Provisions and Reserves
Provisions & Reserves - Meaning and Accounting Treatment
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
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 expen…
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