The terms “provisions” and “reserves” are defined in Part III of Schedule vi to the Companies Act as follows: Provisions represents (i) amounts set aside out of profits for depreciation, renewals, and diminution in the values of assets; or (2) amounts retained by way of providing for any known liability the amount of which cannot be determined with substantial accuracy.
Provision for depreciation of fixed assets, provision for doubtful debts, provision for income-tax, provision for contingencies etc, are examples of “provisions”.
Reserves represent amounts set aside out of profits and other surpluses which are not designed to meet any liability or contingency or diminution in value of assets known to exist at the date of the Balance Sheet, but which are retained in the business to strengthen the financial position.
Reserved are of two types : capital reserves and revenue reserves. A capital reserve represents amounts which are not free for distribution, such as a surplus upon a revaluation of fixed assets. A revenue reserve, on the other hand, is “any reserve other than a capital reserve”. General Reserves, Dividend Equalisation Reserve, Investment Reserve are instances of revenue reserves.
(b) Distinction between Provisions and Reserves
From the above we may indicate the following points of distinction between “provisions” and “reserves”:
1. Provision is a charge against profits, whereas the reserve is an appropriation of profits. A provision is made by debiting the Profit and Loss Account for a specific contingency or expected loss, e.g. provision for doubtful debts, provision for depreciation etc. The reserve is created by debiting the Profit and Loss Appropriation Account for the redemption of a known liability or to strengthen the working capital of the business.
2. In the case of provision, a definite sum is set aside every year to meet the known contingency, whereas the reserve is generally created without taking into consideration the actual amount required.
3. Provisions are generally shown on the assets side of the Balance Sheet by way of deduction from the assets concerned. But reserves are usually shown on i the liability side of the Balance Sheet.
4. A making of provision is obligatory, whereas making of a reserve is usually discretionary and is a matter of financialpolicy.
5. In case of provisions, the auditor’s duty is to see that provisions made by the management are adequate and reasonable. Where the provisions made are, in his opinion, materially inadequate, and he cannot persuade his client to increase them, he should make express reference thereto in his report. As regards reserves, it is not the auditor’s duty to be concerned with the adequacy or otherwise of amounts of profits set aside to reserve. It is a matter of the company’s financial policy.
6. Provisions are to be made even when the company incurs a loss. But a reserve can be created only out ofprofits. (c) Fund The word ‘fund’ in relation to any reserve should be used, according to Part I of schedule VI to the Companies Act, only where such reserve is specifically represented by earmarked investments.