Accountancy: Provisions and Reserves: Need for Provision and Types of Reserves

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A provision is an amount set aside from a company’s profits to cover an expected liability or a decrease in the value of an asset, even though the specific amount might be unknown. In accounting, the matching principle states that expenses should be reported in the same financial year as the correlating revenues. This is because costs that belong to a certain year can become misleading if accounted for in previous or future financial years. Provisions therefore adjust the current year balance to be more accurate by ensuring that costs are recognised in the same accounting period as the relevant expenses. Provisions are recognised on the balance sheet and are also expensed on the income statement.

Need for Provision

  • To redeem the liability

  • To dispute a claim

  • Specific loss on realization of an asset

  • Writing off bad debts

  • Provision for contingent liabilities

A reserve is gains that have been allotted for a specific purpose. Reserves are usually set up to buys fixed assets, pay bonuses, pay an expected legal settlement, pay for repairs & maintenance and pay off debt. When an enterprise earns a profit during the end of a year, a certain part of it is retained in the trading concern to meet future exigencies, growth outlooks etc., The amount of money that is kept aside is known as Reserves in Accounting. They assist in securing the financial situation of an enterprise and can be utilised for different purposes such as stable dividend repayments, expansion, meeting contingencies, legal requirements, investments, improving the financial situation, etc., It is also termed as retained earnings.

For instance – Reserve for Dividends Equalization, General reserve, Reserve for Increased Cost of Replacement, Reserve for Expansion, etc.,

Types of Reserves

Types of Reserves

Types of Reserves

  • Capital Reserve (created out of capital profit)

  • Revenue Reserve (created out of revenue profit)

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