Difference between Provision and Reserve

Provision

Provisions in accounting refer to amounts set aside by a company to cover potential future expenses or losses.
They are recognized as liabilities on the balance sheet, representing the company’s estimated obligation to meet certain expenses or liabilities that are likely to occur in the future.
Provisions are made when there is uncertainty about the timing or amount of an expense, but it is probable that the company will incur the expense.
They are typically based on reliable estimates and are made in accordance with accounting principles and guidelines.

Provisions can be categorized into different types based on their nature:

Provision for Bad Debts: This provision is created to account for potential losses from customers who may not pay their outstanding debts.

Provision for Warranty: Companies that offer warranties on their products may create a provision to cover the potential costs of honoring those warranties.

Provision for Income Taxes: Companies estimate and set aside amounts to cover their future income tax liabilities based on applicable tax laws and regulations.

Provision for Legal Claims: When a company faces pending legal claims or lawsuits, it may create a provision to cover the potential legal costs or settlements.

Provision for Inventory Obsolescence: This provision is created to account for potential losses due to the obsolescence or decline in value of inventory.

Provisions are adjusted over time as new information becomes available or as the estimates change. Any changes to provisions are reflected in the financial statements through appropriate adjustments.

Reserve

In accounting, reserves refer to amounts set aside from a company’s profits to meet future contingencies or to fulfill specific purposes.
Unlike provisions, which are created to cover potential losses or expenses, reserves are created to strengthen the financial position of the company or to allocate funds for specific purposes determined by management or legal requirements.

Here are some common types of reserves:

General Reserve: Also known as retained earnings or accumulated profits, this reserve is created by allocating a portion of the company’s profits from previous years. It serves as a cushion against future losses or as a source of funds for future investments or expansion.

Capital Reserve: This reserve is created from specific capital transactions, such as the sale of fixed assets, issuance of shares at a premium, or revaluation of assets. It is not available for distribution as dividends and is typically used for capital-related purposes, such as funding future capital expenditures or reducing accumulated losses.

Contingency Reserve: This reserve is set aside to cover unforeseen events or contingencies that may affect the financial stability of the company. It provides a buffer for emergencies, legal disputes, or economic downturns.

Dividend Reserve: In some jurisdictions, companies are required to create a reserve specifically for the payment of dividends. This reserve ensures that funds are available to meet dividend obligations to shareholders.

Specific Reserves: These reserves are created for specific purposes determined by the company, such as research and development, employee benefits, environmental liabilities, or loan repayment.

Learn difference between Deferral & Accruals here…