Chapter 6Chapter 6PROVISIONS AND PROVISIONS AND

RESERVESRESERVES

PROVISION: MeaningPROVISION: Meaning

Provision is made for those items Provision is made for those items which are related to current year which are related to current year operating activities but the amount operating activities but the amount of these items is not known.of these items is not known.

Examples: Provision for Depreciation, Examples: Provision for Depreciation, Provision for Bad and Doubtful Debts, Provision for Bad and Doubtful Debts, Provision for Discount on Debtors, Provision for Discount on Debtors, Provision for Taxation etc.Provision for Taxation etc.

Basic Features of ‘Provision’ are:1. To provide for expected decrease in assets or increase in

liabilities on account of the transactions of the current year. For e.g., tax liability is determined at the time of assessment by the income tax authorities at some future date. But as tax liability likely to arise in future is on the income of the current year provision for taxation is created and Dr. to the P&L A/c of the current year.

2. Provision is charged against revenue and other incomes of the current year. It ensures proper matching of revenue and expenses.

3. Provision helps to show assets at their real worth. Provision helps in ascertainment of true profits (or loss) of the enterprise, if provisions are not created the profits are overstated. It helps in depiction of true and fair view of the financial position of the business enterprise.

4. When provision for any item is created, actual expense is charged to provision A/c and not to P&L A/c

ReservesReserves

Reserve refers to retention of profit Reserve refers to retention of profit which is not in the form of provision.which is not in the form of provision.

Reserves means accumulated or Reserves means accumulated or undistributed profits.undistributed profits.

If the provision exceeds the amount If the provision exceeds the amount which is required to meet the loss or which is required to meet the loss or liability, the excess is to be treated liability, the excess is to be treated as reserve.as reserve.

Objectives of ReservesObjectives of Reserves To strengthen the financial position of the To strengthen the financial position of the

enterprise.enterprise. To provide funds for modernization and /or To provide funds for modernization and /or

expansion of existing plant or acquisition expansion of existing plant or acquisition of a new plant.of a new plant.

To equalise the dividends during the To equalise the dividends during the periods of inadequate profits.periods of inadequate profits.

To comply with legal requirements e.g. To comply with legal requirements e.g. Debenture Redemption Reserve, Capital Debenture Redemption Reserve, Capital Redemption Reserve under the Companies Redemption Reserve under the Companies Act,1956.Act,1956.

To meet unforeseen abnormal losses.To meet unforeseen abnormal losses.

Types of ReservesTypes of Reserves

1.1. REVENUE RESERVEREVENUE RESERVE: those reserves which : those reserves which are created out of profits available for are created out of profits available for distribution by way of dividend. These may distribution by way of dividend. These may be classified as:be classified as:

(a)(a) General ReserveGeneral Reserve: Reserve which is not : Reserve which is not created for any specific purpose. E.g. created for any specific purpose. E.g. General Reserve, Contingency Reserve.General Reserve, Contingency Reserve.

(b)(b) Specific ReserveSpecific Reserve: Reserve which is created : Reserve which is created for specific purpose. E.g. Dividend for specific purpose. E.g. Dividend Equalisation Reserve, Debenture Equalisation Reserve, Debenture Redemption Reserve.Redemption Reserve.

2. 2. CAPITAL RESERVECAPITAL RESERVE: those reserves created : those reserves created out of profits of capital nature and not out out of profits of capital nature and not out of operating profits. E.g. Profits prior to of operating profits. E.g. Profits prior to incorporation, Premium on issue of Shares incorporation, Premium on issue of Shares and Debentures, Premium on reissue of and Debentures, Premium on reissue of forfeited shares, Profit on sale of fixed forfeited shares, Profit on sale of fixed assets, Profit on revaluation of fixed assetassets, Profit on revaluation of fixed asset

Revenue Reserves are free for distribution Revenue Reserves are free for distribution by way of dividend whereas amount of by way of dividend whereas amount of capital reserve are not free for distribution capital reserve are not free for distribution by wy of dividend.by wy of dividend.

Distinction Between Provision and ReserveDistinction Between Provision and Reserve

Basis of Basis of DistinctionDistinction

ProvisionProvision ReserveReserve

1. Purpose1. Purpose It is created for some It is created for some specific purpose and can specific purpose and can be used for that be used for that particular purposeparticular purpose

It need not necessarily be It need not necessarily be created for a particular created for a particular purpose. E.g. General purpose. E.g. General ReserveReserve

2. Charge v/s 2. Charge v/s AppropriationAppropriation

It is a charge against the It is a charge against the profit and is required to profit and is required to be created irrespective be created irrespective of the amount of profit.of the amount of profit.

It is an appropriation out It is an appropriation out of profit and can be of profit and can be created only if profits created only if profits have been earned.have been earned.

3. Disclosure 3. Disclosure in Balance in Balance SheetSheet

Usually a provision is Usually a provision is shown by way of shown by way of deduction from the deduction from the amount of the items for amount of the items for which it is created.which it is created.

Reserve is shown as a Reserve is shown as a separate item under the separate item under the head ‘Reserves and head ‘Reserves and Surplus’ on the liabilities Surplus’ on the liabilities oside of the Balance oside of the Balance SheetSheet

4. Investment 4. Investment outside the outside the businessbusiness

There is no question of There is no question of investment of amount of investment of amount of provisionsprovisions

The amount of The amount of Reserve can be Reserve can be invested outside the invested outside the businessbusiness

5. Utilisation for 5. Utilisation for DividendsDividends

It cannot be utilised for It cannot be utilised for distribution by way of distribution by way of dividendsdividends

It can be utilised for It can be utilised for distribution by way of distribution by way of dividendsdividends