Provision & Reserves Definition - Types, Examples, Difference

Provisions and Reserves

In order to keep the financial condition of the business stable and to face the uncertainties and risks of the future, it is necessary that all profits should not be shared among its owners. Every business should keep some amount of its present benefits in the business for the fulfillment of future known and unknown obligations. This is done by making provisions and reserves out of the profits of the current year while making the last account.

Provisions and Reserves are two different words and cannot be used in the same sense. Both terms are clearly defined in the law.

Depreciation Definition - Types, Method, Formula, Calculate depreciation

Provision & Reserves Definition - Types, Examples, Difference
Provisions and Reserves

Provisions Definition

Meaning: According to the Indian Companies Act, provisions mean an amount that is (1) kept on properties for renovation, renovation or reduction in their value, or

The amount held to meet any known liabilities whose amount cannot be determined (estimated) with sufficient accuracy. The amount that can be determined with sufficient accuracy does not come under provisions but is called Liability. And if more provisions are made intentionally than the actual requirement, then such excess provisions will be considered as reserves.

Capital & Revenue Definition

Examples of Provisions

Often written events are created to serve different purposes:

  • (1) Provisions for depreciation of properties
  • (2) provisions for tax
  • (3) Provision for Bad and Doubtful Debts;
  • (4) Provisions for discount on debtors

Features and Characteristics of Provisions

(1) It is constructed to satisfy any known liabilities.

(2) Liabilities are definite, but its amount cannot be estimated with sufficient accuracy. For example, sinking some rupees from debtors is almost certain, but it is not certain how much of the debtors will sink.

(3) The profit is reduced by making provisions in the year in which provisions are made and in the future when such loss occurs, that loss does not affect the profits in that year as the loss is repaid from the provisions in that year.

The Purpose and Importance of Provisions

(1) To find the true net profit of the business: - To find the true net profit of a year, it is necessary that all the expenses related to that year, whether paid or unpaid, are necessary. Profits and losses should be debited and provisions for expenses or liabilities that cannot be estimated with reasonable accuracy, such as making provisions for suspected loans. It is necessary to sink some rupees from the total debtors of the business, but it cannot be estimated with proper accuracy.

(2) To find the correct financial position of the business: - The status statement of any year will reveal the correct financial position at the same time, when appropriate provisions are made for various losses, expenses etc.

(3) For the arrangement of known losses in the future: - Funds are definitely needed to meet the losses and liabilities in the near future. Therefore, provisions are made to cover such losses as provisions for taxes, provisions for repair, provisions to pay damages in a court proceeding and other similar provisions.

(4) For proper division of expenses: - For example, if a machine is to be used for 10 years and it is estimated to cost 10,000 repairs over 10 years, then by debiting 1,000 in the profit and loss statement of each year one A 'Repair Provisions Account' will be created and the actual repair expenses incurred every year will be debited to this account. This will reduce the actual expenses which will be lower in the first year due to the new machine and later when the machine is old, the profit and loss statement. Will have the same effect

Reserve Definition

Meaning - Accumulation refers to an amount that is set aside for future uncertainties out of the benefits and excesses of the business. In other words, reserves are created to meet future unknown liabilities or losses.

According to William Pickills, "Reserve refers to an amount that is set aside from profits and other savings and is not intended to provide for a reduction in the value of any known liabilities on the day of the statement of account."

Examples Of Reserves 

  1. General Reserve
  2. Capital Reserve
  3. Dividend Equalisation Reserve
  4. Investment Fluctuation Fund (v)
  5. Workmen Compensation Fund
  6. Reserve for Redemption of Debentures.

Reserve amounts do not reflect expenditure or loss, so they are not debited in the statement of Profit & Loss. The creation of reserves does not reduce Sr. Profit but only reduces Divisible profit. The creation of reserves is an adjustment of benefits. Therefore, after finding the net profit, it is debited to the Surplus of Statement of Profit & Loss.

Features and Characteristics of Provisions

The reserve has the following characteristics:

(1) The reserve is made out of the year's yearly benefits i.e. Divisible Profits. Therefore, we can also call the Reserve Retained Earnings or Undistributed profits.

(2) It is not strictly necessary to build reserves, but they are constructed voluntarily to keep the economic condition of the business firm and to cope with the difficult economic conditions of the future.

(3) They are not made for the payment of any known liabilities or for the management of property losses, but for the fulfillment of any future unknown liabilities or losses.

(4) A reserve is a type of accumulated or undistributed profit and in the same way that the owner of the business is the owner of the capital engaged in the business, he is also the owner of the reserve. The accruals can be distributed among the shareholders as dividends and as the capital is shown in the liabilities side in the letter, the reserve is also shown in the liabilities side.

(5) When the amount of the reserve is appropriated somewhere outside the business, it is called the Reserve Fund.

Purpose or Importance of Reserves

(1) Helps in meeting unknown liabilities or losses: - If a business has to face any unknown or extraordinary loss in future, it can be replenished from the reserve.

(2) Helps in strengthening the financial position of the business: - Reserves are a type of undistributed or reserve benefits and these are technically called plowing back of profits in the business itself. It is a type of internal finance system for the expansion of business. If the reserves were not created, the profits would be distributed among the shareholders as dividends.

(3) To maintain the same rate of profit per annum: - The reputation of a company depends on whether the dividend paid by them to the shareholders either remains the same every year or gradually increases. The Reserve helps the operators in accomplishing this objective as the rupee can be withdrawn from the reserve in the event of insufficient profits in a given year. Sometimes a reserve is specially created called 'Dividend Equalization Fund' to keep the dividend the same.

(4) To provide funds for the fulfillment of certain liabilities: - At times, accumulation is also made for the fulfillment of a particular purpose, such as 'Debt redemption fund' is created to pay the bills. For example, if we have to pay 5 crores of debentures after 10 years, then for this a fund is drawn out of a certain amount of benefits every year and this fund is appropriated outside the business in such a way that 10 years After receiving the crores from the sale of appropriations. With this, such a large amount can be paid easily.

Types Of Reserves

  • Revenue Reserves 

  1. General Reserves
  2. Specific Reserves

  • Capital Reserves

Revenue Reserves - These are created out of the normal profits of the business earned as a result of everyday business actions, so these Reserves are a type of undistributed profit and are available to distribute dividends to shareholders in future. According to Köhler, profit reserves means "the net worth of a business or that portion of the total liability or a separate portion that relates to accumulated income, which can be taken out by the owners." Revenue Reserves can be divided into two parts:

(A) General Reserve - Often traders do not take the entire profit of their business out of the business but instead reserve a part of those profits for future uncertainties. Such a benefit withheld for a rainy day in business is called General Reserve. Similarly, the companies do not distribute their entire profits as dividends to the shareholders, but instead transfer a part of the profits to the General Reserve. General Reserve is also called Contingency Reserve or Free Reserve as they are not created for any specific purpose and can be used for any purpose of independence. Generally, General Reserve is created to serve the following purposes:

1. To meet any unknown loss in future,

2. To strengthen the financial condition of the business,

3. To expand the business by re-appropriating internal means or benefits

4. In the case of the company, it is not legally mandatory to create a General Reserve to keep the rate of dividend to be distributed among the shareholders every year. They are constructed in those years in which there are substantial benefits and the manager thinks it appropriate to manufacture them. In the balance sheet, General Reserve is shown under the title Owner's Equity.

(B) Specific Reserve - The reserve that is created for the fulfillment of a specific purpose is called Specific Reserve. 

The following are examples of Specific Reserve

  • Dividend Equalisation Reserve - A part of the profit is transferred to this reserve in the year in which the profits are higher in the business so that the rate of dividend distribution in the future can be kept the same. Because in the year when the profits are less, the rate of dividend distribution is kept the same by taking money from this reserve.
  • Reserve for Replacement of Asset - The purpose of creating this reserve is that after a certain period, when a property becomes worthless, new property can be bought in its place. The depreciation that is levied every year on the value of the property can only arrange for the original cost of the property, but due to the increasing value of the property, new property cannot be purchased with that amount. Therefore, this reserve is made for arranging the additional money required for purchasing new property. For example, if a property was purchased for 10 years before 10 lakhs and 10% depreciation was imposed on its initial cost every year, then only 10 lakhs of rupees were arranged from depreciation. If presently the value of this property is 40 lakhs, then additional purchase of 30 lakhs will be required to purchase the new property. The 'Property Replacement Reserve' is made only to arrange this additional amount.

To make this reserve, a certain amount is transferred every year from the surplus ofStatement of Profit & Loss to this reserve. The following entry is made to create an asset replacement reserve

  • Surplus Of Statement Of Profit & Loss (DR)
  •                           To Assets Replacement Reserve A/C

The amount of the asset replacement reserve is either kept and used in business or appropriated out of business at a fixed rate of interest. When appropriating this amount of reserve out of business, it is called the Reserve Fund.

The creation of this reserve reduces Divisible Profits among the shareholders so that less dividends are distributed among the shareholders. In this way, this amount remains in the business and gets accumulated every year and this amount is used in the replacement of wealth. The asset replacement reserve account is closed by transferring the balance to the General Reserve.

  • (3) Investment Fluctuation Fund: It is created to meet the decline in the value of appropriations due to market fluctuations.
  • (4) Workmen Compensation Fund: It is created to compensate workers in case of a sudden or unknown accident.
  • (5) Debenture Redemption Reserve: It is created to provide money for the redemption of debentures.

Capital Reserve - In addition to general benefits in business, Capital Reserve also receives from many sources. The reserves that are made from this Capital Reserve are called Capital Reserv. Often these reserves are not available for cash distribution of dividends. Capital gains are usually derived from the following sources:-

  • 1. Profit from sale of fixed assets,
  • 2. Benefit from revaluation of fixed assets and liabilities,
  • 3. Premiums received on issue of shares and debentures
  • 4. Profit made while purchasing an ongoing business,
  • 5. Profit before amalgamation of the company,
  • 6. Profit on the re-issue of the unsubsidized shares,
  • 7. All the above mentioned capital gains are considered as capital reserves.

Capital reserves can be used to compensate for capital losses and to issue fully paid bonus portions. Often, capital reserves are not available for distributing dividends. But some capital reserves can be used for dividend distribution under the following conditions:-

1. While it is not prohibited in the Articles of Company,

2. Junk capital gains received in cash, and

3. Even after proper revaluation of entire assets and liabilities, such benefit remains.

Capital gains should be used to strengthen the financial condition of the business rather than in dividend distribution.

Secret Reserves

Secret Reserves is a Reserves that is not revealed by the balance sheet. These Reserves are constructed by showing the profits at an amount lower than the actual amount and the assets at lower prices and liabilities at higher values. In the case of secret reserves, the actual position of the firm is much better than the position displayed on the balance sheet. Secret Reserves can be constructed as follows

  1. (i) Excessive Depreciation
  2. (i) By putting capital expenditure (such as increase in assets) in the profit-loss account;
  3. (ii) treating the profit receivable as a capital gain (such as by codifying the rent received in the building account);
  4. (iv) Appraising the assets at a lower value (such as valuation of the final value at a lower value);
  5. (v) By considering any real property as a potential asset
  6. vi) considering the potential liability as the actual liability;
  7. (vii) concealing sales
  8. (viii) By making excessive or unnecessary provisions for doubtful debts and other contingencies.

Advantages of Secret Reserves:

Financial Stability: The financial position of the institution through the creation of secret accumulations. It becomes strong and it is not known to the shareholders or the public.

i) Financial Stability: With the creation of Secret Reserves, the financial condition of the institution improves and this is not known to the shareholders or the public.

(ii) Helpful in Absorbing Unforeseen Losses: Having secret deposits helps these entities in meeting unknown losses and also does not give any dissatisfaction to the public.

(iii) Regularity of Dividends: Secret Reserves are helpful in keeping the rate of dividend constant even under adverse conditions and the adverse state of business does not appear to the shareholders and the public.

(iv) Avoidance of Competition: Competitive firms can be prevented from entering into that type of business by concealing the real benefits of the organization.

Disadvantages of Secret Reserves:

(1) Unfair Presentation of Financial Statements): The profit-loss statement does not reveal the true profit of the institution and the status statement does not present a true and accurate picture of the financial position of the institution.

(2) Loss to Shareholders: The disclosure of its profits and financial position by the institution at less than the reality will not enable the shareholders who wish to sell their shares to get the true value of their shares.

(3) Misuse by Management: Unscrupulous managers can take undue advantage by building Secret Reserves. The company's benefits are reduced by building Secret Reserves. By which they themselves purchase the shares of the company at a lower price and then increase the profit by eliminating Secret Reserves so that they sell those shares at a higher price.

(4) Cover for Misdeeds of Management: By managing Secret Reserves can be used to hide their mistakes or wrongdoings.

The construction of Secret Reserves is banned under the Companies Act 1956 because according to the Companies Act, it is mandatory to make full disclosure of all important facts and important accounting policies in the formulation of financial statements.