Provision and Reserves – tryspring

By | September 6, 2019

Provision and Reserves

Meaning of Provisions

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

– The Institute of Chartered Accountants of India

“Liabilities which can be measured only by using a
substantial degree of estimation.”

– AS-29 issued by Institute of Chartered Accountants of
India

AS 29 also defines liabilities as “a present obligation
of the enterprises arising from past events, the settlement of
which is expected to result in an outflow from the enterprise of
resources embodying economic benefits
.”

Debiting Profit and Loss account, provisions are created and
shown either deducting assets side or on the liabilities side
under relevant sub-head of Balance Sheet.

Provision for bad and doubtful debts, Provisions for Repair &
Renewals, and Provision for discounts & depreciation are the
most common examples.

Meaning of Reserves

“That portion of earnings, receipts or other surplus of an
enterprise (whether capital or revenue) appropriated by the
management for general or a specific purpose other than a
provision for depreciation or diminution in the value of assets
or for a known liability.”

-ICAI

Reserve is an appropriation of profits; on the other hand,
Provision is a charge against profit. Reserves are not meant to
meet out contingencies or liabilities of a business. Reserve
increases working capital of a company to strengthen the
financial position.

There are two types of reserves

  • Capital Reserve − Capital reserve is not readily
    available for distribution as the dividends among the
    shareholders of the company, and it creates only out of
    capital profit of the company. It is like Premium on issue of
    shares or debentures and Profit prior to incorporation.

  • Revenue Reserve − Revenue reserves are readily
    available for the distribution of profit as dividend to the
    shareholders of the company. Some of the examples of this are
    general reserve, staff welfare fund, dividend equalization
    reserve, debenture redemption reserve, contingency reserve,
    and investment fluctuation reserves.

Distinction between Provisions and Reserves

  • Reserve can be made only out of profit and provisions are the
    charge to profit.

  • Reserves reduce divisible profits and provisions reduce the
    profit.

  • Reserves, if remain un-utilized for some period can be
    distributed as dividends, but provisions cannot be
    transferred to General Reserve for the distribution.

  • Purpose of provision is very specific, but reserve is created
    to meet out any probable future liabilities or losses.

  • Creation of provisions is legally necessary, but reserves are
    created to save a concern from the future losses and
    liabilities.

Secret Reserves

Banking Company, Insurance Company, and Electricity Companies
create secret reserves, where the public confidence is required.
In this case, to create secret reserve, assets showed at lower
cost or liabilities at higher value. Some of the examples of it
are as follows −

  • By undervaluing goodwill or stock
  • By excessive depreciation
  • By creating excessive provisions
  • Showing free reserves as creditors
  • By charging capital expenditure to profit and loss account

Advantages of Secret Reserves

Some of the important advantages are given below −

  • Without disclosing to its shareholders, it increases working
    capital of a concern, which is a clear indication of the
    sound financial position.

  • With the help of secret reserves, directors can maintain the
    rate of dividends during the unfavorable time.

  • Non-disclosure of a big profit is useful to avoid an un-due
    competition.

Limitations of Secret Reserves

Major limitations or objections of secret reserves are as follows

  • Due to non-disclosure of actual profit, financial statements
    do not presents true and fair view of the state of affairs.

  • There are lots of chances of misuse of reserves by the
    directors for their personal benefits.

  • Due to secret reserves, chances for the concealment of worst
    position of a company are very high.

  • Company will get very lower amount of claim of insurance at
    the time of loss of stock or other assets, as valuation of
    the assets are done at very low value to create secret
    reserve.

General and Specific Reserves

Specific reserves are created and utilized for the purpose only
for which they are created, like dividend equalization reserve
and debenture redemption reserve.

General reserves are created for any future contingency or to
utilize at the time of expansion of a business. Purpose of
creation of General reserve is to strengthen the financial
position of the company and to increase the working capital.

Sinking Fund

For the purpose to repay of any liabilities or to replace any
fixed assets after particular period, sinking funds are created.
For this, some amount are charged or appropriated from the profit
and loss account every year and invested in any outside
securities. Without any extra ordinary burden, replacement of an
asset may be done in a systematic manner or pay any known
liability on maturity of the sinking fund.

Investment of Reserves

It is a controversial issue, whether a reserve should be invested
in outside securities or not. Thus, to decide anything, it is
important to study the need and requirement of a firm according
to the financial position of a firm. Therefore, investment in
outside securities is justified only in a case where company has
the extra fund to invest.

Nature of Reserve

In-spite of showing reserves on the liabilities side of a Balance
Sheet, reserves are actually not at all any liabilities of a
firm. Reserve represents as accumulated profits, which are
available to disburse among the shareholders.

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