PROVISIONS AND RESERVES

The terms Provisions and Reserves have been used quite loosely in the past on account of lack of
authentic definitions of these two terms. However, the meanings of these two terms have been
considerably clarified by the Companies Act, 1956. It may be noted that though the provisions of
the Companies Act are applicable to only companies registered under that Act, it is proposed in
this chapter to deal with provisions and reserves on the lines of definitions given in that Act.
Provision
The term Provision has been defined by the Instituteof Chartered Accountantsof India (1CAI)
as follows:
Provision means "any amount written off or retained by way of providing depreciation, or
diminution in the value of assets or for providing any known liability of which the amount
cannot be determined with substantial accuracy?
According to AS 29: Provisions, Contingent Liabilties and Contingent Assets, issued by ICAI
a provision is "a liability which can be measured only by using a substantial degree of estimation."
It differes from a liability. According to AS 29 liability is "a present obligation of the enterprise
arising from past events, the settlement of which is expected to result in an outflow from the
enterprise of resources embodying economic benefits."
Thus Provisions are amounts set aside out of profits and other surpluses for:
(a) Depreciation, renewals or dimunition in the value of assets.
(b) Any known liability, of which the amount cannot be determined with substantial accuracy.
It can also be concluded from the above that sums set aside to meet known liability of which
the amount can be ascertained with substantial accuracy should be treated as accruals" or "accrued
liabilities" and not provisions.
The examples of provisions are: Provision for Bad and Doubtful Debts, Provision for Repairs
and Renewals and Provision for Discounts etc.
The provisions are usually created by debiting the Profit & Loss Account. They are either
deducted on the asset side of the Balance Sheet (as in the case of Depreciation and Bad &
Doubtful Debts) or shown on the liability side under appropriate sub-heading.
2. Gujdance Note on terms used in Financial Statement.
 DEPRECIATION PROovISIONS AND RESERVES // 1.311
Where any provisiOn is used for a purpose other than for which it was
shown in the published accounts of the created, the fact should
company. Moreover, when any provision becomes
Rundant, it should be credited back to the Profit &
Loss Appropriation Account.
Reserve

According to the Institute of Chartered Accountants of India, the term Reserve means; "that
Ition of earnings, receipts or other surplus of an enterprise (whether capital or revenue)
gproprnated by the management for a general or a specific purpose other than a provision for
nreciation or dimunition in the value of assets or for a known liability.*
Thus the term Reserve has been defined by ICAI negatively in the sense that profits retained
the business not having any of the attributes of the provision should be treated as reserve.
Moreover, the provision in excess of the amount considered necessary for the purpose it was
mginally made is also considered as a reserve.
It is evident from the above that a provision is a charge against profits while reserve is an
ppropriation of profits. Thus, creation of reserves increases proprietor's funds while creation of
provisions decreases his funds in the business.
Provision and Reserve:
The following are the points of difference between
(a) A provision is created for a specific purpose andfor a known liability the amount of which
created to mneet some possible loss or to
cannot be ascertained with certainty. A reserve is
strengthen the financial position of the company. an accumulation of profits.
charge against profits, while reserve is
0) A provision is a can be distributed as profit.
profit, while a reserve
() Aprovision cannot be distributed as way of deduction from the amount of the
the balance sheet by
(4) A provision is shown in a reserve is shown separately in the balance
created, while
asset for which it has been heading "Reserves and Surplus.
side under the
Sheet on the liability
Reserve Fund
The term Reserve Fund means such reserve against which clearly earmarked investment etc.
outside the business exist. Thus, if the amount of reserve is being utilised by the business itself, it
annot be called reserve fund.
Kinds of Reserves Reserves can be classified into the follcwing categories:
(i) Revenue Reserves These are reserves created out of revenue profits of the business. They
can be categorised as follows:
(a) Specific Reserves These reserves are created out of revenue profits for a specific
purpose. Examples of such reserves are: Dividend Equalisation Reserve, i.e., a reserve
created for maintaining equilibrium in dividend, Debentures Redemption Reserve, i.e., a
reserve created for redemption of debentures etc.
(b) General Reserves These are the reserves created only to strengthen the financial
position or the business and to keep the funds available for any future contingency or
expenditure that may be required. Such reserves are also termed as free reserves, since
they represent profits which are freely available for distribution. The contingency reserve
or undistributed balance of the P. & L. Alc (after taking debit balance, if any) also
comes wvithin this category.
(i)Capital Resenves These reserves are created out of the capital profits. The following are
some of the examples of capital profits, out of thewhich such reserves are created:
(a) Profit on sale of fixed assets. It should be noted that capital profit is only excess of sa
3. Guidance Note on terns used in Financial Statement.
1.312 I/ DEPRECLATION PROVISIONSs AND RESERVES

fixed asset and not the entire surplus over the book value of th
price over the cost of
asset.
(b) Profits prior to incorporation.
(c) Premium on issue of shares or debentures.
profit on forfeiture of shares.
() Protitson redemption of debentures, fixed liabilities.
(e) Surplus on revaluation of fixedassets or Reserve on redemption of
) Amount transferred out of profits to Capital Redemption
redeemable preference shares.
way of dividend among the
Capital profits are generally not available for distribution byavailable for dividend if certain
shareholders of acompany. However, some of the capital profits are Bank of South
conditions are satisfied. For example, in the case of Lubbock vs. The British
(1900), it was held
America Ltd. (1882), and in Foster vs. The New Tinidad Lake Aspalte Co. Ltd. following
that profit on sale of fixed assets can be utilised for declaration of dividends if the
conditions are satisfied:
) The articles of the company do not prohibit such distribution.
(ii) The profits have been actually realised in cash.
(ii) The profits remain after revaluation of all the assets and liabilities of the company.
Capital profits which arise because of revaluation of fixed assets cannot be distributed as
dividend among the shareholders.
Some of the capital profits can be utilised only as per the requirements of the Companies Act.
For example, according to Section 78 of the Companies Act, 1956, the premium of issue shares can
be utilised only for the following purposes:
() Issue of fully paid bonus shares to the members of the company.
(i) Writing off the preliminary expenses of the company.
(iii) Writing off the discount allowed on issue of shares or debentures of the company or the
cost of issue of the shares or debentures.
(iv) Providing for the premium payable on the redemption of preference shares.
Similarly amount utilised out of profits for redemption of preference shares and transferred to
capital redemption reserve can be utilised only for issue of fully paid bonus shares.
(iii) Secret Reserves The reserves explained in the preceding pages are shown on the face of
the Balance Sheet. Secret reserves are the reserves the existence of which does not appear
on the face of the Balance Sheet. In such a situation, net assets position of the business is
stronger than that disclosed by the Balance Sheet.
Secret reserves are created by:
(a) Excessive depreciation of an asset, or excessive over-valuation of a liability:
(b) Complete elimination of an asset, or under-valuation of an asset:
(c) Charging capital expenditure to revenue, or crediting revenue receipts to an asset (e.g.
dividends received and earned credited to investment account):
(d) Permanent appreciation in a fixed asset or permanent diminution or extinction of liability not
recorded in the books of account;
(e) Showing acontingent liability as an actualliability or as a provision therefore;
) Grouping of "free" reserves with creditors; and
(g) Deliberately withholding sales tillthe succeeding period; or taking delivery of goods on
forward contract in a falling market.
Undisclosed Reserves
Sometimes, a reserve is created but its identity is merged with some other account or group o
accounts so that the existence of the reserve is not known. Such areserve is called an undisClosed
 DEPRECIATION PROVISIONS AND RESERVES I/ 1.313
eSCTve. This often
happens in the Balance Sheet of banks where
provision which amounts to
reserve) provision for taxation (incl. exXcess
is shown under the heading of
sCONts" which
includes not only a provision for taxation but also thecurrent and contingency
aCCOunt ofthe customers. Thus, the exact balances in the current
amount of provision for taxation made by the banks
cannot be ascertained from the
published accounts of the banks.
The creation of secret reserves is justified by some
people on the ground that this enables the
Board Directors of a company to bring equalisation in published profits of the company in a
manner which not only gives the anoutsiders impression about the stability of the
also ensures a regular income to the shareholders. Moreover, secret reserves business but
enable the business
meet extraordinary losses and thus prevent public confidence from being
shaken.
However, creation of secret reserves is objectionable on account of the following reasons:
(à Creation of such reserves places shareholders in a false position with regard to the availability
of their holdings. (i) The Profit & Loss Account does not disclose true profit made by the
business since each year is charged with fictitious amount with respect to depreciation, doubtful
debts, repairs etc. Similarly, the Balance Sheet cannot be said to be representing true state of affairs
of business on account of assets being understated and liabilities being overstated. (ii) The
system of creating secret reserves may be abused by the Directors by recourse to undesirable
activities. For example, they may suppress the net profitsof the company to such an extent that the
market value of the shares of th¹ company falls substantially. They may then purchase the shares
at the priceand subsequently sell them at a higher price and make substantial profits.
Prior to coming into force of the Companies Act, 1956,there were no restrictions on the creation
of secret reserves except that whenever secret reserves were brought back into accounts, it was
necessary to disclose the amount adjusted out of such reserves. At present such reserves cannot be
created byacompany because the auditor has to give the report that Balance Sheet of the company
Teveals a true and fair view of the state of affairs of the company. In case secret reserves have been
created, the auditor cannot give such a report without disclosing the extent of such reserves.

Key Terms
Amortization: The process of writing off the intangible assets.
Depletion: The portion of the cost of the natural resources recognised as an expense for each period.
Depreciation: The portion of the cost of tangible operating assets (other than land) recognised as an
expense for each period.
D Depreciation Accounting: A system of accounting which aims to distribute the cost or other basic
values of tangible capital assets (less salvage, if any) over the estimated useful life of the asset ina
systematic and rational manner.
Dilapidation: Damage done to a building or other property during the tenancy.