Are you tired of financial jargon leaving you feeling confused and overwhelmed? Well, fret no more! Today, we’re here to demystify two commonly misunderstood terms in the world of finance – provision and reserve.
The provision refers to the setting aside of funds in anticipation of a known or potential liability or expense, while reserve refers to the allocation of funds from profits for specific purposes, such as future investments, contingencies, or dividends.
Provision vs. Reserve
| Provision | Reserve |
|---|---|
| A provision is a liability or expense that is uncertain in timing or amount, and it is recorded in the financial statements as a best estimate based on available information. | A reserve is a portion of a company’s profits that is set aside for specific purposes, such as future contingencies, dividend payments, or investment in new projects. |
| They are created to account for anticipated expenses or losses that are likely to occur in the future, ensuring that financial statements reflect a true and fair view of the company’s financial position. | They are established to strengthen the financial position of the company, provide a buffer against future uncertainties, and support the company’s growth and stability. |
| Provisions are recognized as liabilities on the balance sheet, reducing the company’s profits and equity, and are often disclosed in the notes to the financial statements. | Reserves are part of the company’s equity, representing retained earnings that have been set aside and are available for various purposes according to the company’s policy. |
| They are made when there is a present obligation as a result of past events, and it is probable that an outflow of resources will be required to settle the obligation. | They are created after profits are generated, and they can be set aside at the discretion of the management based on the company’s financial performance and strategic objectives. |
| Provisions are utilized to cover specific expenses or losses when they occur, such as provisions for bad debts, warranty obligations, or legal claims. | Reserves can be utilized for various purposes, such as funding future capital expenditures, paying dividends, expanding operations, or offsetting future losses. |
| They directly impact the company’s profit by reducing it when they are recognized, reflecting the expected expenses or losses in the financial statements. | They do not directly impact the company’s profit but contribute to the company’s equity, strengthening its financial position and supporting future growth initiatives. |
What is Provision?
Provision is an estimate of the amount of money necessary to cover future losses that are expected to occur over the life of a policy. A provision is made when an insurer first writes a policy and then updated it annually as the claims experience for that policy year develops.
The goal is to have the provision be large enough to pay for all expected losses, but not so large that it results in higher premiums for policyholders.
What is Reserve?
A reserve refers to the portion of a company’s profits that is set aside and retained for specific purposes, rather than being distributed as dividends to shareholders. Reserves can serve different objectives, such as reinvesting in the business, expanding operations, covering future contingencies, repurchasing company shares, or strengthening the financial position.
Reserves help enhance the company’s stability, provide a cushion for unexpected events, support growth initiatives, or fulfill legal requirements. They contribute to long-term financial planning and can be utilized strategically to meet various business needs.
Reasons for creating a Provision or Reserve account
A provision account is created when a business expects to incur a future expense that is not yet known. This could be something like an expected warranty claim or an anticipated lawsuit. The funds in the Provision Account are set aside to cover these potential future expenses.
A reserve account is created when a business wants to set aside funds for a specific purpose. This could be something like an emergency fund or money set aside for future expansion. The key difference here is that the use of the funds in a reserve account is known in advance, whereas the use of funds in a provision account is not yet known.
It really depends on your specific needs and circumstances. If you have ongoing expenses that you need to cover, but you’re not sure exactly when they will occur, then a provision account may be the best option. However, if you have a specific purpose in mind for your saved funds, then a reserve account may be more suitable.
Advantages and disadvantages of Provisions and Reserves
Advantages of Provisions:
- Helps in financial planning and budgeting.
- Ensures accurate financial statements.
- Acts as a buffer against potential losses.
Disadvantages of Provisions:
- Estimation uncertainty may lead to inaccuracies.
- Can impact reported profits and investor perceptions.
Advantages of Reserves:
- Provides financial stability during uncertain times.
- Allows strategic capital allocation for growth initiatives.
- Maintains consistent dividend payments to shareholders.
Disadvantages of Reserves:
- Tying up funds may limit other productive uses.
- Lack of immediate liquidity in certain situations.
- Investor expectations and lack of transparency can cause concerns.
Examples of Provisions and Reserves
- Inventory: All businesses need to have some level of inventory on hand to meet customer demand. The amount of inventory a company carries will vary based on the type of business and industry. For example, a retailer will carry more inventory than a manufacturer because they need to have products available for customers to purchase immediately. A provision for inventory is an estimate of the cost of goods that a company has on hand but has not yet sold.
- Accounts Receivable: Accounts receivable represent money that is owed to a company by its customers. This can be in the form of invoices for goods or services that have been provided but not yet paid for. A provision for accounts receivable is an estimate of the amount of money that a company expects to receive from its customers in the future.
- Employee Severance: Employee severance costs are those associated with terminating an employee’s employment contract. This may include things like paying out unused vacation days, providing health insurance continuation, and paying salary through the end of the contract term. A provision for employee severance is an estimate of the costs associated with terminating an employee’s employment contract.
Key differences between Provision and Reserve
- Nature:
- Provision: Provisions are set aside for anticipated or known liabilities or expenses.
- Reserve: Reserves are retained profits allocated for specific purposes or to strengthen the financial position.
- Purpose:
- Provision: Provisions help in preparing for future expenses or losses and mitigating risks.
- Reserve: Reserves serve various objectives like reinvesting in the business, funding growth initiatives, or maintaining financial stability.
- Recognition:
- Provision: Provisions are recognized as expenses on the income statement, reducing reported profits.
- Reserve: Reserves are part of shareholders’ equity and do not impact reported profits directly.
- Difference between FDI and FPI
- Difference between Previous and Assessment Year
- Difference between NPV and IRR
Conclusion
Provisions are marked for anticipated or known liabilities or expenses, helping in risk mitigation and financial planning. On the other hand, reserves are retained profits allocated for specific objectives, such as future investments, contingencies, or maintaining financial stability. While provisions impact financial statements by reducing reported profits and increasing liabilities, reserves contribute to shareholders’ equity and retained earnings.
