Prov. & Reserves

CHAPTER 6 PROVISIONS AND RESERVES Meaning of Provision Provision is made for those items which are related to current year operating activities but the amount of these items is not known. Examples: Provision for Depreciation, Provision for Bad and Doubtful Debts, Provision for Discount on Debtors, Provision for Taxation etc. Basic Features of ‘Provision’ are: 1. To provide for expected decrease in assets or increase in liabilities on account of the transactions of the current year. For e.g., tax liability is determined at the time of assessment by the income tax authorities at some future date. But as tax liability likely to arise in future is on the income of the current year provision for taxation is created and Dr. to the P&L A/c of the current year. 2. Provision is charged against revenue and other incomes of the current year. It ensures proper matching of revenue and expenses. 3. Provision helps to show assets at their real worth. Provision helps in ascertainment of true profits (or loss) of the enterprise, if provisions are not created the profits are overstated. It helps in depiction of true and fair view of the financial position of the business enterprise. 4. When provision for any item is created, actual expense is charged to provision A/c and not to P&L A/c Reserves Reserve refers to retention of profit which is not in the form of provision. Reserves mean accumulated or undistributed profits. If the provision exceeds the amount which is required to meet the loss or liability, the excess is to be treated as reserve. Objectives of Reserves 1. To strengthen the financial position of the enterprise. 2. To provide funds for modernization and /or expansion of existing plant or acquisition of a new plant. 3. To equalize the dividends during the periods of inadequate profits. 4. To comply with legal requirements e.g. Debenture Redemption Reserve, Capital Redemption Reserve under the Companies Act, 1956; Investment Allowance Reserve, Development Allowance Reserve, Foreign Project Allowance Reserve under Income Tax Act, 1961. 5. To meet unforeseen abnormal losses. Types of Reserves Basically there are two types of reserve viz. Revenue Reserves and Capital Reserve. 1. REVENUE RESERVE: those reserves which are created out of profits available for distribution by way of dividend. These may be classified as: (a) General Reserve: Reserve which is not created for any specific purpose. E.g. General Reserve, Contingency Reserve etc.

(b) Specific Reserve: Reserve which is created for a specific purpose. E.g. Dividend Equalization Reserve, Debenture Redemption Reserve etc. 2. CAPITAL RESERVE: are those reserves which are created out of profits of capital nature and not out of operating profits. E.g. Profits prior to incorporation, Premium on issue of Shares and Debentures, Premium on reissue of forfeited shares, Profit on sale of fixed assets, Profit on revaluation of fixed asset Revenue Reserves refers to the amounts which are free for distribution by way of dividend whereas amount of Capital Reserve refers to the amounts which are not free for distribution by way of dividend. Distinction between Provision and Reserve Provision Reserve It is created for some specific It need not necessarily be purpose and can be used for that created for a particular particular purpose. purpose. E.g. General Reserve. 2. Charge v/s It is a charge against the profit It is an appropriation out of Appropriation and is required to be created profit and can be created irrespective of the amount of only if profits have been profit. earned 3. Disclosure in Usually a provision is shown by Reserve is shown as a Balance Sheet way of deduction from the separate item under the head amount of the items for which it ‘Reserves and Surplus’ on is created. the liabilities side of the Balance Sheet 4. Investment outside There is no question of The amount of Reserve can the business investment of amount of be invested outside the provisions. business. 5. Utilization for It cannot be utilized for It can be utilized for Dividends distribution by way of dividends. distribution by way of dividends. Basis of Distinction 1. Purpose

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