Reserves and provisions are both important financial terms in accounting, but they serve different purposes and are treated differently in financial statements. Understanding the distinction between them is crucial for accurate financial reporting.
1. Purpose:
- Reserves: Reserves are funds set aside by a company from its profits for future use, such as meeting contingencies, expanding operations, or smoothing out fluctuations in profits. Reserves are created voluntarily and are not an obligation. They help in strengthening the financial position of the company.
- Provisions: Provisions are amounts set aside by a company to cover known liabilities or anticipated expenses. Unlike reserves, provisions are created to meet specific future obligations, such as bad debts, warranties, or tax liabilities. Provisions are mandatory and arise due to legal or contractual requirements.
2. Nature:
- Reserves: Reserves are considered part of the owner’s equity and are not deducted from profits when calculating taxable income. They are not meant to cover specific liabilities but rather serve as a safeguard against unforeseen contingencies.
- Provisions: Provisions are liabilities and are deducted from the profits of a company, reducing taxable income. They represent amounts the company expects to pay in the future for known liabilities or expenses.
3. Accounting Treatment:
- Reserves: Reserves are shown in the equity section of the balance sheet and do not reduce the company’s reported profit in the year they are created. Examples of reserves include general reserves and capital reserves.
- Provisions: Provisions are shown as liabilities in the balance sheet and are deducted from profits when they are created. Examples of provisions include provision for bad debts, provision for taxes, and provision for warranties.
4. Flexibility:
- Reserves: The creation of reserves is more flexible, as it depends on the company’s management decisions and future plans.
- Provisions: Provisions are more rigid and based on specific criteria, like legal obligations or expected future expenses.
In conclusion, while reserves are meant to enhance financial strength and flexibility, provisions are created to account for specific, known future liabilities. Both are essential but serve distinct roles in accounting.
Subscribe on YouTube - NotesWorld
For PDF copy of Solved Assignment
Any University Assignment Solution
.webp)
