The key difference between reserves and provisions relates to their nature.

A provision is created in respect of a loss or expense that is most likely to happen in the near future. For example, provisions for bad debts are created because a business knows out of experience that some of its debtors will fail to fully settle their dues.

A provision is created by making a debit to the profit and loss account (i.e., it represents an expense).

A reserve, on the other hand, is an appropriation of profit (i.e., it is created out of profits). Instead of crediting the entire profit to the partners’ current accounts, a portion is transferred to the reserve account.

The aim is not to cover a potential loss but to allow the growth or expansion of the business.

The balance of a provisions account is shown in the balance sheet as a deduction from some asset’s value (e.g., provisions for bad debts are deducted from the debtors account, and the net amount of this account is shown in the balance sheet).

A reserve, as such, is a part of the firm’s equity. It is shown in the balance sheet on the liabilities side, alongside the partners’ capital accounts.

Frequently Asked Questions

Is a reserve also an appropriation of profit?

Yes, it is. Not all businesses have reserves. They are created only if the owners want to use some amount of their profits for something else. For example, they may wish to invest in certain special projects which might not yield any returns immediately but will produce benefits later on. A new machine may have a longer life and produce more output per year, but spending on it will reduce the amount of profit this year. In such cases, businesses transfer part of their profits to reserve accounts so as to maintain their capital value.

What is an appropriation of profit?

It is a method for distributing net profits among shareholders. If any business remains in profit after meeting all its expenses, there are two alternatives before it. It can keep the entire profit to itself to increase its capital fund and also run the business on a larger scale. This would be considered as a conservative approach, because all profits have been appropriated for expansion. The second alternative is to distribute a part of the profits among the shareholders in the form of dividends before starting any new project or extending old ones. This would be considered as a progressive approach, because the profits have been divided among the shareholders.

Can we say that when profits are transferred to a reserve account they are “appropriated” for some other purposes?

No, profits cannot be considered as appropriated until and unless they are set apart in a special account for some specific purposes.

Do companies have to disclose reserve accounts?

Yes, reserve accounts are disclosed in the 'Balance Sheet'. These accounts show that a part of the net profits has been set apart for some specific purpose and another part has been appropriated as dividends or bonus shares by transferring them to capital and suspense account. This is the difference between reserve and appropriation.

What is the balance in a capital account?

Balance in capital account represents an internal debt created within the Partnership firm for certain specific purposes. It may be redeemed either by transferring cash or excess of assets over liabilities through profit and loss account or by appropriating cash against this liability through reserves.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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