June 4th, 2006
Quite a number of us use the word provision and reserves interchangeably as if they are the same but actually there is a very great difference between them.
SO LET’S LOOK AT WHAT IS CALLED A PROVISION:
- Is an amount written off to provide for depreciation, or diminution in value of assets or retained to provide for a known liability.
- Provisions made for expected losses and contingencies are charges against profits
- The liability should be a present obligation whether legal or constructive which has arisen as a result of a past event and where payment is probable ( more likely than not) and the amount can be estimated reliably.
Arises from the accrual and prudence principles
- Examples of these liabilities appearing in the liabilities side of the balance sheet are:
- Provision for retirement benefits
- Provisions for reorganization or severance : this provision is recorded when a company announces a plan to change its organization structure, which will incur significant costs, including termination of personnel
- However, take note that the provisions can also be classified on the asset side of the balance sheet which are then known as negative assets with the objective to decrease the value of other assets of the company.
Examples of provision as negative assets:
- Bad debt provision – provision decreasing the value of receivables, because their recoverability is doubtful. Mostly recorded based on aging of the receivables, older receivables are more doubtful that new ones.
- Provision for product returns / credit note provision – provision decreasing the value of receivables due to expected sales returns. Normally recorded based on historical experience as a percentage of recent sales.
- Provision for excessive, obsolete or damaged inventory – decreasing the value of inventory with uncertain marketability (due to its obsoletness, damages or excessive volume on stock)
- Impairment provisions – generally any provisions recorded when a book value of an asset is significantly higher than its fair value
SO WHAT IS RESERVES?
Reserves are appropriations of profit namely when profits have been ascertained after deducting all expenses which includes provision and others. Reserves are residual earnings after all expenses and taxation which belongs to the owners namely the shareholders.
There are essentially two(2) types of Reserves:
- Are appropriation from profits which cannot be distributed by way of cash dividends.
- These capital reserves arises mainly from (i) equity transactions between the enterprise and its shareholders; (ii) from adjustments arising in accounting for business combinations; (iii) from differences arising on translation of foreign currency operations; (iv) from surpluses arising from asset revaluation; (iv) any unrealized gain which has not been included in income.
- Examples of capital reserves includes: share premium, capital redemption reserves, capital reserves arising on merger and acquisition, statutory reserves, asset revaluation reserve and exchange fluctuation reserves.
Revenue Reserves are:
- Are appropriation from profit which can be distributed by way of cash dividends although some may be set aside for other purposes.
- Examples like retained profits and general reserves.
RECAP: MAIN DIFFERENCE BETWEEN PROVISION AND RESERVE
Remember that provision is a charge to the profit whilst a reserve is an appropriation to the profit. Reserves belongs to the owners equity side while provision can be on a liability side or on the assets side but as a negative asset