Provision is a charge against profit to meet certain known liabilities or contingencies.: True profits of a business can be known properly if all the expenses and losses incurred are deducted from the revenue of the period. This deduction of expenses/losses from revenue is calling charging of expenses against profits. There are times when we are not able to exactly calculate the amount of expense/loss the liability for which may arise later. In that case we estimate the amount of expense and debit that to Profit & Loss Account of the Current year and create a Provision. For example a consumer has filed a suit in court again your company's product and has asked for a compensation of Rs.10000. You as a Manager feel that the decision of Court may go in the favour of consumer and you will have to pay him Rs.10000. If you wish to show the true picture of financial results and health of your company, you will definitely like to treat this as an expense in the current year and show as a liability in the current year's Balance Sheet. Your entry will be:
Profit & Loss A/c Dr. 10000
To Provision for Compensation to consumers A/c 10000
Due to the above entry your profits of the current year have reduced by Rs.10000, this is called charging against the profits. In the current year's balance sheet this provision will come on the liability side.
Reserves on the other hand are created out of the profits. Let us take the example of an average household. For example if a man is getting Rs.50000 as salary and out of this he is regularly putting Rs.10000 in Fixed Deposit with the bank. Why is he saving? He is saving because in future he may have to pay for higher studies of his children or may be for his old age or to meet sudden medical expenses etc. Similarly a business also puts aside a part of its profits for its future growth needs or to meet some unknow contingencies (future is always uncertain). This putting aside of a part of profits is called APPROPRIATION OF PROFITS and the amount put aside is called RESERVE. Entry for that will be:
Profit & Loss Appropriation A/c Dr.
To Reserve A/c
With this entry, the profit available for distribution as dividends will reduce and in Balance Sheet Reserve will be shown on the liability side.
I hope I have made the difference amply clear. In case still some doubt persists, please feel free to ask again.