The difference between Reserves and Provisions explained

Both reserves and provisions refer to the amount retained by an organization to deal with all possible contingencies in the future. In accounting parlance, reserves are appropriations out of profits and provisions are charges against profits. Although the IFRS Standards sometimes call provisions a ‘reserve’, they are not the same thing – a provision is an upcoming liability without a confirmed date or cost. Now let us study the difference between Reserves and Provisions in detail.

Meaning and purposes of Reserves:

Every organization earns either profit or loss in its commercial activities. Net profit is measured once operating costs, taxes, interest, and depreciation have all been subtracted from total revenues.  The net profit earned by an organisation after adjustment of all dues transferred to Reserves and Surplus head in the balance sheet. These are the additional funds available to an organization that can be used to strengthen the organnisation’s financial position, buy fixed assets, business expansion, legal requirements, investment, and other plans. In the other words, this is the additional funds available with the organization kept reserved for specific future requirements.

Reserves are divided into two types viz. Revenue Reserves and Capital Reserves.

The Revenue Reserves is further divided into 2 categories viz. General Reserves and Special Reserves. General reserves are those which are generally created without any specific purpose. Special Reserves are those created for some specific purpose and can be used only for those specific purposes. Examples of Special Reserves include investment fluctuation reserves, debenture redemption reserves, etc. Normally, a corporation is able to pay the dividend due to the shareholders only from revenue reserves, and they are not allowed to pay the dividend from the capital reserve.

A capital reserve is created from capital profit earned through sales of capital assets such as the sale of fixed assets, Premium earned on the issue of share and debentures;    Excess on revaluation of assets and liabilities. A capital reserve cannot be either shared as a dividend to the shareholder or used for any other purpose apart from which it is created. The important point to be noted is Capital Reserve cannot be created out of the profit earned from the core operation.

Purposes of Provisions:

Financial institutions have to make provisions against loan losses, depreciation, income taxes, inventory obsolescence, pension, restructuring liabilities, etc. Provisions are recorded as a current liability on the balance sheet and then matched to the appropriate expense account on the income statement.

A provision is an amount set aside in an organization’s accounts for practically for a known liability or it may be an amount set aside for a future event or circumstance which is possible but cannot be predicted with certainty. IAS 37 [IAS were replaced in 2001 by International Financial Reporting Standards (IFRS)] defines provisions as “liabilities of uncertain timing or amount.” It goes on to clarify that, in certain jurisdictions; the term provision is used in the context of items such as depreciation, impairment of assets, and doubtful debts. It also clarifies that these items represent “adjustments to the carrying value of assets.”

What are asset impairments?

Asset impairment happens when an asset’s fair value is less than its carrying value on the balance sheet. An impairment loss records an expense in the current period which appears on the income statement and simultaneously reduces the value of the impaired asset on the balance sheet. Provision for impairment is based on the prudence concept i.e. if the expected benefit from an asset whether in the shape of its disposal proceeds or reflecting a reduced likelihood of full repayment of a loan the management should recognize the loss in value of asset immediately.

The Risk Weighted Asset (RWA) is a measurement designed to evaluate the element of risk involved in each asset held by the bank. For example, Cash held by the bank is an asset with zero risks, whereas other assets of the bank such as loans and advances, guarantees, etc., are vulnerable to the risk of default. Thus, such assets are called risk-weighted assets and banks have to maintain unimpaired minimum capital funds equivalent to the prescribed ratio on the aggregate of the risk-weighted assets and other exposures, on an ongoing basis. Banks make provisions on those risk-weighted assets to meet future unforeseen losses.

Provisions versus Accounts payable and accruals:

In accounting, accounts payable/accrued expenses and provisions are separated by their respective degrees of certainty. We have already understood that provisions are allocated toward probable, but not certain, future obligations. In the case of Accounts Payable and Accruals, expenses have already been incurred but are not yet paid, but they are certain future obligations.

Difference between Accounts payable and Accruals:

Accounts payable: Accounts Payable are short-term debt, representing the purchase of goods or services, which have been received but not yet paid for. It is the actual amount of liability that has occurred in an accounting year but not paid off. The accounts payable entry is found on a balance sheet under the heading current liabilities.

Accruals: Accruals are liabilities arising from the purchase of goods or services that have been received or supplied but have not been paid, invoiced, or formally agreed with the supplier. Example of accruals includes the purchase of materials, payment of utility expenses such as rent, electricity, professional fees, etc. The accruals entries are found on a balance sheet under the heading current liabilities.

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