What are Provision and Reserve?
Provisions are certain expenses/losses which are related to the current accounting period but the amount of which is not known with certainty because they are not yet incurred. It is necessary to form a provision for such items for ascertaining true net income.
For example, a trader who sells on a credit basis knows that a number of the debtors of the present period would default and wouldn’t pay or would pay only partially. It is necessary to require under consideration such an expected loss while calculating true and fair profit/loss consistent with the principle of Prudence or Conservatism. Therefore, the trader creates a Provision for Doubtful Debts to take care of expected loss at the time of realization from debtors. Similarly, a Provision for repairs and renewals can also be created to supply for expected repair and renewal of the fixed assets. Examples of provisions are :
• Provision for depreciation;
• Provision for bad and doubtful debts;
• Provision for taxation;
• Provision for discount on debtors; and
• Provision for repairs and renewals
It must be noted that the amount of provision for expense and loss is a charge against the revenue of the current period. Creation of provision ensures proper matching of revenue and expenses and hence the calculation of true profits. Provisions are created by debiting the profit and loss account. In the balance sheet, the amount of provision may be shown either:
• By way of deduction from the concerned asset on the assets side. For example, provision for doubtful debts is shown as a deduction from the number of sundry debtors and provision for depreciation as a deduction from the concerned fixed assets;
• On the liabilities side of the balance sheet along with current liabilities, for example, provision for taxes and provision for repairs and renewals.
Accounting Treatment for Provisions
The accounting treatment of all types of provisions is almost similar. Therefore, the accounting treatment is explained here taking up the case of a provision for doubtful debts.
As already stated that when the business transaction takes place on a credit basis, the debtor’s account is created and its balance is shown on the asset side of the balance sheet. These debtors may be of three types:
- Good Debtors are those from where a collection of debt is certain.
- Bad Debts are those debtors from where a collection of money is not possible and the amount of credit given is a certain loss.
- Doubtful Debts are those debtors who may pay but the firm isn’t sure about the gathering of the complete amount from them. In fact, as a matter of business experience, some percentage of such debtors aren’t likely to pay, hence treated as doubtful debts. To consider this possible loss on account of non-payment by some debtors, it’s standard practice (and necessary also) to form an appropriate provision for doubtful debts at the time of ascertaining true profit or loss. The provision for doubtful debts is typically calculated as a particular percentage of the entire amount due from sundry debtors after deducting/writing-off all known bad debts. Provision for doubtful debts is additionally called ‘Provision for bad and doubtful debts. It is created by debiting the quantity of required provision to the profit and loss account and crediting it to provision for doubtful debts account.
For creating a provision for doubtful debts the following journal entry is recorded:
Profit and Loss A/c Dr. (with the amount of provision)
To Provision for doubtful debts A/c
A part of the profit could also be put aside and retained within the business to supply surely future needs like growth and expansion or to satisfy future contingencies such as workmen compensation. Unlike provisions, reserves are the appropriations of profit to strengthen the financial position of the business. Reserve isn’t a charge against profit because it isn’t meant to hide any known liability or expected loss in future.
However, the retention of profits within the sort of reserves reduces the number of profits available for distribution among the owners of the business. It is shown under the top Reserves and Surpluses on the liabilities side of the record after the capital. Examples of reserves are:
- General reserve;
- Workmen compensation fund;
- Investment fluctuation fund;
- Capital reserve;
- Dividend equalization reserve;
- Reserve for the redemption of the debenture.
Difference between Reserve and Provision
- Basic nature: A provision is a charge against profit whereas a reserve is an appropriation of profit. Hence, net profit cannot be calculated unless all provisions have been debited to the profit and loss account, while a reserve is created after the calculation of net profit.
- Purpose:- Provision is made for a known liability or expense about the current accounting period, the amount of which is not certain. On the other hand, the reserve is created for strengthening the financial position of the business. Some reserves are also mandatory under the law.
- Presentation in balance sheet:-Provision is shown either (i) by way of deduction from the item on the asset side for which it is created, or (ii) on the liabilities side along with current liabilities. On the other hand, the reserve is shown on the liabilities side after the capital.
- Effect on taxable profits:- Provision is deducted before calculating taxable profits. Hence, it reduces taxable profits. A reserve is created from profit after tax and therefore it does not affect the taxable profit.
- The element of compulsion:- Creation of provision is necessary to ascertain true and fair profit or loss in compliance with ‘Prudence’ or ‘Conservatism’ concept. It has to be made even if there are no profits. Whereas the creation of a reserve is generally at the discretion of the management. However, in certain cases law has stipulated for the creation of specific reserves such as Debenture Redemption Reserve. Reserve cannot be created unless there are profits.
- Use for the payment of dividend:- Provision cannot be used for distribution as dividends while general reserve can be used for dividend distribution
|Basic of Difference||Provision||Reserve|
|1. Basic Nature||Charge against profit.||Appropriation of profit|
|2. Purpose|| |
It is created for a known liability or expenses about the current accounting period, The amount of which is not certain.
|It is made if strengthening the financial position of the business. Some reserves are also mandatory under law.|
|3. Effect on taxable profits.|| |
It reduces taxable profits.
|It does not affect taxable profits.|
|4. Presentations in the balance sheet|| |
It is shown either (i) by way of deduction from the item on the asset side for which it is created, or (ii) In the liabilities side along with current liabilities.
|It is shown on the liabilities. Side after capital amount.|
|5. Element of compulsion|| |
Creation of provision is necessary to ascertain true and fair profit or loss in compliance ‘Prudence’ or ‘Conservatism’ concept. It must be made even if there are no profits.
|Generally, the creation of a Reserve is at the discretion of the management Reserve cannot be created unless there are profits. However, in certain cases law has stipulated for the creation of specific reserves such as Debenture’ ‘Redemption ’reserve.|
|6. Use for the payment of dividend|| |
It can not be used for dividend distribution.
|It can be used for dividend distribution.|
Types of Reserves
- General reserve:- When the purpose for which reserve is created is not specified, it is called General Reserve. It is also termed as a free reserve because the management can freely utilize it for any purpose. General reserve strengthens the financial position of the business.
- Specific reserve:– Specific reserve is the reserve, which is created for some specific purpose and can be used only for that purpose. Examples of specific reserves are given below :
- Dividend equalisation reserve: This reserve is created to stabilise or maintain the dividend rate. In the year of high profit, the amount is transferred to the Dividend Equalisation reserve. In the year of low profit, this reserve amount is used to maintain the rate of dividend.
- Workmen compensation fund: It is created to provide for claims of the workers due to accident, etc.
- Investment fluctuation fund: It is created to make for the decline in the value of the investment due to market fluctuations.
- Debenture redemption reserve: It is created to provide funds for the redemption of debentures.
Reserves are also classified as revenue and capital reserves according to the nature of the profit out of which they are created.
(a) Revenue reserves: Revenue reserves are created from revenue profits which arise out of the normal operating activities of the business and are otherwise freely available for distribution as dividend. Examples of revenue reserves are:
• General reserve;
• Workmen compensation fund;
• Investment fluctuation fund;
• Dividend equalisation reserve;
• Debenture redemption reserve;
(b) Capital reserves: Capital reserves are created out of capital profits that do not arise from normal operating activities. Such reserves are not available for distribution as dividend. These reserves can be used for writing off capital losses or issue of bonus shares in the case of a company. Examples of capital profits, which are treated as capital reserves, whether transferred as such or not, are :
• Premium on issue of shares or debenture.
• Profit on sale of fixed assets.
• Profit on the redemption of debentures.
• Profit on revaluation of fixed asset & liabilities.
• Profits before incorporation.
• Profit on the reissue of forfeited shares
Difference between Revenue and Capital Reserve
- Source of creation:- Revenue reserve is created out of revenue profits, which arise out of the normal operating activities of the business and are otherwise available for dividend distribution. On the other hand, The capital reserve is created primarily out of capital profit, which does not arise from the normal operating activities of the business and is not available for distribution as a dividend. But revenue profits may also be used for the creation of capital reserves.
- Purpose:- Revenue reserve is created to strengthen the financial position, to meet unforeseen contingencies or for some specific purposes. Whereas capital reserve is created for compliance with legal requirements or accounting practices.
- Usage:- A specific revenue reserve can be utilised only for the earmarked purpose while a general reserve can be utilised for any purpose including distribution of dividend. Whereas a capital reserve can be utilised for specific purposes as provided in the law in force, e.g., to write off capital losses or issue of bonus shares.
|Basic of Difference||Revenue Reserve||Capital Reserve|
|1. Source of creation||It is created out of revenue.||It is created primarily out of.|
|2. Purpose||It is created to strengthen the financial position, to meet unforeseen contingencies or for some specific purposes.||It is created for compliance with legal requirements or accounting practices.|
|3. Usage||A specific revenue reserve can be utilised only for the earmarked purpose while the general reserve can be utilised for any purpose including distribution of dividend.||It can be utilised for specific purposes as provided in the law in force e.g., to write off capital losses or issue of bonus shares.|
Importance of Reserves
A firm may consider it proper to line up some mechanism to guard itself against the results of unknown expenses and losses, it’s going to be required in touch in future. It may also regard it as more appropriate in certain cases to scale back the quantity which will be drawn by the proprietors as profit to conserve business resource to meet certain significant demands in future. An example of such a requirement is that the much-needed expansion within the scale of business operations.
This is presented because of the justification for reserves in business activities and accounting. The amount so set aside may be meant for:
- Meeting a future contingency
- Strengthening the general financial position of the business;
- Redeeming a long-term liability like debentures, etc.
Secret Reserve:- Secret reserve is a reserve that does not appear on the balance sheet. It may also help to scale back the disclosed profits and also liabilities. The secret reserve is often merged with the profits during the lean periods to point out improved profits. Management may resort to the creation of secret reserve by charging higher depreciation than required. It is termed as ‘Secret Reserve’ because it isn’t known to outside stakeholders. The secret reserve can also be created by way of :
- Undervaluation of inventories/stock
- Charging capital expenditure to profit and loss account
- Making excessive provision for doubtful debts
- Showing contingent liabilities as actual liabilities
The creation of secret reserves within reasonable limits is justifiable on grounds of expediency, prudence and preventing competition from other firms.