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Difference Between Reserves and Provisions | Accounting & Finance for Bankers

Difference Between Reserves and Provisions | Accounting & Finance for Bankers

In this article, we will talk about the meaning of reserves & provisions & how the two are different from each other. It’s important that the bankers understand the two terms & their proper differentiation to pass the paper 2 of Junior Associate of the Indian Institute of Bankers i.e. Accounting & Finance for Bankers (AFB) NOV 2022.

The Reserve & Provisions are the terms & line items of Financial Statements & form part of all (Statement of Profit & Loss, Balance Sheet & Cash Flow Statement). So, its well understood that JAIIB candidates need to be clear of the accounting terms that fall in the whole applicable JAIIB AFB Syllabus 2022.

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So, let us begin with the Meaning of Reserves & Provisions.

MEANING OF RESERVE

Reserve is the term refers to an aggregate or portion of profits that an organisation maintains or holds aside on financial year end towards meeting future contingencies or emergencies that might materialize. It is also used to support the businesses, they also help in keeping the financial position of a company stable when reserves are being used to expand & investing in assets, dividend payments & investments.

Reserves are presented under ‘Reserves and Surplus’ section on the liabilities side of a balance sheet (Financial Statement).

An organization has 2 types of Reserves, namely:
  1. Capital Reserve:A capital reserve is created from the profits earned from capital items and is not available for dispersal to shareholders in the form of dividends or other way. Therefore, Capital Reserves cannot be created from the earnings from the core operations of a business.

    There are several types of capital reserves, including:

      • Profit earned before an enterprise is incorporated,
      • Premiums earned on the issue of debentures and shares,
      • Gains arising from the re-issuance of forfeited shares,
      • Capital redemption reserve
      • Profits from the sale of non-current assets, and
      • Surpluses from revaluations of liabilities and assets.

 

  1. Revenue Reserve:Revenue reserve is the reserve created from the profits earned from the main functions of a organisation or business. A profit and loss appropriation account is required to be made for creating Revenue reserve.

    Revenue reserve is also called as Retained earnings & the same can be used for the following purposes:

    1. To pay dividends to shareholders
    2. To expand the business
    3. To stabilise the dividend rate
    4. To finance a new product of the business
    5. To enter into Merger or acquisitions

What is the Difference Between the Capital Reserve and Revenue Reserve?

Capital Reserves and Revenue Reserves are somewhat alike have different purposes & are made from different sources & both are important. Following are few points of difference between Capital & Revenue Reserves:

Parameters

Capital Reserve

Revenue Reserve

Source of creation

It is composed of the earnings accrued on capital appreciation.

It is composed of the earnings from the normal or core business activities.

Dividend Distribution

Capital Reserve cannot be used for paying dividends to shareholders.

Money lying in the Revenue Reserve can be distributed as dividends among the shareholders.

Purpose of Reserve

Its’ basic purpose is to create or write off capital losses & to fund long-term projects.

Its’ basic purpose is to improve the financial position of the firm and also its expansion.

Usage of the Reserve

Capital Reserve can’t be utilized for purpose other than for what it was created for.

Depending on the type of reserve, businessed can use it accordingly

MEANING OF PROVISION

Provision is the term refered to an amount that is held aside from a company’s profit for the purpose of covering the possible expenditures arising in future or a possible decline in the value of an asset.
Provisions are important for a business as they handle certain expenses in businesses and payments made for those expenses. Provisions are not savings because the purpose of their creation is different i.e. Provisions are basically to meet expenses for an anticipated liability for tomorrow.

Provisions appear in the statement of Profit & Loss in the form of expenses & are recorded as a current liability on the balance sheet.

The Need For Making Provisions In Businesses:

Countless reasons exist for setting aside funds, including the following: Depreciation, renewal, or reduction in asset value, Redemption of Liability, Writing off bad debts/doubtful debts, Contingent Liabilities, Any known liability – whose amount cannot be determined accurately, Specific losses on taxes or asset realization.

What is the Difference Between Reserves and Provisions?

Reserves and provisions are somewhat alike but are created for different reasons and under distinct circumstances. Both are important for a business and one can’t reduce the importance of the other. Following are few points of difference between reserves and provisions.

 Reserves  Provisions
1. Reserves are made to strengthen the financial position of a  business and meet unknown liabilities or losses. 1. Provisions are made to meet specific liability or contingency, e.g. a provision for doubtful debts.
2. Reserves are only made when the business is profitable. 2. Provisions are made irrespective of profits earned or losses incurred by a business.
3. They can be used to distribute dividends to shareholders. 3. They cannot be used to distribute dividends as they are made for specific liability.
4. They are made by debiting P&L Appropriation Account. 4. They are made by debiting P&L Account.
5. It is not mandatory to create reserves for the business, it is mainly done for prudence. 5. Legally, it is mandatory to create provisions.
6. Reserves are shown on the liability side of a balance sheet. 6. Provisions are either shown on the liability side of a balance sheet or as a deduction from the asset concerned.

 

We hope you would now have understood how the reserves & provisions are different from one another & will not mistake provision for reserve or vice-versa.

 

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