June 4th, 2006
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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.
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SO LET’S LOOK AT WHAT IS Â CALLED A PROVISION:
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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
- Arises from the accrual and prudence principles
- 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
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
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SO WHAT IS RESERVES?
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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:
Capital 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:
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RECAP: MAIN DIFFERENCE BETWEEN PROVISION AND RESERVE
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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
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exclude the capital reserve and revenue reservese, other terms of reserve appear in B/S, i.e. Bad debt reserve , inventory reserve and reserve for sales return can be used insteadly by provison, right? Thanks and looking forward your reply.
Superb, you got it right for the first part where reserves comprises both capital and revenue reserves and the rest in the balance sheet are provisions.
However,for the bad debt/inventory/sales return, they should be called provisions for bad debt/inventory/sale return instead of reserves for bad debt/inventory/sales return.Using too loosely the word reserves might be quite confusing.
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Reserves are recorded in liablity side of the balance sheet even after the company earns profit after all the expenses and losses are covered. But we call profit is an asset, amount profit is kept as an reserve but still we call as an liabity. Why?
Why cant we record reserve in asset side. Why should we record in liabilty side.
Please answer the question.
Reserves actually are not taken up into so-called the liability side. When we look a conventional balance sheet format, we have the asset,liabilities and share equity/shareholder funds.
In the case of reserves, which can be capital or revenue reserves(refer to my earlier article) it is at the shareholders fund side.
rgds
thanks for the valuable informations , but why we take the prepaid expenses as an asset account?
actually,prepayments are “suspended” in the balance sheet until it can be expensed off/matched to the next accounting period. As the company had already paid the amount, it is “parked” as an asset in the balance sheet.
Hi,
I am working for a MNC (US Based). I would like to know the terminology used “accrual”. What does accrual mean? “provision” or “reserve”. I handle a task of valueing the inventory. I use a prorata % to calculate the obsolescence of inventory and accordingly a reserve (provision ???) is being created in the books of accounts.
I learn that in common parlance, provision should be for a certain amount of money. Reserve is appropriation against profits.
Can you please throw more light on the above.
Thanks,
Sivakumar
Examples of accruals are accruals for utilities,audit fees and other type of expenses which can be estimated quite accurately.(take the past few months bills trend) The purpose of Accruals and provisions is the same re: matching costs against the revenue being generated. However,Provision are a bit more of estimate in nature compared to accruals for example say 2% of provision for doubtful debtors or 3% for provision for stock obsolesence. Reserves are of different class as it it appropriated/taken off from profit to provide for certain event/contingency.
I have just concluded working on the balance sheet of a company and it turns out that on the liability and equity side of the balance, there is a negative reserve. I believe its a capital reserve. My question is, can it be possible to have a negative reserve? if yes, what is the implication of that to the company? if no, could it be that the negative “reserve”shown in the balance sheet is actually under a wrong heading? Please advice. Thanks
Can different reserves be consolidated as one without reference to the Board who initially approprited the profits?
it,s cool to get things in such a nice manner
thanks