The Provision means to keep aside a particular sum of money to cover up an anticipated liability which arises from the past events. It is a recognition of an expected obligation, which will result in the outflow of cash from the business. The amount of the liability should be easily estimated by the entity to provide for it.

The recognition is to be made to provide for a known liability or decrease in the value of assets over time or a disputed claim whose probability of occurrence is maximum.

If a provision is made in excess of the amount what is required, then after paying off the liability, it needs to be written back to the profit and loss account.

Examples:

• Provision for Bad Debts
• Provision for Depreciation
• Provision for Tax

Reserves

The Reserve is a fraction of retained earnings, which is kept aside for any use in future. It is regarded as a part of shareholder’s fund. The sum appropriated in the name of reserves can be used for any of the given purposes:

• For purchasing an asset in future.
• To pay the dividends to shareholder consistently year by year.
• For meeting out unexpected contingencies.

The reserves are mainly divided into following categories:

1. Capital Reserve
2. Revenue Reserve
   • General Reserve
   • Specific Reserve