Provision vs. Reserve: What's the Difference?
Edited by Janet White || By Harlon Moss || Updated on October 23, 2023
A provision is an amount set aside for known liabilities, while a reserve is an amount set aside from profits for future uncertainties.
Key Differences
A provision represents a company's acknowledgment of current liabilities or reductions in the value of assets. By establishing a provision, businesses anticipate these obligations, ensuring that they're financially prepared. On the other hand, a reserve is fundamentally a portion of profits kept aside by companies. This "reserved" amount ensures that the firm can manage unforeseen financial challenges or capitalize on upcoming opportunities.
It's crucial to understand that while both provisions and reserves serve as financial safety nets, they address different concerns. Provisions handle identified financial responsibilities, ensuring they're met without straining the company's resources. Reserves, conversely, provide a cushion for future events that might or might not occur. By having a reserve, companies display financial prudence, preparing for possible economic downturns or other uncertainties.
In accounting, the distinction between provision and reserve is essential. While drafting financial statements, provisions are acknowledged as expenses, reducing the company's profit. Reserves, however, don't impact the profit directly but are deducted from the company's retained earnings. This means reserves reduce the distributable profit available to shareholders.
To sum it up, provisions and reserves are vital components in financial accounting. Provisions address known financial commitments, ensuring the business remains compliant and financially stable. Reserves, in contrast, are amounts kept aside from profits, fortifying the company against future uncertainties and potential investment opportunities.
Comparison Chart
Purpose
To cover known liabilities or asset reductions
To set aside a portion of profits for future uncertainties
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Nature
Obligatory
Discretionary
Effect on Profit
Reduces profit as it's recognized as an expense
Reduces distributable profit but not recognized as an expense
Accounting Treatment
Included in the profit and loss statement as an expense
Deducted from profits in the balance sheet
Basis of Calculation
Estimated based on known liabilities or anticipated asset reductions
Decided by the company's management or as per statutory requirements
Provision and Reserve Definitions
Provision
An amount set aside to cover known future liabilities or losses.
The company made a provision for the impending lawsuit settlements.
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Reserve
An amount earmarked for specific future expenses or investments.
The board created a technology upgrade reserve for next year.
Provision
An acknowledgment of present financial responsibilities in accounting.
The year-end accounts showed a significant provision for asset depreciation.
Reserve
A demonstration of financial prudence in business.
To ensure sustainability, the startup established a six-month operational reserve.
Provision
A financial safety net for identified business costs.
The provision in the accounts covered bad debts from unpaid invoices.
Reserve
Funds kept aside from profits for potential future needs.
The company maintained a reserve for new project investments.
Provision
An arrangement made in advance for a future obligation.
The management made a provision for equipment replacement next year.
Reserve
A discretionary portion of profits not distributed as dividends.
Shareholders agreed to increase the reserve instead of taking higher dividends.
Provision
A calculated estimate for expected economic obligations.
The provision was adjusted based on the expected increase in warranty claims.
Reserve
A financial buffer against unforeseen events or opportunities.
The reserve was used to cover losses during the economic downturn.
Provision
The act of providing or supplying something
The provision of health care.
The provision of rations.
Reserve
To keep back, as for future use or for a special purpose
The hospital reserves certain drugs for the most serious cases.
FAQs
How does a provision affect a company's profit?
A provision reduces the company's profit as it's recognized as an expense.
Is it mandatory to create a reserve?
Some reserves are statutory and required by law, while others are discretionary.
When is a provision used in accounting?
When there's a known liability or anticipated asset reduction.
What's the main difference between a provision and a reserve?
A provision covers known liabilities, while a reserve is for uncertain future needs.
Why are reserves important for a company?
Reserves provide financial stability, covering unforeseen challenges or capitalizing on opportunities.
How is a provision calculated?
Provisions are estimated based on known liabilities or anticipated asset reductions.
What happens if provisions are overestimated?
Overestimation can be reversed in subsequent periods to reflect accurate values.
What's an example of a statutory reserve?
A statutory reserve could be one mandated by banking regulations for financial institutions.
Are reserves considered liquid funds?
Not necessarily. While reserves represent funds set aside, they might be invested or tied up in non-liquid assets.
Can a reserve be used for any purpose?
Specific reserves have designated purposes, while general reserves are more flexible.
How often should provisions be reviewed?
Provisions should be reviewed regularly, at least annually, to ensure accuracy.
Why might a company increase its reserves?
To prepare for future uncertainties, investments, or downturns.
Can provisions benefit a company's image?
Yes, provisions show a company is responsible and prepared for liabilities.
Is capital reserve the same as a general reserve?
No, capital reserves arise from non-operational activities, while general reserves are from profits.
Do provisions directly reduce the distributable profit?
No, provisions reduce profit but not directly the distributable profit.
Are reserves shown on the balance sheet?
Yes, reserves are shown under the shareholders' equity section.
Can provisions be used for any future costs?
No, provisions are specifically for identified future costs or liabilities.
Can a company decide the amount of general reserve?
Yes, general reserves are discretionary and set by the company's management.
Is a reserve an asset or liability?
A reserve is neither; it's a portion of retained earnings in the equity section of the balance sheet.
Can reserves be negative?
No, reserves represent funds set aside and cannot be negative.
About Author
Written by
Harlon MossHarlon is a seasoned quality moderator and accomplished content writer for Difference Wiki. An alumnus of the prestigious University of California, he earned his degree in Computer Science. Leveraging his academic background, Harlon brings a meticulous and informed perspective to his work, ensuring content accuracy and excellence.
Edited by
Janet WhiteJanet White has been an esteemed writer and blogger for Difference Wiki. Holding a Master's degree in Science and Medical Journalism from the prestigious Boston University, she has consistently demonstrated her expertise and passion for her field. When she's not immersed in her work, Janet relishes her time exercising, delving into a good book, and cherishing moments with friends and family.
