Difference Between Reserve and Provision
In business, Reserve and Provision are often used terms. The terms Reserve and Provision may sound the same, but they are used for different purposes in business organisations. These terms are both important to maintain the integrity of any business.
Business experts say that it’s a good idea for companies to set aside a portion of their profits as reserves to cover unforeseen events.
Reserve
The term reserve refers to the sum or percentage that a business retains at the end a year for future contingencies. The reserve is used to improve the business.
Stabilizes the financial position of an organization by being used to expand assets, pay dividends and make investments.
Two types of reserve are available to an organisation
- Capital Reserve
- Revenue Reserve
Capital profits are used to create a capital reserve, which is not distributed as dividends to shareholders. It cannot be made from profits from core operations.
Profits from core operations are used to create revenue reserve. For creating Revenue Reserve, a profit and loss account must be created.
Retained earnings is another name for Revenue reserve. You can use it for the following.
- Dividends to shareholders
- Expansion of the business
- Stabilizing the dividend rate
Meaning of the word “Provision”
Provision is an amount set aside from the profits of a business to cover future expenses or possible decreases in asset value.
Provisions can be important to a business, as they cover certain business expenses and the payments that are made. Provisions are not savings, as they are made to cover future liabilities.
In the income statement, it appears as expenses. It is also recorded in the balance sheet as a current liability.
In the table below, we will examine some of the main differences between Reserve and Provision.
Differences Between Reserve and Provision
| Aspect | Reserve | Provision |
|---|---|---|
| Definition | A portion of profits set aside to cover unforeseen business obligations. | The amount set aside to meet known liabilities and expenses. |
| Method of Creation | Created by debiting the Profit and Loss Appropriation Account. | Created by debiting the Profit and Loss Account. |
| Purpose | Provides capital for business operations and protects against unexpected expenses. | Protects the business from known liabilities. |
| Allocation | Allocated only if there is a profit. | Can be allocated even without profits. |
| Dividend Payment | Can be used to pay dividends. | Cannot be used for dividend payments. |
| Impact on Profit | Reduces net profit of the organization. | Reduces profits available for dividend distribution. |
| Appearance in Financial Statements | Always shown on the liability side of the balance sheet. | Deducted from assets or shown in the liabilities section. |
| Utilization | Can be used for any purpose. | Must be used for the specific purpose it was created for. |
Conclusion:
This comparison provides a clearer understanding of the key differences between Reserve and Provision, helping students and professionals in Commerce to grasp these essential financial concepts. Understanding how reserves and provisions are managed can significantly impact the financial stability and decision-making process within an organization.