Chapter 18 – Provisions and Reserves
Provisions: A provision is an amount set aside to meet a known liability or expense when the exact amount cannot be determined with reasonable accuracy, but its occurrence is highly probable. It is a charge against profit, meaning it is created even if the business is incurring losses.
Characteristics of Provisions:
Known Liability/Expense: The existence of the liability or expense is certain.
Uncertain Amount: The precise amount of the liability or expense is not known and needs to be estimated.
Charge Against Profit: Provisions are debited to the Profit and Loss Account, thereby reducing the net profit of the business.
Mandatory: Creation of certain provisions might be a legal necessity or required by accounting principles (e.g., prudence principle).
Cannot be used for Dividend Distribution: Provisions are created to meet specific future obligations and cannot be distributed to shareholders as dividends.
Presentation in Balance Sheet:
For a decrease in asset value (e.g., depreciation), it’s shown as a deduction from the concerned asset.
For a liability, it’s shown on the liabilities side.
Importance/Need for Creating Provisions:
To Ascertain True Net Profit: By accounting for anticipated expenses and losses, provisions help in calculating the actual net profit of the business.
To Present a True and Fair View of Financial Position: They ensure that the balance sheet reflects potential future obligations, providing a realistic picture of the company’s financial health.
To Provide for Future Losses: They act as a buffer against expected future losses, preventing a sudden drain on profits in the year the actual loss occurs.
Compliance with Accounting Principles: Adhering to the prudence (conservatism) principle, which states that anticipated losses should be accounted for, but anticipated profits should not.
Examples of Provisions:
Provision for Depreciation: To account for the estimated decline in the value of fixed assets due to wear and tear, obsolescence, etc.
Provision for Bad Debts: To cover potential losses from debtors who may not be able to pay their outstanding amounts.
Provision for Discount on Debtors: To account for discounts that might be offered to debtors for early payment.
Provision for Taxation: To cover the estimated income tax liability for the current year.
Provision for Repairs and Renewals: To meet the anticipated cost of major repairs or renewals of assets in the future.
Reserves
Reserves are amounts set aside out of profits (or other surpluses) to strengthen the financial position of the business, meet unforeseen contingencies, or for specific future purposes. Reserves are an appropriation of profit, meaning they are created only when there are sufficient profits.
Characteristics of Reserves:
Appropriation of Profit:Reserves are created by debiting the Profit and Loss Appropriation Account, which is prepared after the net profit has been calculated. They do not reduce the net profit but reduce the divisible profit.
Discretionary(Mostly): While some reserves might be statutory, many are created voluntarily by the management as a matter of prudence.
Can be used for Dividend Distribution (General Reserve): A general reserve can be used for various purposes, including dividend distribution (to equalize dividends over time). However, specific reserves are tied to their purpose.
Strengthens Financial Position: Reserves provide a financial cushion for the business, enhancing its solvency and liquidity.
Investment Outside the Business (Reserve Fund): If the amount of a reserve is invested in outside securities, it is called a “Reserve Fund.”
Presentation in Balance Sheet: Shown on the liabilities side under the heading ‘Reserves and Surplus’ as part of shareholder’s equity.
Importance/Need for Creating Reserves:
To Meet Unforeseen Liabilities/Losses: Provides a financial buffer for unexpected events or losses in the future.
To Strengthen Financial Position: Enhances the solvency and liquidity of the business, making it more resilient.
Equalisation of Dividends: Allows the company to maintain a stable dividend payout even in years of lower profits.
Financing Expansion and Growth: Reserves can be used to fund future expansion plans, modernization, or other long-term investments.
Meeting Statutory Requirements: Some reserves (e.g., Debenture Redemption Reserve) are legally mandatory.
Types of Reserves:
- Revenue Reserves: Created out of the profits earned from the normal, day-to-day operations of the business.
- General Reserve:
A reserve created for general purposes, without any specific intended use. It is a portion of profits retained in the business to meet future uncertainties or contingencies.
Also known as “Free Reserves” or “Contingency Reserves.”
Can be used for any legitimate business purpose, including dividend distribution.
- Specific Reserves:
Reserves created for a particular, identified purpose. Their use is restricted to that specific purpose.
Examples:
Debenture Redemption Reserve (DRR): To provide funds for the repayment of debentures.
Workmen’s Compensation Fund (or Reserve): To meet claims of workmen in case of accidents or injuries.
Investment Fluctuation Fund (or Reserve): To cover potential losses arising from a fall in the market value of investments.
- Capital Reserves:
Created out of capital profits (profits not arising from the normal operating activities of the business). These profits are generally non-recurring in nature.
Cannot be used for Dividend Distribution (unless specifically permitted by law and articles of association).
- Examples:
Profit on Sale of Fixed Assets: Excess of sale price over the book value of a fixed asset.
Premium on Issue of Shares or Debentures: Amount received over and above the face value of shares or debentures.
Profit on Reissue of Forfeited Shares: Profit made when forfeited shares are reissued.
Profit on Redemption of Debentures: Profit earned when debentures are redeemed at a price lower than their face value.
Profit prior to Incorporation: Profits earned by a company before its formal incorporation.
Differences between Provisions and Reserves
| Basis | Provision | Reserve |
| Basic Nature | Charge against profit | Appropriation of profit |
| Purpose | To meet a known liability of uncertain amount | To strengthen financial position, meet unforeseen contingencies, or specific future uses |
| Compulsion | Often legally mandatory or required by accounting principles (e.g., prudence) | Generally optional, except for statutory reserves (e.g., DRR) |
| Effect on Profit | Reduces net profit | Reduces divisible profit, but not net profit |
| Creation | Even if there are insufficient profits (or losses) | Only if there are adequate profits |
| Account Debited | Profit and Loss Account | Profit and Loss Appropriation Account |
| Dividend Distribution | Cannot be used for dividend distribution | General reserves can be used; specific and capital reserves generally cannot |
| Investment | Cannot be invested outside the business | Can be invested outside the business (known as Reserve Fund) |
| Disclosure | Disclosed in the Balance Sheet as a deduction from asset or a liability | Disclosed in the Balance Sheet under ‘Reserves and Surplus’ |
Difference between Revenue Reserves and Capital Reserves
| Basis of Difference | Revenue Reserves | Capital Reserves |
| Source of Creation | Created out of revenue profits (profits from normal operating activities of the business) | Created out of capital profits (profits not arising from normal operating activities, generally non-recurring). |
| Nature of Profit | Arise from regular, recurring business operations. | Arise from extraordinary or non-recurring transactions. |
| Purpose | To strengthen the financial position, meet unforeseen contingencies, provide for expansion, or stabilize dividends. | To strengthen the long-term financial position, finance capital expenditure, or write off capital losses. |
|
Accounting Treatment |
Debited to Profit and Loss Appropriation Account. | Debited to Profit and Loss Account (for capital profits) or specific capital profit accounts. |
| Examples | General Reserve, Workmen’s Compensation Fund, Investment Fluctuation Fund. | Profit on Sale of Fixed Assets, Capital Redemption Reserve, Revaluation Reserve. |
| Financial Strength Impact | Enhances operational liquidity and solvency. | Enhances long-term financial stability and asset base. |
| Legal Restrictions | Less stringent legal restrictions on their use. | More stringent legal restrictions on their use, often governed by company law. |
| Impact on Net Profit | Does not reduce net profit, but reduces the divisible profit (profit available for distribution). | Does not impact the calculation of operational net profit, as they arise from non-operational gains. |
- Secret Reserves:
Reserves that are not openly disclosed in the balance sheet.They are created by deliberately understating assets or overstating liabilities.
To further strengthen the financial position of the company and to conceal the true profit/financial strength from competitors or potential acquirers.
Creation Methods:
- Charging excessive depreciation.
- Undervaluation of assets (e.g., stock).
- Overstating liabilities.
- Charging capital expenditure to revenue.
While they provide financial strength, their creation is generally discouraged as they do not present a “true and fair view” of the financial statements.