Difference Between Provision and Reserve in Accounting Explained
Provision is a fundamental concept in Commerce, especially in Accounting and Business Law. The term "provision" commonly refers to the act or process of providing or making something available. In accounting and commerce studies, provision typically means setting aside an amount to cover anticipated liabilities or expenses.
A provision helps organisations ensure they can meet expected future obligations, even when the exact amount or timing is uncertain. Understanding its meaning is essential for anyone learning about business finances, legal agreements, and financial planning.
Meaning and Definition of Provision
The word provision originates from the idea of making necessary arrangements in advance. In commerce, it means to provide or reserve funds or resources to meet possible future requirements. This process safeguards a business against sudden financial strain due to unexpected liabilities.
In accounting, provision generally refers to an estimated amount set aside from profits to cover a likely future expense, even though the exact figure or obligation might not be completely certain.
Examples of Provision in Accounting
To understand provision better, let us look at how it appears in business practice:
- Provision for Doubtful Debts: When a company sells goods on credit, there is a risk some customers may not pay what they owe. To be cautious, businesses set aside a provision (an estimated amount) to cover the possibility of these defaults.
- Provision for Taxation: Businesses estimate taxes payable at the end of the year. They create a provision to ensure that money is available to pay tax liabilities when they arise.
- Provision for Depreciation: To account for the fall in value of assets over time, businesses set aside a provision for depreciation annually.
These examples help a business maintain accurate records and show a true financial position.
Key Principles of Provision
Some important principles regarding provision are:
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Provision relates to an anticipated loss or liability that can be reasonably estimated.
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It is recorded as an expense in the Profit and Loss account, reducing the net profit.
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The purpose is to show prudent financial results and avoid overstating profits.
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Provision is part of the ongoing process of providing, preparing, or supplying for future requirements (as in the core dictionary meaning).
Approach: How to Create a Provision
The step-by-step method to create a provision in accounting includes:
- Estimate the amount required based on past data or reasonable foresight. For example, if previous years' unpaid debts were 5% of total sales, one might use this rate.
- Record an expense (provision) in the Profit and Loss account.
- Display the provision as a deduction from the relevant asset or as a liability in the balance sheet.
This process helps businesses manage risk and obligations carefully.
| Term | Meaning | Example in Accounting |
|---|---|---|
| Provision | The act or process of providing or making something available for future needs or events. | Setting aside funds for possible bad debts, taxes, or depreciation. |
Legal Use of the Word "Provision"
In law, a provision refers to a specific section or clause in statutes, contracts, or other legal documents. It states a rule or requirement that must be followed. For example, a contract may contain a provision specifying delivery terms or penalties for late payment.
This aligns with the dictionary's legal definition: a specified part of a document that describes an act or obligation.
| Context | Provision as Used | Illustrative Example |
|---|---|---|
| Accounting | Estimated liability set aside for future expenses | Provision for bad debts |
| Law | Clause or section stating a requirement | Provision in a lease agreement |
Why Provisions Are Important
Provisions provide a cushion for businesses and organisations to prepare for possible financial obligations. They ensure that businesses do not overstate their financial health and help them comply with sound accounting and legal practices.
Provisions are also important because they uphold the principle of prudence: always make arrangements for likely losses but never anticipate uncertain gains.
Practical Example: Creating a Provision for Doubtful Debts
Suppose a company has credit sales of ₹2,00,000 and, based on trends, expects that 3% may not be recovered. The provision created would be:
Provision = ₹2,00,000 × 3% = ₹6,000
This means an expense of ₹6,000 is shown in the Profit and Loss account and deducted from the total amount receivable in the balance sheet.
Learn More and Practice on Vedantu
- Explore more Commerce concepts and related principles in this resource.
- Want to deepen your understanding of how provisions relate to broader business functions? Review energy in business operations.
- Practice more accounting topics and return to key definitions for exam success on Vedantu’s learning platform.
Provisions play a critical role in both accounting and legal contexts. By recognising likely obligations and making proper arrangements, businesses remain prepared and financially sound.
For thorough study and practice, keep learning with Vedantu’s trusted resources and examples on core Commerce topics.
FAQs on Provision: Meaning, Definition & Practical Examples for Commerce
1. What is a provision in accounting?
A provision in accounting is an amount set aside from profits to cover a known liability or loss, the amount of which can be estimated reliably. It ensures that financial statements reflect anticipated expenses such as provision for doubtful debts or provision for taxation.
2. How is provision different from reserve?
Provision is created to meet a specific and anticipated liability, while a reserve is set aside from profits to strengthen the financial position or cover unforeseen future losses. Provisions are usually compulsory, but reserves are discretionary, and reserves can sometimes be used for dividends while provisions cannot.
3. What are the types of provisions in accounting?
Types of provisions in accounting include:
• Specific Provisions: For a known liability (e.g., provision for doubtful debts).
• General Provisions: For uncertain but probable losses (e.g., general provision for bad debts).
4. What is a provision with example?
A provision is an estimated amount set aside for a future expense or obligation.
Example: If a business expects some of its customers will not pay their dues, it creates a provision for doubtful debts to reflect this anticipated loss in its accounts.
5. How is a provision for doubtful debts calculated?
Provision for doubtful debts is calculated as a percentage of total outstanding debtors.
Example: If total debtors are ₹80,000 and provision is to be created at 5%, the provision will be ₹80,000 × 5% = ₹4,000.
6. What is the journal entry for creating a provision?
To create a provision, the usual journal entry is:
Profit & Loss A/c Dr.
To Provision for Doubtful Debts A/c
This entry transfers the expected loss from profit to a separate provision account.
7. In which part of the balance sheet are provisions shown?
Provisions are usually deducted from the related asset (such as debtors) or shown under 'Current Liabilities and Provisions' depending on the accounting treatment and type of provision.
8. What is provision meaning in law?
In law, a provision refers to a specific clause or section within an act or legal document that lays out a rule, requirement, or obligation. For example, Section 135 of the Companies Act, 2013 is a legal provision mandating Corporate Social Responsibility for certain companies.
9. What is the difference between a provision and an accrual?
A provision is created for a probable, but uncertain, future liability with a reliable estimate. An accrual records expenses or income that have been incurred or earned but not yet settled in cash. Provisions involve estimation for potential losses, while accruals deal with amounts due for past events.
10. What is a general provision?
A general provision is an amount set aside to cover possible future losses or liabilities that cannot be estimated precisely and are not linked to any specific transaction. It ensures conservatism in financial reporting.
11. What are examples of provisions in business law?
Examples of provisions in business law include:
• Statutory requirements for maintaining a minimum level of reserves
• Provisions related to director remuneration in the Companies Act, 2013
• Clauses requiring audits of company financial statements annually.
These provisions outline legal compliance for businesses in official acts or statutes.
12. Why are provisions important in financial statements?
Provisions are important because they:
• Ensure a true and fair view of a company's financial position
• Account for anticipated losses or expenses
• Prevent overstatement of profits
• Align with accounting standards and statutory requirements
By making provisions, businesses follow the prudence principle and maintain reliable financial reporting.
