Entities need to recognize their expenses correctly so that the books of accounts reflect the true financial condition of their business. Expenses which arise within a specific year are recorded in the books as and when they are incurred. However, most of the businesses operate as going concerns and are thus required to consider expenses that may be incurred in future and the funds required for them. Accounting for provisions and reserves are done to take into cognizance such expenses or losses where required.
This article looks at meaning of and differences between provisions and reserves.
Definitions and meanings
A provision is the creation of a liability in the books of accounts towards a cost, expense or loss that may be or is likely to be incurred. It is created when a probability exists that an obligation to pay or bear loss may arise in the future.
Provisions are created in the books of accounts so as to adhere to the accounting principle of prudence or conservatism. This concept provides that incomes should not be recognized unless they are actually due but all probable expenses should be recognized. In other words, expenses are to be anticipated but not incomes.
Example: ABC Inc. has sold goods worth $10,000 to its debtor Mr. X. This amount is outstanding to be received at the year-end inspite of several follow-ups. ABC has received credible information that Mr. X may be filing for bankruptcy and thus this receivable may become a bad debt.
In accordance with the concept of prudence, ABC would create a provision for bad or doubtful debts in its books of accounts for this. This provision would remain in the books either till the debt is conclusively irrecoverable when it will be written off or till it is recovered when the provision will be extinguished.
The journal entry in the books of accounts would be:
Profit and loss a/c …10,000 [Dr]
Provision for doubtful debts a/c*…10,000 [Cr]
(Being – liability created for doubtful debts on account of receivable of Mr. X)
* Will be transferred to liabilities in the balance sheet (may also be disclosed as a reduction from balance of debtors on the asset side)
Jurisdictional accounting standards generally lay down certain conditions for recognition of provision in the books of accounts. In most of the cases these are as follows:
- An obligation exists for the entity, as a result of a past event
- It is likely that an outflow of resources would be required to settle the said obligation
- The amount of anticipated loss on this account can be estimated reliably
A reserve is the setting aside of profits to meet future obligations of the entity. Over the course of its business operations, an entity requires funds for several purposes, especially for larger expenses or costs such as upgradation of assets, payment of dividends and settlement of legal claims etc. In order to prepare for these future requirements, management periodically sets aside part of its profits and accumulates them in a reserve account to be applied in the future.
Entities can create general reserves which serve as generic appropriations created to meet future obligations. They can be freely used at the discretion of the management and are not earmarked for any specific purpose. They can also create special reserves that are earmarked for a specific purpose and can be utilized only to fulfill that purpose such as dividend equalization reserve and investment fluctuation reserve etc.
Example: XYZ passes a resolution that states that it would transfer 20% of its profits each year to a General Reserve account. This appropriation towards general reserve shall be accumulated year on year and can be utilized for several purposes such as distribution of dividend, expansion of its business etc.
The journal entry in the books of accounts would be:
Profit and loss appropriation a/c… XXXX [Dr]
General reserve a/c*…XXXX [Cr]
(Being – 20% of profits transferred to general reserve)
*Reserves are carried on the liabilities side of the balance sheet, below share capital and form part of Shareholder’s funds.
Difference between provision and reserve:
The key points of difference between provision and reserve have been detailed below:
- Provision is the recognition of a probable expense or loss by way of creation of liability in the books of accounts.
- Reserve is an appropriation of profits so as to meet entity’s future expenses.
- The purpose of creating a provision is so that the books of accounts adhere to the accounting principle of prudence and thus represent a true and fair view of entity’s financial state.
- The purpose of creating a reserve is to set aside and accumulate funds to ensure financial stability of the entity and meet future expenses of the entity.
3. Nature of entry
- Creation of a provision is done through a charge to the profit and loss account and thus reduces the profit of the entity.
- Creation of a reserve, on the other hand, is not a charge to the profit but an appropriation of profit.
4. Routed through
- Creation of provision is routed through profit and loss account.
- Creation of reserve is routed through profit and loss appropriation account.
5. Creation in case of loss
- A provision is required to be created in case of anticipated expense so as to abide by accounting standards. It is thus created where mandated, irrespective of whether the entity has made profits or losses in the year.
- A reserve, on the other hand, is a setting aside of profits for future obligations and can thus be created only if the entity has actually earned profits in the year.
6. Presentation in financial statements (balance sheet)
- A provision results in the creation of liability disclosed in the balance sheet either as a separate liability or as a reduction from the respective asset.
- A reserve remains a part of profit and thus forms part of shareholders’ fund. It is disclosed on the liabilities side of the balance sheet.
7. Statutory requirement
- A provision is mandatorily required to be created by accounting standards when certain conditions with respect to likelihood of occurrence of expense or loss exist.
- Reserves are primarily created at the discretion of the management on a need basis, except for some statutory reserves which are mandatory by law.
- A provision is extinguished from the books either when the related expense is incurred or when it is concluded that the expense will not be incurred and the provision can be written back.
- A reserve is extinguished when it is used or applied for its required purpose. For example, reserves are reduced when dividends are announced out of retained earnings.
- Examples of provisions include provision for bad and doubtful debts, provision for income tax, provision for legal fees, provision for warranty expenses etc.
- Examples of reserves include general reserve, capital redemption reserve, dividend equalization reserve etc.
Conclusion – provision vs reserve:
Both provisions and reserves relate to future expenses or costs. Provisions are a charge on profit as it is for known expenses that are presently quantifiable and likely to be incurred whereas reserves are not entirely quantifiable and are created as a safeguard for any expenses that may be required in the future. In most jurisdictions, the tax treatment of both provision and reserve however is the same. As both relate to future expenses which have not yet been incurred, they are usually not tax deductible.