Provision, Reserve, and Liability

Liability

• Definition: Amount which is known and must be paid.
• Example:
  • Employee salary: ₹6,00,000; paid ₹5,00,000; Liability: ₹1,00,000
  • Building rent: ₹2,40,000 annually; paid ₹2,00,000 for 10 months; Liability: ₹40,000
• Characteristics:
  • Known amount
  • Must be paid
  • Ex: Outstanding salary, rent, creditors

Provision

• Definition: Amount set aside for a known liability, but the exact amount cannot be determined with substantial accuracy.
• Example: Tax
  • Company profit: ₹5,00,000; Tax: unsure if it's ₹1,50,000, ₹1,20,000, or ₹80,000
  • Provision created for estimated amount
• Characteristics:
  • Liability is certain, but exact amount is uncertain
  • Ex: Provision for tax, doubtful debts, depreciation
• Creation: Mandatory, reduces net profit
• Purpose: Cover anticipated expenses with uncertain amounts

Reserve

• Definition: Amount set aside from profits to meet future uncertainties.
• Example: Workman compensation reserve for potential accidents
• Characteristics:
  • May or may not be an actual liability
  • Ex: General reserve, capital reserve, investment fluctuation reserve
• Creation: Optional
• Purpose: Prepare for potential, uncertain future costs
• Use: Can be distributed as profit among shareholders

Comparison

• Liability: Known amount, must be paid
• Provision: Liability certain but amount uncertain; mandatory
• Reserve: Uncertain future requirements; optional
• Effect on Accounts:
  • Provision is a charge against profit
  • Reserve is an appropriation of profit

Practical Examples

1. Outstanding Liabilities: Salary, rent etc., known and must be paid
2. Provisions Created: Estimation for taxes, doubtful debts etc.
3. Reserves: Set aside for emergencies, future needs

Conclusion

• Understanding Differences: Between liability, provision, and reserve helps in accurate financial planning and reporting.

Remember: Provision is mandatory for uncertain amounts in future liabilities whereas reserves are optional and for future uncertainties.