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Provisions and reserves are comparable in that they both deal with losses and obligations while reducing a company’s net assets and equity. The primary distinction between both is that provisions are formed to cover known losses and liabilities when the amount is not definite, whereas reserves are developed to meet future unknown losses and obligations.
Provisions and reserves documented in corporate financial statements are generally not tax-deductible until the costs are actually incurred. When there is a commitment or duty to pay the real expenditure, an expense is incurred (not just a provision for a future expense that may or may not is paid).
Reserves
They are a percentage of profits placed aside to bolster a company’s financial condition. Reserves are often established to address unforeseen future liabilities that may develop as a result of various business causes.
General reserves, reserve for growth, dividend equalisation reserves, debenture redemption reserves, capital redemption reserves, higher replacement cost reserves, and so forth.
Certain reserves, as the name implies, are created for specific purposes and may only be utilised for those reasons. The main distinction between reserves and provisions is that provisions are usually specific, whereas reserves might be generic.
Provisions
The “provisions” refers to the amount set aside by charging to the Profit and Loss Account to cover any known obligation, the amount of which cannot be specified precisely.
A provision is the amount of a cost or reduction in the value of an asset that a business chooses to record in its accounting system before having accurate knowledge regarding the exact amount of the expense or asset reduction. An organisation, for example, frequently records provisions for bad debts, sales allowances, and inventory obsolescence. Severance payments, asset impairments, and reorganisation expenses are less usual provisions.
Types of Reserves
General Reserve
A general reserve is the retention of a percentage of revenue income for the purpose of improving an enterprise’s overall financial state and overall health. It is an important aspect of corporate finance. The establishment and maintenance of a general reserve aid in the following areas: resource conservation, saving for unanticipated losses, and risk management.
Specific reserves
As the name suggests, specific reserves are put aside for a specific purpose and cannot be utilised for anything else. Special reserves are another name for specific reserves. A bad debt reserve, for example, is money set aside in case a customer does not pay.
Provision for Taxation
A provision for taxation is generated and maintained to cover the income tax payable in the current year, which is an obligation for the firm. Such a provision is made by debiting the profit and loss account for that year’s income tax and crediting the amount for provision for taxes.
Provisions for Debtor Discounts
Most firms use a strategy of rewarding early payers and encouraging debtors to pay their debts on time by granting a set amount of a discount on their bills. If realised, this represents a cost for the entity. As a result, a provision for debtor discounts is provided. So that if a debtor comes back to collect the discount in the future, the firm can accommodate him.
Provision for Asset Depreciation
The goal of establishing depreciation provisions is to make a balance sheet more realistic and to represent the true worth of an entity’s fixed assets. The depreciation provision is determined based on the entity’s depreciation method. It can be a straight line technique in which an identical amount of depreciation is deducted each year. It might also be the decreasing balance approach, in which depreciation is computed on the asset’s residual value at the end of each year.
Difference between the Reserves and Provision
Provision | Reserves |
The provision is deducted from the Profit and Loss a/c. As a result, the profit is reduced. | A reserve is a profit appropriation. As a result, the divisible profit is reduced. |
Its value is not invested in outside ventures. | Its value is invested outside of the company. |
It is made owing to a legal requirement. | As a matter of prudence, it is created. |
It is either recorded as a liability under the heading “Current obligations” or as a reduction from the asset. | It is included under the heading ‘Reserve and Surplus’ on the liabilities side of the Balance Sheet. |
Provisions are created to cover a specific responsibility or contingency, for example, a provision for questionable debts. | Reserves are created to enhance a company’s financial position and to cover unknown obligations and losses. |
Provisions are made regardless of whether a business earns profits or suffers losses. | Reserves are only created when the company is profitable. |
Because they are designed for a specific responsibility, they cannot be utilised to distribute dividends. | They can also be used to pay out dividends to shareholders. |
Conclusion
The primary distinction between both is that provisions are formed to cover known losses and liabilities when the amount is not definite, whereas reserves are developed to meet future unknown losses and obligations. When there is a commitment or duty to pay the real expenditure, an expense is incurred. The main distinction between reserves and provisions is that provisions are usually specific, whereas reserves might be generic. A provision is the amount of a cost or reduction in the value of an asset that a business chooses to record in its accounting system before having accurate knowledge regarding the exact amount of the expense or asset reduction. A general reserve is the retention of a percentage of revenue income for the purpose of improving an enterprise’s overall financial state and overall health.
