1.0
INTRODUCTION
There are many risks
and uncertainties in business and in order to save the business from such
happenings and events, it is necessary to make provisions and reserves in every
business. Provisions and Reserves are used in different senses in accounting terminology.
2.0
OBJECTIVES
At the end of this note,
you should be able to:
• know the meaning of
Reserve and Provision
• classification of
Reserve:
i. Capital Reserve
ii. Revenue Reserve
• distinction between
Provisions and Reserve
• explain Secret
Reserve.
3.0
MAIN CONTENT
3.1
Provisions and Reserves
3.2
Meaning
3.2.1
Provision
The term 'Provision'
means any amount written off or retained by way of promising depreciation,
renewals or diminution in the value of assets or retained by way of providing
for any known liability the amount of which may not be determined with
substantial accuracy. If the amount of such liability can be ascertained it
will be a liability and not a provision. Provisions for depreciation for
repairs and renewals, provision for contingencies are some examples of
provisions. It is a charge to Profit and Loss Account.
3.2.2
Reserve
Any sum which is
appropriated out of Profit and Loss Appropriation Account and is not meant to
cover up any liability, contingency, commitment, or reduction in the value of
an asset is a reserve. It is provided for meeting prospective losses or
liabilities, creation of reserves increase the working capital in the business
and strengthen its financial position. Sometimes the amount is not kept in the
business as additional working capital but is invested in the purchase of
outside securities, then it is called reserve fund and not a reserve. Reserve
may be (i) Capital Reserve and (ii) Revenue Reserve.
i.
Capital Reserve
Any reserve which is
created out of capital profits and is not readily available for distribution as
dividend among the shareholders is called Capital Reserve. Profits prior to
incorporation, premium on the issue of shares or debentures, profit on the
reissue of shares, profit on redemption of debentures, profit on the sale of
undertaking or a part of it and profit of abnormal nature which is not meant
for distribution as dividend to shareholders are examples of such reserves.
ii.
Revenue Reserve
Any Reserve which is
available for distribution as dividend to the shareholders is called revenue
reserve. General Reserve, dividend equalization reserve, staff welfare reserve,
investment fluctuation reserve and contingency reserve are some of examples of
such reserves.
3.3
Distinction between Provision and Reserve
From the meaning of
Provision and Reserve stated above, you can easily distinguish between them.
The following are the
main points of distinction between a provision and a reserve.
1. Provision is a
charge to profit and loss account whereas reserve is an appropriation of
profit. Thus provision must be charged to Profit and Loss Account before
calculating the Net Profit or Net Loss, but Reserve can be made only when there
is profit.
2. Provision is made
because of legal necessity but creating a reserve is a matter of financial
prudence and to save the business from prospective losses and liabilities.
3.4
Types of Reserves
3.4.1
Secret Reserves
A Secret Reserve is a
reserve the existence and or the amount of which cannot be disclosed in the
Balance Sheet. Secret Reserves are created in those concerns where public
confidence is required for its working like banking companies, insurance
companies and electricity companies. Such reserves are created by showing the
assets at a lower figure and liabilities at higher figure.
Some of the ways for
creating secret reserves are given as under:
i) by charging
excessive depreciation
ii) by undervaluing
stock in trade and goodwill.
iii) by creating
unnecessary provisions for bad debts and other contingencies
iv) by charging
capital expenditure to profit and loss account
v) by suppressing the
sales
vi) by showing a
contingent liability as a real liability
vii) showing asset as
a contingent asset.
Advantages
of Secret Reserve:
The following are
main advantages of Secret Reserve:
1. It increases the
working capital of the concern and strengthens its financial position without
disclosing this fact to the shareholders.
2. It discourages
competition by not disclosing the larger profits made by a concern in a
particular line of business and industry.
3. It enables the
directors to tide over unfavorable times. As and when there is less profit, the
directors can maintain the rate of dividend by utilizing the secret reserve and
without disclosing this fact to the shareholders.
Disadvantages
of Secret Reserves:
The following are the
main objections raised against the secret reserves:
1. The balance sheet
will not disclose a true and fair view of the state of affairs of the business.
2. Sometimes the
directors make use of such reserves for their personal benefits.
3. The company worse
position can be concealed by the directors for some time by making the use of
secret reserve.
4. When secret
reserves are created, the assets are shown at less value in the balance sheet.
The concern will not get full claim for loss by fire of the assets as and when
such assets are destroyed by fire.
3.4.2
General and Specific Reserves
1. General reserves
are those reserves which are not created for any
specific purpose and
are available for any future contingency or expansion of the business. These
are created to provide additional working capital and strengthening the
financial position of the concern.
2. Specific Reserves
are those reserves which are created for a specific purpose and can be utilized
only for that purpose. Dividend equalization reserve and debenture redemption
reserve are good examples of such reserves.
3.5
Sinking Funds
Sinking Funds are
created to have ready money after a particular period either for the
replacement of an asset or for the repayment of a liability. Every year some
amount is charged or appropriated from the profit and loss account and is
invested in outside securities with the idea that at the end of the stipulated
period money will be equal to the amount we need.
Distinction between a
Sinking Fund to replace a wasting asset and sinking fund to repay a liability:
The following are the
main differences:
1. The annual
installment in case of sinking find to replace a wasting asset is really
depreciation and is a charge against profit and loss account while in case of
sinking fund to repay a liability, it is an appropriation of profit.
2. At the end of the
working life when the asset is to be replaced, sinking fund is utilized for
writing off old asset account but in other case it is closed by transferring
the balance to general reserve as the annual charge was on the profit and loss
appropriation.
3.6
Nature of Reserves
Reserves are shown on
the liabilities side of the balance sheet and by virtue of this, some persons
understand reserve as a liability but this is wrong. You should note that
Reserve is not a liability in the real sense. It represents accumulated
divisible profit which belongs to the shareholders just like capital and not
have been distributed as dividend as yet, that is why it is shown on the
liabilities side of the balance sheet.
Moreover, Reserve represents a portion
of the asset which is free to be utilized by the business as it likes i.e.
assets equal to reserves are not meant to meet any liability of the business.
4.0
CONCLUSION
Reserves are part of
the profit of any business set aside to meet unforeseen contingencies. In
cooperative, the law made this mandatory that at least 25% of the net surplus
be earmarked for this purpose as previously mentioned.
While Provision is
also part of the profit withheld for a particular purpose. You should note that
provision is created before profit or surplus is realized. It is charged to
Profit and Loss Account or Income and Expenditure Account. Whereas Reserve is
created if there is profit. No profit, no reserve.
5.0
SUMMARY
In this note, we
explained the meaning of Provision and Reserve. Provision means any amount
written off by way of providing for depreciation or diminution in the value of
assets. While Reserve means any amount which is appropriated out of Profit and
Loss Appropriation Account. No profit, no reserve.
Note that reserve is not
really a liability, but it represents accumulated profit which belongs to the
shareholders just like the capital.
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