What is a Reserve?

A reserve is funding that is set aside for expected financial requirements. For example, a company might set aside a reserve to pay for an expected adverse judgment in a lawsuit that is about to be settled. The amount in the reserve is the expected amount of the lawsuit payout.

What is an Allowance?

An allowance is pared with and offsets another account to show how expected losses will reduce the balance of the paired account. For example, a company creates an allowance for doubtful accounts that is paired with and offsets its trade accounts receivable account. The intent of this allowance is to recognize the expected amount of bad debts contained within the current accounts receivable balance.

Comparing a Reserve and an Allowance

A reserve is typically used to set aside a portion of a firm’s retained earnings, which signals to investors that the company plans to use the funds for specific future purposes, such as the purchase of fixed assets or an expansion into a new geographic region, rather than paying out the funds as dividends. An allowance is commonly associated with bad debts, such as the allowance for doubtful accounts, and so is paired with the trade receivables account to show the expected amount of receipts expected from those receivables. Another common allowance account is the allowance for obsolete inventory.