Provisions and resercves

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Chapter 12

Provisions and Reserves

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Provisions and Reserves CHAPTER AT A GLANCE (Chapter 12)12.01 Provisions

12.01.01 Meaning 12.01.02 Importance

12.02 Reserves12.02.01 Meaning 12.02.02 Importance

12.03 Types of Reserves12.03.01 Revenue Reserve 12.03.02 Capital Reserve12.03.03 General Reserve and Specific Reserve

12.04 Secret Reserve


Provisions and Reserves 12.01 PROVISIONS12.01.01 Meaning When the amount in respect of a liability or expected loss is not certain, an estimated amount is set aside by debiting the Profit and Loss Account. The amount so set aside is known as a Provision. ExamplesProvision for depreciation, provision for doubtful debts, provision for taxation, provision for repairs and renewal and provision for contingencies


Provisions and Reserves 12.01 PROVISIONSFeatures:1. The purpose, for which a provision is created, is to meet• an anticipated loss which has occurred but the amount is not ascertained, or• a known depletion or diminution in the value of an asset, or• a liability which has been known to have arisen.

2. The exact amount of the anticipated loss, or the depletion in the value of the asset or the liability is not

ascertained or ascertainable, at the time of accounting.3. It is a charge to Profit and Loss Account.


Provisions and Reserves 12.01 PROVISIONS12.01.02 Importance 1. Creation of provision is an attempt to retain out of

current earnings amounts considered necessary to guard against all losses as are expected to arise out of transactions upto the date of accounting.2. It is an endeavour to retain future operating performance undisturbed by losses arising out of transactions of prior periods.


Provisions and Reserves 12.01 PROVISIONS3. A provision is created because of the conservative

approach of accountants. By creating provisions, accountants ensure playing safe. By way of

provisions, a part of the profits and corresponding assets are retained, which could otherwise have been spent away by way of distribution of profits.

4. Any loss or depletion in the value of an asset, or any liability as may not have been provided against

income or profit would effectively erode the capital of a business. Creation of provisions is an attempt to maintain the capital of business intact.


Provisions and Reserves 12.02 RESERVES12.02.01 Meaning Reserves are the amounts set aside out of profits. It is

an appropriation of profits or accumulated profits to strengthen the financial position of the business.

It is not a charge against profits. Reserves are not meant to cover any liability or depreciation in the value of assets. Examples are General Reserve, Reserve for Expansion,

Reserve for Equalisation of Dividends, Reserve for Increased Costs of Replacement, etc.


Provisions and Reserves 12.02 RESERVESImportant Note When the amount equal to the reserve is invested in

outside securities, the reserve will be named Reserve Fund.

But if there are no specific investments it will not be called a Reserve Fund but merely a ‘Reserve’.

General reserve, Reserve for expansion and Dividend Equalisation Reserve are shown in the Profit and Loss Appropriation Account and not in the Profit and Loss Account.


Provisions and Reserves 12.02 RESERVES12.02.02 Importance Reserves are important in a business to strengthen the

financial position of the enterprise. The reserves enable the enterprise to face difficult

financial period that may arise in the future by using reserves which are cost free source of internal

financing.


Provisions and Reserves 12.02 RESERVESThe reserves may be created for:1. Expansion2. Better financial position3. Redemption of liabilities4. Meeting unforeseen contingencies5. Making dividends uniform from year to year 6. Meeting legal requirements


Provisions and Reserves 12.03 TYPES OF RESERVES1. Revenue Reserves2. Capital Reserves3. General Reserve And Specific Reserve


Provisions and Reserves 12.03 TYPES OF RESERVES12.03.01 Revenue Reserves Any reserve which is available for distribution as dividend to the shareholders is called Revenue ReserveExamples

(i) General Reserves,(ii) Dividend Equalisation Reserve,(iii) Debenture Redemption Reserve and(iv) Investment Fluctuation Reserve, etc.


Provisions and Reserves 12.03 TYPES OF RESERVES12.03.02 Capital Reserves Any reserve which is created out of capital profits or is not

available for distribution as dividend to the shareholders is called Capital Reserve.

Examples(i) Profit prior to incorporation,(ii) Premium on issue of shares or debentures,(iii) Profits on redemption of debentures,(iv) Profit on forfeiture of shares,(v) Profit on sale of fixed assets,(vi) Capital redemption reserve and(vii) Profit on revaluation of fixed assets and liabilities


Provisions and Reserves 12.03 TYPES OF RESERVESDISTINCTION BETWEEN REVENUE RESERVE AND CAPITAL RESERVE

Revenue Reserves Capital ReservesIt is created out of business profits.

It is created out of capital

profits.



Revenue Reserves Capital ReservesIt can be used for distribution of dividends without the any precondition.

It can be used for distribution of dividends only if the company satisfies certain conditions prescribed by the Companies Act.



Revenue Reserves Capital ReservesIt is created for strengthening the financial position and meeting the unforeseen contingencies or some specific purpose.

It is created for meeting capital losses or to be used for purposes specified by the Companies Act.


Provisions and Reserves 12.03 TYPES OF RESERVES12.03.03 General Reserve and Specific ReserveGeneral Reserve It is the amount set aside out of profits for no specific

purpose. It is available for any future contingency or expansion

of business. Such reserve strengthens the financial position of the

business. It is to be noted that General Reserve and Contingency

Reserve generally mean the same thing.Slide 17/27www.afzalur.com

Provisions and Reserves 12.03 TYPES OF RESERVESSpecific ReserveIt is that reserve which is created for a specific purpose and can be utilised only for that purpose. ExamplesDividend Equalisation Reserve, Debenture Redemption Fund, Capital Redemption Reserve, Development Rebate Reserve, etc.Dividend Equalisation Reserve is a specific reserve because it is created to maintain a steady rate of dividend flow.


Provisions and Reserves 12.03 TYPES OF RESERVESReserve Fund If reserves are invested in outside securities and such securities are earmarked for a particular purpose denoted by the reserve, the reserve will be called ‘Reserve Fund’. A company will invest the funds outside only if:(i) ready cash is necessary on a certain date, or(ii) the funds cannot be profitably invested in the business

itself.


Provisions and Reserves 12.03 TYPES OF RESERVESNature of Reserves Reserves are shown on the liabilities side of a Balance

Sheet Reserves are liability and belongs to the proprietor.


Provisions and Reserves 12.04 SECRET RESERVE A secret reserve is a reserve the existence and/or the

amount of which is not disclosed in the Balance Sheet. It is also called a Hidden Reserve or Internal Reserve.

It can be said that there is a surplus of assets over liabilities and that the surplus is not disclosed or shown by the Balance Sheet.

Such reserves are created by showing the assets at a lower amount and liabilities at a higher amount.


Provisions and Reserves 12.04 SECRET RESERVE Under the provisions of the Companies Act, 1956, no

company (other than a banking company or insurance company) is allowed to maintain a secret reserve.

Secret reserves are created in concerns like banking companies, insurance companies, etc., where public confidence is required for its working life.


Provisions and Reserves 12.04 SECRET RESERVECreation of a Secret ReserveSecret Reserve can be created1. by charging excessive depreciation,2. by undervaluing stock-in-trade and goodwill,3. by creating excessive provision for bad debts and other contingencies,4. by charging capital expenditure to the Profit and Loss

Account,5. by suppressing sales,6. by showing a contingent liability as a real liability and7. by grouping free reserves as creditors.


Provisions and Reserves 12.04 SECRET RESERVEAdvantages of a Secret Reserve1. It increases the working capital of the concern and also strengthens its financial position.2. It discourages competition by not disclosing the total profit

made by a concern.3. It enables the directors to tide over unfavourable time. As

and when profit reduces, the directors can maintain the rate of dividend by utilising it.

4. Heavy losses of an exceptional nature can be met without disclosing the fact in the published statements and

without disturbing the normal business profit.Slide 24/27www.afzalur.com

Provisions and Reserves 12.04 SECRET RESERVEDisadvantages of a Secret Reserve1. The Balance Sheet will not disclose a true and fair position of the affairs of the business.2. Losses arising from bad and inefficient management

are not disclosed to the shareholders.3. Sometimes the directors make use of such reserves for

their personal benefits.


Provisions and Reserves 12.04 SECRET RESERVEDisadvantages of a Secret Reserve4. Value of shares goes down in the market.5. The shareholders do not get their due share of profit

from the business.6. The creation of secret reserve is not allowed under the

Companies Act, 1956 as it requires a full disclosure of all material facts and financial position.


Provisions and Reserves

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Provisions and resercves