Provisions and Reserves in Financial Accounting

In the business world, the words reserve and provision are frequently used. Both of these phrases are critical to a company’s long-term viability. Reserves and provisions are similar in appearance, but they are developed for different reasons and in various situations. Both are critical to a company’s success, and neither can be overlooked. According to business experts, saving a portion of profits as reserves for the unforeseeable future is a smart idea, therefore corporations set aside funds to fulfil those needs or for compliance with the provisions of law .

Definition of Provisions

A provision is an amount set aside by an entity to meet potential future costs or losses or a prospective decrease in the value of an asset. Provisions are vital to a firm since they handle specific business expenditures and payments. Provisions are not savings since they are made to cover costs for future responsibility.

Need of Provisions

• Depreciation of Assets

• Bad and Doubtful Debts

• Taxation

• Discount on Debtors

• Repair and Renewals of Assets etc

Types of Provision

Provision for Doubtful Debts – Amount written off as bad debt once it is certain that a debt will not be recovered. However, it is possible that some of the outstanding debts will not be fully repaid, for such provision will be created up to the loss proportion.

Provision for Debtor Discounts – Businesses offer their consumers cash discounts. For sales made during the existing accounting year, the discount’s duration may extend into the next accounting year.

Provision for Taxation – It is established and maintained to cover the income tax bill for the current year. This provision is made by debiting the income tax amount from the profit and loss account for that year and depositing the tax with the department upon which provision for taxation amount is recorded.

Provision Depreciation – It is the amount of depreciation that will be taken in that accounting year. Depreciation is usually levied at the end of the fiscal year, decreasing the asset’s book value.

Definition of Reserve

A reserve is a quantity or percentage of earnings that a firm preserves or sets aside at the conclusion of a fiscal year to cover future eventualities. It’s also employed to help the company grow. Being utilised for asset expansion, dividend payments, and investments helps to stabilise a company’s financial condition.

Need of Reserve

• Helpful in the event of an unexpected responsibility or loss.

• Helpful in bolstering the company’s financial position

• To give finances for the payment of a specified obligation

• Dividends have been equalised over time.

• Statutory Requirements

Types of Reserve

Capital Reserve – The capital reserve is a profit-saving accounting method. It gives a company’s finances a sense of steadiness. A capital reserve is created when long-term assets are sold or liabilities are settled. It excludes any unallocated funds that may be utilised to distribute earnings.

Revenue Reserves – They are immediately accessible for the distribution of profit as a dividend to the company’s shareholders. General reserves, staff welfare funds, dividend equalisation reserves, debt redemption reserves, contingency reserves, and investing fluctuation reserves are some examples.

Difference Between Provision And Reserve

 Conclusion

While both provision and reserves reduce earnings, provision is required to cover known future expenses. Liabilities must be acknowledged when they emerge, which is why provisions have been established. Reserves tend to be a bit different; they’re set up to save money for the future, therefore experts recommend them.