According to the Companies Act the term 'Provision' refers to any of the following amounts
(a) The amount retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy.
(b) The amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets.
Examples of Provisions:
1. Provision for Depreciation of Assets.
2. Provision for Taxation.
3. Provision for Bad and Doubtful Debts.
Characteristics or Features of Provisions:
(1) Provision is made to meet a known liability.
(2) The liability is known but the amount of such liability cannot be determined with reasonable accuracy.
(3) 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:
(1) 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, whether paid or outstanding, must be debited to Profit and Loss account.
(2) 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.
(3) 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. As such, provisions are made to provide funds for meeting those future losses.
(4) For the equitable distribution of expenses-
For example, if a machine is estimated to run for 10 years and the total amount of repairs expected to be incurred during its entire life span is Rs. 10,000, a 'provision for repairs a/c' will be created by debiting 1,000 to each year's Profit & Loss Account.
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.
Examples of reserves are:
(1) General Reserve.
(2) Capital Reserve.
(3) Workmen Compensation Fund.
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. 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 utilised 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'. In case the reserves had not been maintained the profit would have been distributed as dividend among shareholders.
(3) Equalisation 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 liabilit-
Sometimes a reserve is created for a specific purpose such as 'Debenture Redemption Fund' for the payment of debentures.
Difference between Provisions and Reserves:
Basis of Difference
|1||Meaning||It is created to meet a known liability.||It is created to meet an unknown liability.|
Necessity (Charge or Appropriation)
|Creation of provision is a legal necessity.||Creation of reserves is discretionary. It can be created only if adequate profits have been earned.|
|3||Object||The object is to provide for depreciation, doubtful debts and other specific liabilities.||The object of reserves is to strengthen the financial position of the business.|
|4||Mode of Creation||It is created by debiting to P & L a/c.||It is created not by debiting to P & L a/c but through P & L appropriation a/c.|
|5||Investment outside the business||Provisions are never invested outside the business.||Reserves may be invested outside the business.|
Presentation in Balance Sheet
|It is either shown on the assets side by way of deduction from the asset for which it is created or as a distinct item on the liabilities side.||It is shown on the liabilities side under the head 'Reserves and Surplus'.|
|7||Utilisation for dividends||It cannot be utilised for distribution as dividends among shareholders.||It can be utilised for distribution as dividends among shareholders.|
|8||Utilisation for other purposes||It is created to provide for a specific loss and hence can only be used for meeting that loss.||It is not-created to provide for a specific loss and hence can be used for any purpose.|
These reserves come into existence out of profits which have been earned in the course of day-to-day business operations. Therefore, the revenue reserves represent undistributed profits and as such are available for the distribution of dividends.
Revenue reserves may be of the following two types:
(A) General Reserve- 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'. Companies also do not distribute the entire profits as dividends but keep aside a part of it in the form of General Reserve. Reserves are also termed as 'Contingency Reserves' or 'Free Reserves' because these are not created for any specific purpose and can be freely used for any purpose.
(B) Specific Reserve- Such a reserve is created for a specific purpose and can be utilized only for that purpose.
Examples of specific reserves are:
1. Investment Fluctuation Fund: It is created to provide for decline in the value of investments due to market fluctuations.
2. Workmen Compensation Fund: It is created to meet compensation payable to workers in case of unexpected or unknown event of an accident.
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. All the Capital profits mentioned below should be treated as Capital Reserves.
Profits received from the following sources are termed as capital profits:
1. Profits on the sale of fixed assets.
2. Profits on the revaluation of fixed assets and liabilities.
3. Premiums received on issue of Shares or Debentures.
4. Profit on the purchase of a running business.
Distinction between Revenue Reserves and Capital Reserves:
Basis of Difference
|Revenue Reserves||Capital Reserves|
|1||Source of Creation||These reserves are created out of revenue profits which arise from the normal activities of the business.||These reserves are created out of capital profits, which do not arise from the normal operating activities of the business.|
|2||Usage||A specific reserve can be utilised only for the earmarked purpose while a general reserve can be utilised for any purpose.||Normally, these reserves cannot be utilised for distribution of dividends to shareholders.|
|3||Purpose||These reserves are created for meeting unforeseen losses and for strengthening the financial position of business.||These reserves are created to meet Capital losses or may be used for purposes laid down by Companies Act.|
Secret Reserves are the reserves which are not shown in Balance Sheet. They are created by showing profit at figure much lower than actual or by showing assets at a lower figure or liabilities at a higher figure. It is also known as 'Hidden Reserve' or 'Internal Reserve'.
Secret Reserve can be created by the following methods:
(i) By providing excessive depreciation.
(ii) By creating more provision for Doubtful Debts and discount on debtors.
(iii) Treating a revenue receipt as a capital receipt.
(iv) Undervaluation of assets.
(v) Charging Capital Expenditure as Revenue Expenditure.
(vi) Showing Contingent Liabilities as Actual Liabilities.
Advantages of secret reserves:
1. Financial Stability- Creation of secret reserves strengthens the financial position of the business without disclosing the fact to the shareholders or to the public.
2. Helpful in ansorbing unforeseen losses- Secret reserves enable concerns to absorb unforeseen losses without any public discomfiture.(disclose)
3. Regularity of dividends- Secret reserves help the firm to pay regular dividends even in adverse trading conditions without disclosing this to the public.
4. Avoidance of competition- Secret reserves avoid competititon as the competing firms are unable to find the actual profitability of the enterprise.
Disadvantages of secret reserves:
1. Loss to shareholders- Shareholders who wish to sell their shares may not get the actual price of their shares because of understatement of profits and financial position of the enterprise.
2. Misuse by management- Fraudulent managements may take undue advantage by creating secret resrves. Profits are suppressed to reduce the price the shares at the time of purchasing the shares and these profits are again increased by the use of secret reserves which again increase the market value of shares purchased by them.
3. Cover for misdeeds and mistakes of the management- Secret reserves can be utilized to cover the mistakes of managemenent.
4. Unfair presentation of financial statements- Creation secret reserves is against the principle of full disclosure as it doesn’t shows the true profit & loss of the enterprise.