Reserve and Provision are two accounting terms that sometimes confuse people. It is important to understand the difference between these two accounting terms and how they are used. It will also help if you know what these terms mean in the context of the banking system.
What is Reserve?
It is collateral that can be raised from the lenders whenever required to back short-term borrowing. Reserves are set aside for anticipated future cash flows (purchases, sales, changes in working capital) not yet realized by the business. The reserves are expected to cover an unexpected cash shortfall required to finance unexpected purchases or sale of inventory or working capital items or any other need of business entity from time to time. Reserves are utilized by businesses to meet their short-term cash needs and are subject to liabilities as of the date of valuation. Reserve is usually recorded in the books of accounts at cost, less accumulated amortization, and any imputed interest.
Uses of Reserve
Business relies on reserves to meet their short-term cash needs. The business entities can use these reserves to meet short-term cash needs at any time until funds are paid into the business entity.
a) Company X can request a loan from the bank on a date y. On that date, company X will provide $100,000 required for one year to the bank for customers’ needs. At the end of the year, the company has to pay back $100,000 or more as per mutually agreed terms.
b) Company Y will supply $100,000 for one year from date n and ask for payment at end of each month during period n-12 as outlined in mutual agreement. At the end of the year, company Y will pay back $100,000 or more to the bank as per mutually agreed terms.
What is Provision?
Provision is an estimated liability created to cover a loss on account of some future event, which is not expected to occur. A provision is recorded in the accounts when it is considered necessary to provide for a contingent amount where specific recoverable costs or other factors have been established; however, the amounts cannot be determined with certainty.
Uses of Provision
Provision is created for the estimated future obligations that may be due to the suppliers or third parties. The business entity records provision at cost, less accumulated amortization.
a) Company Z provides $100,000 to a customer on a mutually agreed term for one year based on delivery and payment cycle. The company will pay back $100,000 or more at end of each month during period n-12 as outlined in mutual agreement. The payments are made by the company to be allocated for a specific account called “Provision for Discount on Sales”. The future obligation is estimated based on mutually agreed terms and conditions.
Provision can be used to estimate the expected cost of goods sold related to future sales.
a) Company X provides $100,000 to a customer on a mutually agreed delivery cycle and asks for payment after one month of delivery. At the end of one month, company X will pay back $100,000 or more as per mutually agreed terms.
Difference between Reserve and Provision
1) Reserve is used to cover short-term cash needs whereas provision is used to cover probable losses.
2) Reserve is effected at the time of raising funds whereas provision is made during the year based on need.
3) Reserve and provision are both classified under liabilities in the books of accounts.
4) All the reserves are charged to revenue or expense except reserve for depreciation in fixed assets.
5) Provision can be created after a loss, whereas reserves should be created before an expected loss.
6) When a company wants to raise funds, it raises a reserve and not a provision. A company cannot raise a provision from another business entity where it has provided funds as per agreement unless mutually agreed upon otherwise.
7) A provision can be classified under income with a corresponding entry in the income statement whereas reserve is not recognized as income.
8) The accounting cost of provisions can be deducted from profit to arrive at net profit.
9) Provision for depreciation is created for the expected removal of fixed assets over some time and is recognized as an expense if the fixed asset is not expected to be utilized beyond a certain period.
10) Provisions should be original/created from the entity’s resources and should not be raised from another business entity where the funds have been provided for some other purpose.
11) Provisions are subject to other provisions recorded on other related accounts such as accrued salaries, accrued interest, inventory discounts, etc.
Reserve and provision are two accounting terms that sometimes confuse people. It is important to understand the difference between these two accounting terms and how they are used. It will also help if you know what these terms mean in the context of the banking system.