The accounts of a business are prepared following the going concern concept, i.e., assuming that their business will continue for a foreseeable future and there is no intention to close or scale down its operations significantly.

Hence, to ascertain the net profit for each year, not only the current contingencies but future contingencies should also be considered.

In fact, Provisions and Reserves are such considerations that actually relate to the future needs for which a part of the current earning is set aside.

PROVISIONS

Provision is an amount set aside, by charging it in the Profit and Loss Account, to provide for a known liability the amount of which cannot be determined with accuracy.

It is charged in the Profit and Loss Account on an estimate basis.

Provision for Depreciation, Provision for Doubtful Debts, Provision for Repairs and Provision for Tax are few examples of Provisions.

Provision differs from liability to the extent that provision is an estimated amount while liability is ascertained amount.

For example, providing for wages of ₹ 50,000 payable for the month of March is a liability. Thus, Provision is an estimated amount set aside to meet an uncertain loss or expense in the future.

“A Provision is the amount written off or retained by way of providing depreciation, renewals or diminution in the value of assets or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy.”

-Penguin Dictionary of Commerce

Concept of Provisions

Accrual Assumption is a fundamental accounting assumption. It means all liabilities, losses and expenses, whether ascertained or not, should be recorded in the books of accounts to determine profit or loss for the accounting period.

The unascertained liabilities are recorded in the books of accounts on an estimated basis which should be close to actual liability or expense. The amount so set aside is known as ‘Provision’.

Objectives of Provisions

The objectives of provision are to provide for all expenses and losses even when the amount of such expenses and losses is not ascertained or determined.

They are provided on an estimated basis. As a result of provision, correct (or near correct) profit or loss is ascertained, liabilities and assets are shown at correct values.

Features of Provision are:

1. It constitutes an amount set aside out of income or profits. It is the retention of profit, made temporarily, for a specific purpose.

2. The purpose, for which a provision is created is to meet.

• (a) an anticipated loss which has occurred but the amount is not ascertained or
• (b) a known depletion or diminution in the value of an asset or
• (c) a liability which has been known to have arisen.

3. 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.

4. It is a charge to Profit and Loss Account.

Importance of Provisions

1. A Provision is an amount set aside out of current earnings considered necessary to provide for all losses that are expected to arise out of transactions entered into during the accounting period.

2. A provision is made to retain future operating performance undisturbed by losses arising out of transactions of prior periods.

3. A Provision is following the prudence concept of accounting which holds ‘provide, for anticipated expenses and losses but do not provide for anticipated incomes’. By making a provision, a part of the profits and corresponding assets are retained, which otherwise could have been distributed as 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. The creation of Provisions is an attempt to maintain the capital of business intact.

It is clear from the above that Provisions represent

(a) maintenance of capital,

(b) adjustment of capital as is lost or eroded in the process of generation of revenue with current revenue and;

(c) a shield where loss arising out of past transactions does not affect the result of future operations.

The above discussion brings out the point that current income or profit cannot be measured without creating Provisions. Provisions are accordingly, considered as a charge against revenue or profits.

RESERVES

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 but an appropriation of profits.

Reserves are not meant to cover any liability or depreciation in the value of assets.

Reserve is set aside to meet known or unknown contingency that may arise in the future.

Examples are General Reserve, Reserve for Expansion, Reserve for Equalisation of Dividends, Reserve for Increased Costs of Replacement, etc.

It is important to note that if 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.

Importance of Reserves: Reserves are important in a business to strengthen the financial position of the enterprise.

The creation of Reserves enables the enterprise to tide over a difficult financial period in the future or to plowed back profits (which is a cost-free source of internal financing). The purpose of Reserves may be:

(i) Expansion,

(ii) Better Financial Position,

(iii) Redemption of Liabilities,

(iv) Meeting unforeseen Contingencies,

(v) Making Dividends uniform from year to year and

(vi) Meeting legal requirements such as Investment Reserve required by the Income-Tax law.

Types of Reserves:

To have a better understanding of the nature and purpose of Reserves, let us classify them into different types. These are:

(1) Revenue Reserves and Capital Reserves

Revenue Reserves are created out of revenue profits which are available for distribution as dividend. Examples of Revenue Reserves are:

Capital Reserves are created out of capital profits and are normally not available for distribution as dividend. In other words, reserve created out of capital profits and which is not readily available for distribution as dividend among the shareholders is called Capital Reserve. Examples of capital reserves are:

(i) Profit prior to incorporation,

(ii) Premium on issue of shares or debentures,

(iii) Profit 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.

All capital profits should, therefore, be regarded as Capital Reserves. Having understood the meaning and purposes of Revenue Reserve and Capital Reserve, we can now distinguish them in a more orderly manner as follows:

DISTINCTION BETWEEN REVENUE RESERVE AND CAPITAL RESERVE

Basis	Revenue Reserve	Capital Reserve
1. Source	It is created out of business profits.	It is created out of capital profits.
2 Usage	It can be used for distribution of dividends without any precondition.	It can be used for distribution of dividends only if the company satisfies certain conditions prescribed by the Companies Act.
3. Purpose	It 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.

(2) General Reserve and Specific Reserve

General Reserve 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.

Specific Reserve is that reserve which is created for a specific purpose and can be utilised only for that purpose. For example, Dividend Equalisation Reserve is a Specific Reserve because it is created to maintain a steady rate of dividend flow. Thus, this reserve will be utilised to keep the dividend up in the year in which the profits are insufficient. Debenture Redemption Fund, Capital Redemption Reserve, Development Rebate Reserve, etc., are other examples of Specific Reserve.

It should be remembered that both General Reserve and Specific Reserve are created out of profits by debiting Profit and Loss Appropriation Account.

Reserve 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:

(a) ready cash is necessary on a certain date or

(b) the funds cannot be profitably invested in the business itself.

Nature of Reserves: Reserves are shown on the liabilities side of the Balance Sheet. This perplexes many a new student of Accountancy. He argues that the business owes this sum to no one. Why should it be a liability? And if a Reserve is a Liability, what is its use? It should be an asset. The truth is that reserves belong to the proprietors just as capital does. This sum is owed by the business to the proprietors. Hence, it is quite proper to show it as a ‘liability’. Look at in another way, Reserves themselves are not assets. Reserves mean that a portion of assets equalling reserves is free to be utilised by the business as it likes and assets equalling reserves are not required to pay liabilities. Also, Reserves indicate that, taking into account the capital brought in cash into the business by the proprietor and the sums owed to outsiders, there is a surplus of assets. The surplus is actually measured by the amount of Reserves.

It should be remembered that a reserve fund debit balance in Profit and Loss Account cannot exist together. In case Profit and Loss Account shows a debit balance, at any subsequent date, it is adjusted against the Reserve Fund. The reason being that it would be a contradiction to state on one side of the Balance Sheet, an item representing a deficiency in Profit and Loss Account, and on the other side, an item representing the surplus set aside out of profits. Thus, the debit balance in the Profit and Loss Account (if any) should be shown as a deduction from the Reserve Fund or General Reserve under the head ‘Reserves and Surplus’ on the liabilities side of the Balance Sheet.

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.

Under the provision 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.

Creation of a Secret Reserve

Some of the ways in which Secret Reserve can come into existence are:

• 1. by charging excessive depreciation,
• 2, by undervaluing stock-in-trade and goodwill,
• 3. by creating excessive provision for doubtful 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 and
• 7. by grouping free Reserves as creditors.

Advantages of a Secret Reserve

• 1. 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.

Disadvantages of a Secret Reserve

• 1. The published accounts—Profit and Loss Account and Balance Sheet—become inaccurate and misleading. They fail to accurately represent the true and fair position of the affairs.
• 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.
• 4. Value of shares goes down in the market.
• 5. The shareholders do not get their due share of profit from the business.

DISTINCTION BETWEEN RESERVE AND PROVISION

Basis	Reserve	Provision
1. Nature	It is an appropriation of profit.	It is a charge on profit.
2. Purpose	It is created to strengthen the financial position and to meet unforeseen liabilities or losses.	It is made to meet known liability or contingency, if the amount is not determined.
3. Effect on Profit	It is debited to the Profit and Loss Appropriation Account. Hence, profit is not affected.	It is debited to the Profit and Loss Account, Hence, profit is reduced.
4. Investment	It may be invested outside the business.	It is not invested.
5. Distribution	Unutilised part can be distributed as dividend. It reduces divisible profits.	It cannot be used for distribution as profit/ dividend. It reduces net profits.
6. Compulsion/Prudence	It is created as a matter of prudence out of profits.	It is made out of legal necessity.
7. Presentation	A reserve is shown on the liabilities side of Balance Sheet under the head ‘Reserves and Surplus.	It is shown either as liability under the head ‘Current Liabilities’ or as deduction from the asset.

CHAPTER SUMMARY

• Provision is providing for a liability the amount of which is not certain. In other words, the amount provided is an estimate. Examples are: Provision for Doubtful Debts, Provision for Discount on Debtors, etc.

• Concept of provision is to provide for liabilities, losses and expenses, whether the amount thereof is ascertained or not.

• Objective of provision is to show correct profit or loss and liabilities and assets are shown at correct values.

• Reserve is an amount set aside out of profits to meet future contingencies or to strengthen the financial position of the enterprise. Examples of reserves are General Reserve, Reserve for Expansion, Dividend Equalisation Reserve, etc. All Reserves appear on the liabilities side of the Balance Sheet.

• Reserves may be:

(i) Revenue Reserves: They are created out of revenue profits which are available for distribution as dividend. Examples are General Reserve, Debenture Redemption Reserve, Dividend Equalisation Reserve, etc.

(ii) Capital Reserves: They are created out of capital profits. Examples are Profit prior to incorporation, Premium on issue of securities, Profit on forfeiture of shares, etc.

HIGH ORDER THINKING SKILLS QUESTIONS

Q.1. Do you think that a Provision is a charge against profit?

Ans. Yes, a Provision is a charge against profit for the purpose of providing for any liability or loss.

Q.2. If the amount of a known Liability can be ascertained with accuracy, it should be treated as a Liability or a Provision. Comment.

Ans. It should be treated as a liability and not a Provision.

Q.3. A provision can be specific or general. Do you agree?

Ans. A Provision can be specific, e.g., provision against a particular debtor or general, expressed as a percentage of total debtors.

Q.4. Reserve is not a liability in the real sense. Do you agree with this statement?

Ans. Yes, Reserve is not a liability in the real sense. It represents accumulated divisible profit which belongs to the shareholders or partners just like capital and has not been distributed as dividend as yet; that is why it is shown on the liabilities side of the Balance Sheet.

Q.5. Capital Reserves are freely distributed as profits. Comment.

Ans. No. Capital Reserves are not freely distributed as profits.

Q.6. Capital Reserve may or may not involve any receipts of cash. Do you agree?

Ans. Yes. Capital Reserve may or may not involve any receipts of cash.

VERY SHORT ANSWER TYPE QUESTION

Q. 1. What is meant by Provision?

Ans. Provision is an amount set aside by charging it in the Profit and Loss Account to provide for a known liability the amount of which cannot be determined with accuracy.

Q.2. Give two examples of Provisions.

Ans. (i) Provision for Depreciation.

(ii) Provision for Repairs.

Q.3. What is meant by Reserves?

Ans. Reserve is an amount set aside out of profits. It is an appropriation of Profits.

Q.4.What are major types of Reserves?

Ans. (i) General Reserve.

(ii) Securities Premium Reserve.

Q.5.What is meant by General Reserve?

Ans. General Reserve is the amount set aside out of profits for no specific purpose.

Q.6.What is meant by Capital Reserve?

Ans. Capital Reserve means reserve created out of Capital Profits.

Q.7.Give two examples of Capital Reserve?

Ans. (i) Profit earned prior to incorporation.

(ii) Premium on issue of shares or debentures (Securities Premium).

Q.8.What is meant by Revenue Reserve?

Ans. Revenue Reserves are the reserves being the amount set aside out of revenue profits.

Q.9.What is meant by Specific Reserve?

Ans. Specific Reserve is the reserve created for a specific purpose and can be utilised only for that purpose.

Q.10.What is meant by Reserve Fund?

Ans. The term ‘Reserve Fund’ means reserve the amount of which has been invested outside the business.

Q.11.What is meant by Specific Reserve?

Ans. Secret Reserve is a reserve which is not disclosed in the Balance Sheet. For example, assets shown at lower amount and liabilities shown at higher amount.

Q.12.Give one example of each of ‘provision’ and ‘reserve’.

Ans. Provision: Provision for Tax

Reserve: General Reserve.

Q.13.Differentiate between Revenue Reserve and Capital Reserve on the basis of source. (Delhi 2010)

Ans. Revenue Reserve is created out of business profits whereas Capital Reserve is created out of capital profits.

Objective Type Questions

1. Choose out the correct alternative:

(i) Reserves arising from capital receipts are known as

(a) capital reserve. (b) reserve fund. (c) None of these.

(ii) Provisions are

(a) external transactions. (b) internal transactions. (c) None of these.

(iii) A Provision is

(a) an appropriation out of profits. (b) charge against the profits. (c) None of these.

(iv) If the amount of any known liability cannot be determined with accuracy

(a) a liability should be provided. (b) a provision should be made. (c) a reserve should be set aside.

(v) If the amount of any known liability can be determined with accuracy

(a) a liability should be provided. (b) a provision should be made. (c) a reserve should be set aside.

Ans.: (i) (a); (ii) (b); (iii) (b); (iv) (b); (v) (a).

2. State whether the following statements are True or False:

(i) Reserves can be specific or general.

(ii) Reserves appear on the liabilities side of the Balance Sheet.

(iii) Capital Reserves are not freely distributed as profits.

(iv) Reserves are not the items of the owners’ equity.

(v) Secret Reserves are disclosed in the Balance Sheet.

(vi) A Specific Reserve can be created for any purpose.

(vii) A General Reserve is created to meet contingency liability.

(viii) Revenue Reserves are created out of revenue profits of the business.

Ans.: (i) True; (ii) True; (iii) True; (iv) False; (v) False; (vi) True; (vii) True; (viii) True.

3. Fill in the blanks with appropriate words:

(i)____________reserve may or may not involve any receipts of cash.

(ii) Provision is debited to __________________Account.

(iii) All reserves appear on the ________________side of the Balance Sheet.

(iv) Reserves, other than Capital Reserves, can be distributed to______________

Ans.: (i) Capital; (ii) Profit and Loss; (iii) liabilities; (iv) shareholders/partners.

4. Fill in the blanks with respect to reserves that complete the sentences.

(i) __________________are created in business for rainy day.

(ii) _________________are created for specific purpose.

(iii) _________________are created out of capital gains. (MSE Chandigarh 2012)

Ans.: (i) General Reserve; (ii) Specific Reserve; (iii) Capital Reserve.