Difference Between Provision and Reserve

A simple and easy way to remember the difference between provision and reserve is that provisions are for known liabilities or losses, while reserves are for specific purposes. The article talks about two finance terms that are often interchangeably and wrongly used, provision and reserve, and covers the difference between provision and reserves. 

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Every business faces some profits or losses in a given financial year, but their amount is unknown as they have not yet been incurred. A provision is created for such expenses/losses as a charge against profit.

Similarly, a particular portion of the profits is retained in the business as reserves to be used at the time of need, invested in growth activities, or cover future contingencies. Reserves are the only profit appropriation.

What is Provision?

It is a different sum from the profits of a company. This sum is to cover an anticipated liability or loss in the price of an item, even if the actual amount is uncertain.

A provision is not a savings account. Instead, it is a statement of impending debt. A provision is commonly known as a reserve in International Financial Reporting Standards (IFRS); however, reserves and provisions are not interchangeable. A reserve is a portion of a company’s profitability set aside to strengthen the company’s financial condition through development or expansion. At the same time, a provision is supposed to pay for anticipated liabilities.

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A loan loss provision is the most common type of provision. An insolvency provision has been prepared to meet the obligations. These obligations are not supposed to be paid within an accounting period. 

Key Features of Provisions

• Mandatory in Nature: Provisions are created per accounting standards and legal requirements to address known liabilities or uncertain obligations.
• Defined Purpose: Provisions are created for a specific anticipated expense, such as bad debts, warranties, or legal claims.
• Reduces Profit: Provisions are charged to the profit and loss account, reducing the profits for the period.
• Based on Estimates: The amount of provision is often estimated because the exact value of the liability is uncertain.
• Represents a Liability: Provisions are shown as liabilities in the balance sheet, as they signify future obligations.
• No Link to Surplus: Provisions are not dependent on the company’s profits; they are created irrespective of whether a profit or loss is made.

Examples:

• Provision for bad debts.
• Provision for warranties.
• Provision for legal expenses.

What is a Reserve?

It is money that has been set aside from earnings or benefits. These are for a specific purpose. Reserves are created to buy fixed assets, pay bonuses, advance legal settlement, repairs and maintenance, and debts.

When a business makes a profit at the year’s end, a portion remains in the trading business to meet future needs, growth projections, and more. Reserve is a term used in accounting to describe money saved.

The capital reserve is created from capital gains, not generally distributed as dividends to shareholders. It cannot be derived from the profits generated by the basic operations of a company.

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Revenue reserves are created from profits generated by the company’s management. On the liability side of an accounting record, reserves are shown in the Reserves and Surplus portion.

Key Features of Reserves

• Voluntary or Statutory: Reserves may be created voluntarily by the management or as per statutory requirements (e.g., a statutory reserve for banks).
• General Purpose or Specific: Reserves can be general (for overall business needs) or specific (for a particular purpose, like a reserve for expansion).
• Does Not Reduce Profit: Reserves are created from net profit and represent retained earnings; they do not reduce the current year’s profits.
• Represents Equity: Reserves are shown as part of shareholders’ equity in the balance sheet, not as liabilities.
• Linked to Profitability: Reserves are created only when the company has sufficient profits.
• Acts as a Buffer: Reserves are a cushion to meet unexpected expenses or losses and maintain financial stability.

Examples:

• Unrestricted reserve.
• Capital reserve.
• Debenture redemption reserve.

Main Difference Between Provision And Reserve

• The provision is a part of the capital reserved to cover possible financial liabilities. The reserve is a part of the earnings reserved to face unexpected economic liabilities in a company.
• The provision is the amount deducted or charged from the company’s profits. On the other hand, it is not the same as the reservation. It is a part of the profits.
• The provision protects a company from unexpected financial commitments. On the other hand, the reserve helps continue corporate activities while protecting them from unforeseen liabilities.
• In the provision, financial gain is not required for allocation, unlike reserve, where there must be financial gain.
• Provision creation is required by law, but reserve creation is not mandatory.

The primary difference between reserve and provision is that we can calculate the net profit only after giving effect to all provisions, while reserves can be created only after calculating profits. I hope this article helped you to understand provision and reserve differences.

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