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. 
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.
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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.
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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.
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Main Difference Between Provision And Reserve
| Provision | Reserve |
|---|---|
| Provides for an expected future liability. | Retains a portion of earnings for future use |
| It is a charge against earnings | Reserves are the appropriation of profits |
| A business can never pay dividends with provisions | The dividend can be paid out of reserves. |
| Provisions can only be used for which they are created | There is no defined use of reserves, which are used in other ways. |
| On balance sheets, provisions are shown as a deduction from the asset. | It is shown on the liability side. |
- 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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FAQs
How are provisions and reserves recorded?
Provisions are recorded as expenses on the income statement, reducing the company's reported profit. They also lead to a corresponding reduction in the company's retained earnings on the balance sheet. Reserves, on the other hand, do not appear on the income statement. They are included in the shareholders' equity section on the balance sheet.
What are some examples of provisions?
Provisions include a warranty, bad debt, restructuring, and legal provisions. For instance, a company might create a provision for potential customer returns or pending lawsuits, as these are known liabilities that will likely require future payments.
Can provisions and reserves be reversed?
Yes, both provisions and reserves can be reversed under certain circumstances. Provisions can be reversed if the event for which the provision was created no longer requires the funds reserved. Reserves can be adjusted if there are changes in the company's financial position, such as increased profits allowing for higher reserves or unexpected losses necessitating a decrease in reserves.
How do provisions and reserves impact financial statements?
Provisions are recognized as expenses on the income statement, reducing the reported profit and taxable income. As part of shareholders' equity, reserves do not directly impact the income statement. Both provisions and reserves are reported on the balance sheet, affecting the overall financial position and shareholders' equity.
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