The term ‘provision’ means an amount, which is written off, or retained, by way of providing for depreciation, renewals, diminution in the value of assets; or retained by way of providing for any unknown future liability of which the amount cannot be determined with reasonable accuracy.
Provision is a charge against the profit of the year and hence, it is debited to profit & loss account before calculating the net profit for the year, and is shown in the balance sheet after the certain liabilities on the liability side. Provision has to be made irrespective of the fact whether the firm makes profits or loss. Provisions are made :
(i) To meet an outstanding liability—Outstanding rent.
(ii) To meet anticipated liability—Doubtful Debts.
(iii) To meet known losses—Depreciation.
Types of provisions
The number of provisions made by an enterprise depends upon its requirements which are governed by its volume, range and nature of its operations. Normally, an enterprise creates and maintains provision for the following purposes :
(i) Taxation
(ii) Repairs and Renewals
(iii) Depreciation
(iv) Discount on Debtors
(v) Bad and Doubtful Debts
(vi) Fluctuations and Investments
Importance of provisions Equitable Distribution of
Expenses : If a plant is estimated to last for 8 years and the total amount of repairs expected to be incurred during its life time is Rs. 8,000, a ‘provision for repairs A/c’ will be created by debiting Rs. 1000 to each year’s profit and loss account. Actual expenses of repairs incurred each year will be debited to this account.
Provision for Known Losses : Funds are required to meet the losses and liabilities that are likely to occur in near future. Provision is made for such losses.
To Ascertain True Net Profit : All expenses paid and outstanding must be debited to profit and loss account to ascertain the true profit of an enterprise. Provision should also be made for expenses or liabilities the amount of which cannot be estimated.
To Know True Financial Position : In order to depict the true and fair view of financial position of an enterprise, adequate provision should be made for all the anticipated expenses and losses.
Reserves
In the words of 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 on the date of balance sheet.”
The following are the examples of reserves :
(i) General Reserve
(ii) Capital Reserve
(iii) Reserves for Equalisation of
Dividends
(iv) Contingency Reserves
(v) Reserves for Expansion
The amount of reserves does not represent any expense or loss. Therefore, it is not debited to profit and loss account. Creation of reserves does not reduce the net profits but only reduces the divisible profits. It is an appropriation of Profit and as such after ascertaining the net profits, it is debited to profit and loss appropriation account.
Features of reserves
(i) Reserves represent accumulated or undistributed profits, as such they belong to proprietors just as capital does. They are available for distribution as dividends among shareholders and just as capital is shown on the liabilities side of the balance sheet, they are also shown on the liabilities side.
(ii) They are not created to meet known liabilities or depreciation in the value of assets but for meeting an unknown liability or loss in the future.
(iii) When the amount of reserves is invested outside the business, it is known as ‘reserve fund.’
(iv) Creation of reserves is not a legal necessity. It is created voluntarily for strengthening the general financial position of the business and for meeting an unanticipated situation in the future.
(v) It is created out of net profits or divisible profits. As such, the reserves are also termed as retained earnings or undistributed profits.
Importance of reserves
(i) Reserves are equalization of dividends over the years.
(ii) Reserves provide funds for meeting a specific liability, such as ‘debenture redemption fund.’
(iii) Reserves help in meeting the unforeseen liability or loss.
(iv) Reserves are helpful in strengthening the financial position of the business.
Distinction between provision and reserves
Purpose : Provision is created to meet a known liability. But reserves is created to meet an unknown liability.
Object : Provision is matter of prudence and made out of profits. Reserve is made due to legal necessity an made even if there is loss.
Appropriation of Profits : Reserve is an appropriation of profits. Provision is check against profits.
Balance Sheet : Reserves are shown as liabilities in the balance sheet. Provisions are shown on assets side by deducting from the concerned asset.
Utilization : Reserve can be distributed as profit. But provision cannot be utilized for distribution of profits.
Investment : Reserves may be invested outside the business. But provision cannot be invested outside the business.
Amount : Amount of reserves is not exact. But provision are made for an exact amount.
Necessity : Reserves are created to strengthen the financial position of the business. But provision is made for a specific liability.
Distinction between reserves & reserve funds
(i) Creation of reserves needs one transaction. But creation of reserves funds involves two transactions.
(ii) Reserves appears on the liability side of the balance sheet. Reserve fund appears on both the sides of the balance sheet.
(iii) Reserve may or may not involve any receipt of cash. But reserve fund always involves payment of cash.
(iv) A reserve can be created without creating a reserve fund but a reserve fund cannot be created without creating a reserve.
Types of reserves
Reserves are basically of two types: (i) Revenue reserves and (ii) Capital reserves.
Revenue Reserves : According to Kohler, revenue reserves are, that portion, or any detail thereof, of the networth or total equity of an enterprise representing retained earnings available for withdrawal by proprietors.
Revenue reserves may be of the following two types:
(a) General Reserve, (b) Specific Reserve. These reserves are invested outside the business for a specific period. At the end of the specified period, all investments are sold. Examples of specific reserves are Debenture Redemption Fund, Capital Redemption Reserve, Development Reserve, Dividend Equalization Reserve, and Investment Fluctuation Reserve.
Capital Reserves : Capital reserves are those which are not generally distributed on profits. These reserves are out of the following.
(a) Profit on Redemption of Debenture.
(b) Profit on forfeiture of shares.
(c) Profit on sale of fixed assets.
(d) Profit on upward revaluation of assets.
(e) Any other capital gain.
Capital reserves may or may not involve cash receipts.
The difference
(i) Capital reserve may be internal or external. But revenue reserve is always internal transaction.
(ii) Whereas capital reserve is not created by retaining profits, revenue reserve is created by retaining profits.
(iii) Capital reserve is always specific but revenue reserve can be general and specific both.
(iv) Whereas capital reserve may or may not involve receipt of cash, revenue reserve may or may not involve any payment of cash.
(v) Capital reserve is not generally distributed as profit. Revenue reserve may be distributed as profit.
Secret reserves
A secret reserve is that reserve which is not apparent on the face of balance sheet. It is also known as ‘hidden reserve’—or ‘inner reserve’. It is not disclosed in the books of accounts.
Examples of secret reserves
(i) Omitting some assets from balance sheet.
(ii) Providing excessive reserves.
(iii) Under estimation of assets.
(iv) Creating more reserve for bad debts.
(v) Showing contingent liabilities as real liabilities.
Purpose of creating secret reserves
(i) Utilization of funds in lean years.
(ii) Equalisation of payment of dividend.
(iii) Increase in working capital.
(iv) Meeting extra-ordinary losses without bringing into the notice of share holders.
(v) Increase in financial soundness of the enterprise.
Demerits of secret reserves
(i) Indulgence in speculation.
(ii) Non-availability of true financial position of balance sheet.
(iii) Non-payment of due share of profit to shareholders.
(iv) Value of assets of the enterprises goes down in the market.
Sinking fund
Sinking fund is a kind of reserve by which a provision is made is order to on.
(i) Renew a lease.
(ii) Replace depreciating assets.
(iii) Replace wasting asset—mines.
(iv) Replace a liability—redemption of debentures. The amount is invested in resalable securities.
Provision for doubtful debts
All the business transactions are not against cash. Some of them are on credit. As such, the debtors may be of following types :
Good : Those debtors from whom the realization is certain, are known as good debtors.
Doubtful : All debtors are not good. Some of them are doubtful. As such realization from them is not certain. They are known as doubtful debtors. Generally, there is a possibility of collection of debt from such debtors. But when it becomes certain that they will not pay, their amount is written as bed debts. Provision made in the business is treated as loss while preparing profit and loss account. The provision for doubtful debts is generally calculated as a certain percentage on the total amount due from such debtors.
Bad debts : Bad debts are those debtors from whom collection of money is not possible. It is a loss to the business. It is debited to the profit and loss account and then written off.
Journal Entry
Profit & Loss A/c Dr.
To Provision for Doubtful Debts A/c
(Being provision made for doubtful debts)
or
Bad Debts A/c Dr.
To Sundry Debtors A/c
(Being bad debts written off)
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