Provisions and Reserves

Provisions & Reserves - Meaning and Accounting Treatment

Objectives

After going through this lesson, you shall be able to understand the following concepts.

• Meaning of Provision
• Meaning of Reserves
• Distinction between Provisions and Reserves

Provision
Every business organisation is exposed to some common known expenses or losses the exact amount of which in the future period is unknown such as depreciation on fixed assets, payment of tax liability, default in payment by customers, etc. For the purpose of meeting such expenses or losses a business may keep aside a certain amount every year.
The amount that is kept aside from the profits of an enterprise to meet the future ‘known’ liabilities is known as provision. It is created only for those liabilities, the amount of which cannot be ascertained precisely and accurately beforehand. Therefore, if a provision is created for a liability whose amount is already known cannot be considered as a provision rather, it would be considered as a liability for the business. From this it is clear that there lies a difference between a provision and a liability as the former is to provide for a future known liability whose amount is difficult to be determined while the latter is in itself a future known liability whose amount is already known. For example, provision created for a tax liability of Rs 10,000 to be paid in the month of December is a liability and not a provision. This is because, here, the amount of liability is already known, therefore provision cannot be created for this liability.
This creation of provision is truly based on the intuitions and past experiences of a business. In other words, it is created on an estimated basis based on the past performances. The unascertained liabilities in the form of provisions are kept aside which helps a business to sustain from the future unexpected losses.
Provision is considered as an expense of a business which is charged from the profits by debiting it to the Profit and Loss Account.
The underlying principle behind creation of provision is accounting principle of Conservatism which state that ‘provide for all anticipated expenses or losses but do not provide for anticipated incomes or gains’. It should be noted that creation of provision is compulsory even if the business does not have profits. The main rationale for making provisions is to provide cushion to the future business performance against the uncertain and unforeseen losses that may arise from the past transactions. The creation of provision helps in determining the true profits or losses during an accounting period.
As per Penguin Dictionary of Commerce ‘A provision is the amount written off or retained by way of providing depreciation, renewals or diminution in the value of assets or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy’.
 

The following are few examples of provisions.

i. Provision for Doubtful Debts
ii. Provision for Discount on Debtors
iii. Provision for Taxation
iv. Provision for Depreciation
v. Provision for Repairs and Renewals

Accounting Treatment
The amount of provisions is charged against profits by debiting it to the Profit and Loss Account. It is charged in the accounting period in which such provision is created. We know that provision is compulsorily to be create therefore, it has to be created by the business even in case of losses. The following is the Journal entry for creating provision.

 
Disclosure of Provision in the Balance Sheet
The amount of provision in the Balance Sheet can be shown in any of the following ways-

a. It can be shown either on the Assets Side of the Balance Sheet as a deduction from the concerned asset. For example, Provision for Depreciation is shown as a deduction from the concerned fixed asset,

b. Or it can be shown on the Liabilities Side of the Balance Sheet. For example, Provision for Taxation.

Features of Provisions
The given below are some features of provision that can be derived from its above explanation.

i. It is created to meet the f…