PROVISIONS & RESERVES EXTRA NOTES

PROVISION

A provision is a charge against profit for the purpose of providing for any liability
or loss. It is an amount set aside to meet an uncertain loss or expense in future.

Eg- Provision for depreciation, Provision for doubtful debts, Provision for tax etc.

Features

 Amount set aside out of income/profit.

 Charge to Profit & Loss account.
 Created to meet an anticipated loss/expense in future.
 Based on Prudence Concept of Accounting.

Objectives

Provision account all the expenses & losses. So that a business can estimate
correct profit/loss and assets are shown on correct values.

RESERVE

Reserves are the amount set aside out of profits. It is an appropriation of profit to
strengthen the financial position of the business. It is made to meet the unknown
contingency that may arise in future.

Eg- General Reserve, Capital Reserve, Reserve for Expansion etc.

Reserve Fund

Amount of reserve when invested in outside securities is known as Reserve fund.

Importance of Reserve

 Expansion of business
 Improvement of financial position
 Meeting unforeseen contingencies.
Types of Reserve

1. Revenue Reserve 2. Capital Reserve

a. General Reserve
b. Specific Reserve
1. Revenue Reserve
a) General Reserve
 Set aside out of profit and not for any specific purpose
 Available for any future contingency/expansion of business
 Strengthens the financial position of business.
b) Specific Reserve
 Set aside for specific purpose & can be utilized only for that purpose

Eg- Workmen Compensation Reserve, Investment Fluctuation Reserve.

2. Capital Reserve
 Set aside out of capital profit(created out of capital profit)
 Normally not available for distribution as dividend.
Eg- Capital Redemption Reserve,
Premium on issue of shares/ debentures etc

Difference between Revenue Reserve & Capital Reserve

Basis Revenue Reserve Capital Reserve

Source Created out of business Created out of capital profit
profit
Usage Used for distribution of Used for distribution of
dividend without any pre dividend only if the company
condition satisfies certain conditions
Purpose Created for strengthening Created for meeting capital
the financial position & losses & used for specific
meeting unforeseen purposes.
contingency.
 Secret Reserve/ Hidden Reserve

 Amount which is not disclosed in the Balance sheet.

 Reserves are created by showing the assets at a lower amount & a
liabilities at a higher amount.

Creation of Secret Reserve

 By charging excessive depreciation.

 By undervaluing stock in trade/goodwill.
 By creating excessive provision for bad debts/contingencies
 By showing a contingent liability

Advantages

 Increases the working capital

 Strengthens the financial position
 Heavy losses of an exceptional nature can be met without disclosing the
fact in the published statements.

Disadvantages

 Balance sheet will not disclose true & fair position

 Share value goes down in the market.

Difference between Reserve & Provision

Basis Reserve Provision

Nature Appropriation of profit
Purpose Created to strengthen the
financial position
Effect on profit Debited to Profit & Loss
Appropriation a/c
Investment May be invested outside
Distribution Unutilized part can be
distributed as dividend
Presentation Shown on Liability side
under ‘ Reserves & Surplus’
Charge against profit
Made to meet known liability
/contingency
Debited to Profit & Loss
Account
Not invested
Cannot be used for distribution
as dividend
Shown either as a Liability
under ‘Current Liability’ or
deduction from concerned
Asset.