Accountancy · Ch 7 — Depreciation, Provisions and Reserves
Difference between Reserve and Provision
Difference between Reserve and Provision
The Core Idea: Charge vs. Appropriation
The single most important distinction between a provision and a reserve lies in how each relates to profit. A provision is a charge against profit — it is an expense that must be deducted to arrive at the true net profit. A reserve, on the other hand, is an appropriation of profit — it is a portion of the net profit that is set aside after the profit has been calculated.
This means you cannot determine the correct net profit unless all provisions have been debited to the Profit and Loss Account. Reserves are created only after that net profit figure is known.
The Six Points of Difference
1. Basic Nature
| Aspect | Provision | Reserve |
|---|---|---|
| Nature | Charge against profit | Appropriation of profit |
| Timing | Made before calculating net profit | Made after calculating net profit |
| Effect on P&L | Debited to Profit and Loss Account | Debited to Profit and Loss Appropriation Account |
2. Purpose
A provision is created for a known liability or expense that relates to the current accounting period, but whose exact amount is uncertain. Examples include provision for doubtful debts, provision for depreciation, and provision for taxation.
A reserve is created primarily for strengthening the financial position of the business. Some reserves are also created because the law requires them — for instance, a Debenture Redemption Reserve is mandatory under the Companies Act.
3. Presentation in the Balance Sheet
Provision can appear in either of two ways:
- As a deduction from the asset for which it is created (e.g., provision for doubtful debts is deducted from sundry debtors on the asset side).
- As a liability shown alongside current liabilities on the liabilities side (e.g., provision for taxation).
Reserve is always shown on the liabilities side after capital. It appears under the head "Reserves and Surplus," which comes after the capital account.
4. Effect on Taxable Profits
A provision is deducted before calculating taxable profits. Therefore, it reduces taxable profits and consequently reduces the tax liability.
A reserve is created from profit after tax. It has no effect on taxable profit whatsoever.
5. Element of Compulsion
Creating a provision is compulsory if you want to show a true and fair view of the profit or loss. This follows the Prudence (Conservatism) concept of accounting — you must provide for all known losses and expenses. A provision must be made even if the business has made no profit at all.
Creating a reserve is generally at the discretion of management. However, in certain cases, the law makes it compulsory — for example, a company issuing debentures must create a Debenture Redemption Reserve. A critical point: a reserve cannot be created unless there are profits.
6. Use for Payment of Dividend
A provision cannot be used for distribution as dividends. It is meant to cover a specific expense or loss.
A general reserve can be used for dividend distribution. The management may decide to transfer a part of the general reserve to the Profit and Loss Appropriation Account and then distribute it as dividends to shareholders.
Summary Table
| Basis of Difference | Provision | Reserve |
|---|---|---|
| Basic nature | Charge against profit | Appropriation of profit |
| Purpose | Created for a known liability/expense of the current period, amount uncertain | Created for strengthening financial position; some are mandatory under law |
| Effect on taxable profit | Reduces taxable profits | No effect on taxable profit |