Chapter - 17

Provisions & Reserves

Meaning of Provisions:

According to the Companies Act the term ‘Provision’ refers to any of the following amounts :

a) The amount written off or retained by way of providing for depreciation, renewals or
diminution in value of assets; or

b) The amount retained by way of providing for any known liability of which the amount cannot
be determined with substantial accuracy.

Examples of Provisions:

1) Provisions are created for the fulfillment of various objectives:

2) Provision for Depreciation of Assets
3) provision for Taxation
4) Provision for Bad and Doubtful Debts
5) Provision for Discount on Debtors
6) Provision for Repairs and Renewals of assets

Characteristics or Features of Provisions:

• Provision is made to meet a known liability.

• The liability is known but the amount of such liability cannot be determined with reasonable
accuracy.
• Provision is a charge against profits and as such reduces the profits of the year in which it is
created.

Purpose or Importance of Provisions:

To ascertain the true net profit of the business

• In order to ascertain the true profit of a business it is necessary that all expenses pertaining to
that year, must be debited to Profit and Loss account and a provision should also be made for
expenses or liabilities the amount of which cannot be estimated with reasonable accuracy.

To ascertain the true financial position of the business

• The Balance Sheet will depict the true and fair view of the financial position of the business
only if adequate provision is made for all the anticipated losses and expenses.

To provide for known losses in the future

• Funds will be required to meet the losses and liabilities that are likely to occur in the near
future.

Meaning of Reserves:

• Reserves mean amounts set aside out of profits and other surpluses to meet future
uncertainties. In other words, a reserve is meant for meeting any unknown liability or loss in
the future.

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 • According to William Pickles, “Reserves mean the amounts set aside out of profits and other
surpluses, which are not earmarked in any way to meet any particular liability, known to exist
on the date of the Balance Sheet”.

Examples of Reserves:

1) General Reserve
2) Capital Reserve
3) Dividend Equalisation Reserve
4) Investment Fluctuation Fund
5) Workmen Compensation Fund
6) Reserve for Redemption of Debentures

Characteristics or Features of ‘Reserves’

1) It is created out of net profits or divisible profits. As such the reserves are also termed as
‘Retained Earnings’ or ‘Undistributed Profits’.
2) Creation of reserves is not a legal necessity.
3) Normally, it is not created to meet any known liability or depreciation in the value of assets
but for meeting an unknown liability or loss in the future.
4) Reserves represent accumulated or undistributed profits and as such they belong to the
proprietors just as capital does.
5) When the amount of reserve is invested in outside securities it is known as ‘reserve fund’.

Purpose or Importance of Reserves:

1) Helpful in meeting the unforeseen liability or loss

• If any unforeseen or abnormal loss arises in the future, reserves can be utilized to meet such
eventualities.
2) Helpful in strengthening the financial position of the business
• Reserves are undistributed or accumulated profits and technically known as ‘ploughing back
of profit’.
3) Equalization of dividends over the years
• Goodwill of a Company depends upon maintaining a uniform rate of dividend from year to
year and also to increase the dividend steadily.
4) To provide funds for meeting a specific liability
• Sometimes a reserve is created for a specific purpose such as ‘Debenture Redemption Fund’
for the payment of debentures.

Distinction between Provision and Reserves:

Basis of Distinction Provision Reserve

1) Meaning It is created t meet a known liability. It is created to meet an unknown

liability

2) Necessity Creation of provision is a legal Creation of reserves is

(Charge or necessity. Provisions have to be discretionary. It can be created
Appropriation) provided for even if there are no only if adequate profits have been
profits. Thus, provision is a charge earned. Thus, reserve is an
against profits. Appropriation of Profit.

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 3) Object The object is to provide for The object of reserves is to
depreciation, doubtful debts and strengthen the financial position of
other specific liabilities the business.

4) Mode of It is created by debiting to P & L A/c. It is created not by debiting to P &

Creation hence, net profit cannot be L A/c but through P & L
calculated unless all provisions have appropriation A/c. As such, it is
been debited to P & L A/c. created after the calculation of net
profit.

5) Investment Provisions are never invested outside Reserves may be invested outside
outside the the business. the business.
business

6) Presentation It is either shown on the assets side It is shown on the liabilities side
in Balance by way of deduction from the asset under the head ‘Reserves and
Sheet for which it is created or as a distinct Surplus’.
item on the liabilities side.

7) Utilization for It cannot be utilized for distribution It can be utilized for distribution as
dividends as dividends among shareholders dividends among shareholders

8) Utilization for It is created to provide for a specific It is not created to provide for a
other loss and hence can only be used for specific loss and hence can only be
purposes meeting that loss. used for any purpose.

Types of Reserves:

1) Revenue Reserves:
• These reserves come into existence out of profits which have been earned in the course of
day-to-day business operations.

1.1 General Reserves:

• Usually, the businessmen do not withdraw the entire profits from the business but retain a
part of it in the business to meet unforeseen future uncertainties. Profits
so retained in the business for ‘a rainy day’ are known as ;General Reserve’.
• Similarly, Companies also do not distribute the entire profits as dividends but keep aside a
part of it in the form of General Reserve. Such reserves are also termed as ‘Contingency
Reserves’ or ‘Free Resereves’ because these are not created for any specific purpose and can
be freely used for any purpose.
• Objectives: General Reserves may be created or utilized for any of the following purposes :
a) For meeting unforeseen losses.
b) For the strengthening of financial position of business.
c) For expansion of business through internal resources or ploughing back of profits.
d) For equalization of dividends over years, in case of Companies.

1.2 Specific Reserve:

Such a reserve is created for a specific purpose and can be utilized only for that purpose.
Examples of Specific Reserves are:

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 a) Dividend Equalization Reserve: Such a reserve is created to maintain steady rate of dividend.
b) Reserve for Replacement of Asset: Such a reserve is created to provide finances for the
replacement of an asset at the end of its serviceable life.
c) Investment Fluctuation Fund: It is created to provide for decline in the value of investments
due to market fluctuations.
d) Workmen Compensation Fund: It is created to meet compensation payable to workers in
case of unexpected or unknown event of an accident.
e) Debenture Redemption Reserve: It is created to provide funds for the redemption i.e.,
repayment of debentures.

2) Capital Reserves:
• In addition to the normal profits, capital profits are also earned in the business from many
sources. The reserves created out of such capital profits are known as Capital Reserves.
• Such reserves generally, are not available for distribution as cash dividend among the
shareholders of a Company.
a) Profits on the sale of fixed assets.
b) Profits on the revaluation of fixed assets and liabilities.
c) Premiums received on issue of Shares or Debentures.
d) Profit on the purchase of a running business.
e) Profit prior to the incorporation of a Company.
f) Profit from the reissue of forfeited shares.
g) Profit on redemption of debentures.

Distinction between Revenue Reserves and Capital Reserves:

Basis of Revenue Reserves Capital Reserves

Distinction

Source of Creation These reserves are created out of These reserves are created out of
revenue profits which arise from the capital profits, which do not arise
normal operating activities of the from the normal operating activities
business and are otherwise available of the business and are not available
for distribution of dividends. for distribution of dividends.

Usage A specific reserve can be utilized Normally, these reserves cannot be

only for the earmarked purpose utilized for distribution of dividends
while a general can be utilized for to shareholders. However, some
any purpose including distribution capital reserves can be utilized to
of dividends to shareholders distribute dividends subject to
without any pre-conditions. fulfillment of certain conditions laid
down by Companies Act.

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 Purpose These reserves are created for These reserves are created to meet
meeting unforeseen losses and for Capital losses or may be used for
strengthening the financial position purposes laid down by Companies
of business. Act.

Secret Reserves:

• A secret reserve is one which is not disclosed by the Balance Sheet. These reserves are created
by showing a profit at a figure much lower than the actual and by showing the assets at a lower
figure and liabilities at a higher figure.

• When secret reserves exist, the actual position of the firm is much better than what is disclosed
by the Balance Sheet.

Secret reserves may be created in the following ways:

a) Writing off excessive depreciation;

b) Charging Capital expenditure (such as addition to assets) to Profit & Loss Account;

c) Treating a revenue receipt as a capital receipt (such as rent received credited to Building
Account);

d) Undervaluation of Assets (such as undervaluation of closing stock);

e) Showing an actual asset as a contingent asset;

f) Showing a contingent liability as an actual liability;

g) Suppressing the sales;

h) Creating excessive or unnecessary provision for doubtful debts and other contingencies.

Advantages of Secret Reserves:

1) Financial Stability : Creation of secret reserves strengthens the financial position of the
enterprise without disclosing this fact to the shareholders or the public.

2) Helpful in Absorbing Unforeseen Losses : The presence of secret reserves enable such
concerns to absorb any unexpected losses without any public discomfiture.

3) Regularity of Dividends : Such reserves help the enterprise in maintaining the rate of
dividend during adverse trading conditions without disclosing this fact to shareholders or the
public.

4) Avoidance of Competition : Because of concealment of actual profitability of the enterprise,

the entry of the competing firms in the particular line of business is avoided.

Disadvantages of Secret Reserves:

1) Unfair Presentation of Financial Statements: Statement of Profit & Loss fails to disclose true
profit and the Balance Sheet fails to disclose a true and fair view of the financial position of
the enterprise.

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2) Loss to Shareholders: Shareholders who wish to sell their shares may not get actual price of
their shares because of understatement of profits and financial position of the enterprise.

3) Misuse by Management: Fraudulent managements may take undue advantage by creating

secret reserves.

4) Cover for Misdeeds of Management: Secret reserves may be utilized by management to

cover their mistakes or misdeeds.