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Distinction between provisions and reserves

Written by: Anil Kumar Gupta

Article Overview: The differences between reserves and provisions are outlined in this article.

Distinction between provisions and reserves

Reserves

1. It is created by debiting the profit and loss appropriation account.

2. It is created to meet an unknown liability, or to strengthen the financial position of the company or for equalization of dividends etc.

3. A reserve is created only when there is profit in the business.

4. It can be distributed among shareholders as dividend.

5. The reserve is created without taking into consideration the actual amount required except in the case of redemption of debentures when a definite sum is set aside.

6. Creation of reserve depends upon the financial policy of the business and discretion of its management.

7. It is usually shown on the liability side of the balance sheet as it is not a specific reserve.


Provisions

1. It is created by debiting the profit and loss account.

2. It is created to meet a known liability or a specific contingency, e.g.. provision for bad and doubtful debts, or provision for depreciation etc.

3. A provision is created irrespective of whether there is profit or loss in the business.

4. It is not available for distribution as dividend among shareholders.

5. A provision is made for a definite amount and, therefore, a definite sum is set aside every year to meet the known contingency.

6. Making of a provision is a must to meet known liability or contingency.

7. The provision is generally shown on the assets side of the balance sheet.


Distinction between general reserve and specific reserve

General reserve

1. It is created for a specific purpose.

2. It is utilized for that specific purpose, for which it was created.

3. Whether profit or no profits, it must be created.

4. It is necessary to create in order to ascertain profit.

5. It is shown on the debit side of profit and loss account.

6. Net profits are reduced because of it.


Specific Reserve

1. It is created not for any specific purpose but for meeting future contingencies.

2. It can be utilized for meeting any future loss.

3. It is created only when there are sufficient profit.

4. They are created only when there are profits i.e. they depend upon profits.

5. It is shown on the debit side of profit and loss appropriation account.

6. Only distributable profits are reduced because of it.


Reserve Fund

Profit set aside and used in the business is a reserve. But profit set aside and invested outside the business is a reserve fund. Thus, the use of the term 'fund' indicates
investment of reserve outside the business.


Sinking Fund

A sinking fund is a fund built up by annual contributions. The contributions are invested outside the business in readily realizable securities. Interest received on investments is reinvested in the same securities.

A sinking fund may be (i) for replacement of fixed assets or (ii) for the redemption of debentures or repayment of loan. A sinking fund for the replacement of a fixed asset is a provision. But a sinking fund for redemption of debentures or repayment of loan is an appropriation of profits. A sinking fund represents amount invested outside the business.


Distinction between reserve fund and sinking fund

Reserve fund

1. Investments are not for definite period.

2. It is created always out of divisible profits.

3. Interest received on investments representing reserve fund may not be re-invested.

Sinking fund

1. Investments are for a definite period.

2. It is not always out of divisible profit e.g. sinking fund for replacement of asset is provision for depreciation, it must be created even if there are no profits.

3. In case of sinking fund, interest is always re-invested.

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Article Tags: balance sheet, contingencies, contingency, debentures, debit side, depreciation, dividend, dividends, doubtful debts, financial position, liability side, net profits, profit 5, profit and loss, profit and loss account, profit and loss appropriation account, provision, redemption, shareholders, taking into consideration



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