Provisions and Reserves

Provisions

In accounting, a Provision is an amount set aside out of profits to meet a known liability or expense, the exact amount or timing of which is uncertain but can be reasonably estimated. It represents a charge against the profit for the current period, as the liability relates to events that have already occurred.

The creation of provisions is based on the Conservatism (Prudence) Concept, which requires that profits should not be anticipated, but all known or expected losses and liabilities should be provided for.

Key Characteristics of Provisions:

It is a charge against profit: It is created by debiting the Profit and Loss Account.
It is created for a known liability or expense: The obligation exists, but the exact amount or timing is uncertain.
The amount is an estimated amount: While uncertain, a reasonable estimate is made based on past experience or other relevant information.
It reduces the distributable profits: Since it's a charge against profit, it reduces the net profit available for distribution as dividends.

Common Examples of Provisions:

Provision for Doubtful Debts: Created to cover estimated losses from debtors who may not pay the amounts owed to the business.
Provision for Depreciation: Although often treated separately, it fits the definition of providing for the estimated decline in asset value. (See previous chapter).
Provision for Taxation: Created to cover the estimated amount of tax payable on the current year's profits, as the final tax assessment might happen later.
Provision for Repairs and Renewals: Created to spread the cost of major expected repairs/renewals of assets over their useful lives, even if the repairs haven't occurred yet.

Accounting Treatment For Provisions

Creating a provision involves recording an expense (Depreciation or specific provision expense) and creating a corresponding liability or reducing the value of an asset.

Journal Entry for Creating a Provision:

Date	Particulars	Debit (₹)	Credit (₹)
(End of Period)	Profit and Loss A/c Dr.	[Amount of Provision]
	To Provision for [Specific Purpose] A/c		[Amount of Provision]
	(Being provision created for ...)

The Provision for [Specific Purpose] Account is shown in the Balance Sheet. Provision for Doubtful Debts is typically shown as a deduction from Debtors (Current Asset). Provision for Depreciation is deducted from the original cost of the asset or shown as a liability. Provision for Taxation is shown as a Current Liability.

When the actual expense or liability materialises, it is set off against the provision.

Example 1. Using a Provision for Doubtful Debts.

A business created a Provision for Doubtful Debts of ₹5,000 at the end of the last year. This year, a debtor owing ₹1,500 becomes definitely bad (amount is irrecoverable).

Answer:

The loss of ₹1,500 is debited to the Provision for Doubtful Debts Account, reducing the provision.

Date	Particulars	Debit (₹)	Credit (₹)
(Date of Bad Debt)	Provision for Doubtful Debts A/c Dr.	1,500
	To Debtor's A/c		1,500
	(Being bad debt set off against provision)

If there was no provision, the bad debt would be debited to Bad Debts Account (an expense) and credited to Debtor's Account.

At the end of the current year, a new provision for doubtful debts is estimated and created (or adjusted) based on the current year's debtors.

Reserves

A Reserve is an amount set aside out of profits and other surpluses, not to meet any known liability, contingency, or diminution in the value of assets, but to strengthen the financial position of the business, to provide for unforeseen future needs, or to achieve specific objectives. It is an appropriation of profit, meaning it is created after the profit has been ascertained and after provisions have been made.

The creation of reserves is generally voluntary, although certain types of reserves may be required by law or contractual agreements.

Key Characteristics of Reserves:

It is an appropriation of profit: It is created by debiting the Profit and Loss Appropriation Account (or directly P&L if no separate appropriation account is maintained).
It is created for unknown future contingencies, expansion, or strengthening the business: There is no specific known liability attached to it at the time of creation.
The amount is based on the discretion of management (for voluntary reserves).
It increases the owner's equity/undistributed profits.
It does not represent cash set aside; it is merely a part of the accumulated profits. The actual amount of cash/assets available depends on the overall financial position.

Accounting Treatment for Creating a Reserve:

Date	Particulars	Debit (₹)	Credit (₹)
(End of Year)	Profit and Loss Appropriation A/c Dr.	[Amount of Reserve]
	To [Specific Reserve] A/c (or General Reserve A/c)		[Amount of Reserve]
	(Being amount transferred to Reserve)

Reserves are shown on the Liabilities side of the Balance Sheet under the heading "Reserves and Surplus", adding to the owner's equity.

Difference Between Reserve And Provision

Though both involve setting aside amounts from profit, their nature and purpose are fundamentally different.

Basis of Difference	Reserve	Provision
Purpose	To strengthen the business, meet unknown contingencies, or achieve specific goals (e.g., expansion).	To meet a known liability or expense, the amount or timing of which is uncertain but can be estimated.
Nature	Appropriation of Profit (created after profit is calculated).	Charge against Profit (created to calculate the correct profit).
Necessity	Generally voluntary (except for certain legal requirements like DRR).	Necessary and mandatory if a known liability/expense exists (based on Conservatism).
Impact on Profit	Reduces distributable profit (profit is already calculated).	Reduces the amount of profit itself.
Shown in Balance Sheet	Shown on Liabilities side under "Reserves and Surplus" (adds to Owners' Equity).	Shown on Liabilities side or deducted from the related asset (e.g., Provision for Depreciation from Fixed Assets).
Usability	Can generally be used for distribution as dividends (Revenue Reserves) or specific capital purposes (Capital Reserves).	Cannot be used for distribution as dividends. Must be used for the specific purpose for which it was created.
Created for	No specific known liability.	Specific known liability or reduction in asset value.

Types Of Reserves

Reserves are primarily categorised based on the source from which they are created.

1. Revenue Reserves:

Created out of the revenue profits of the business (profits earned from normal operating activities). The purpose is generally to strengthen the financial position or for specific purposes related to revenue activities. Revenue Reserves can generally be distributed as dividends to shareholders (unless specifically created for a non-distributable purpose).

General Reserve: Created without any specific purpose. Can be used for any general financial strengthening or future contingency.
Specific Reserve: Created for a specific purpose (e.g., Dividend Equalisation Reserve - to maintain a stable dividend rate year after year; Debenture Redemption Reserve (DRR) - legally required in India for redemption of debentures; Investment Fluctuation Reserve - to cover potential loss on sale of investments).

Revenue reserves appear under Reserves and Surplus on the Balance Sheet.

2. Capital Reserves:

Created out of capital profits of the business (profits earned from transactions that are not related to normal operating activities). Capital profits are usually non-recurring in nature. Capital Reserves cannot be distributed as dividends to shareholders. They are generally used for specific capital purposes like writing off capital losses or issuing bonus shares.

Examples of Capital Profits that lead to Capital Reserves:

Profit on sale of fixed assets.
Profit on revaluation of fixed assets.
Premium received on issue of shares or debentures.
Profit prior to incorporation.
Profit on forfeiture and re-issue of shares.

Capital reserves are also shown under Reserves and Surplus on the Balance Sheet, but they are distinguished from revenue reserves due to restrictions on their distribution.

Difference Between Revenue And Capital Reserve

Basis of Difference	Revenue Reserve	Capital Reserve
Source of Creation	Created out of revenue profits.	Created out of capital profits.
Purpose of Creation	To strengthen financial position, meet revenue contingencies, or equalise dividends.	Generally created due to legal or accounting requirements; cannot be used for revenue purposes. Used for capital purposes or writing off capital losses.
Usability for Dividend Distribution	Can generally be distributed as dividends (except specific types like DRR).	Cannot be distributed as dividends.
Legal Requirement	Generally voluntary (e.g., General Reserve), but some specific revenue reserves (like DRR) are legally mandatory.	Created when specific capital profits arise; legal restrictions apply on their use.

Importance Of Reserves

Maintaining adequate reserves is important for the long-term health and stability of a business.

1. Financial Strength:

Reserves represent accumulated profits that have been retained in the business, not withdrawn by owners or distributed as dividends. This increases the net worth of the business, making it financially stronger and more stable.

2. Meeting Future Contingencies:

General reserves can be used to absorb unexpected losses or meet unforeseen liabilities in the future, helping the business navigate difficult times without jeopardising its operations.

3. Funding Expansion and Growth:

Accumulated reserves provide internal funds that can be reinvested in the business for expansion, modernisation, or diversification without relying heavily on external borrowing.

4. Stabilising Dividends:

Dividend Equalisation Reserve helps maintain a stable dividend rate for shareholders even in years of low profit by drawing from the reserve.

5. Meeting Legal Requirements:

Certain reserves (like DRR) are mandatory under Indian law, ensuring compliance and providing a safeguard for stakeholders.

6. Building Confidence:

A business with substantial reserves is perceived as sound and well-managed, building confidence among investors, creditors, and the public.

In essence, reserves represent retained earnings that contribute to the business's ability to grow, absorb shocks, and meet its obligations, benefiting both the owners and other stakeholders.

Secret Reserve

A Secret Reserve is a reserve that is not disclosed in the Balance Sheet. It is created by intentionally understating profits or overstating liabilities or assets in the financial statements, resulting in the actual financial position of the business being better than what is shown in the Balance Sheet.

Methods of Creating Secret Reserves:

Understating Assets:
- Charging excessive depreciation on fixed assets (more than required by accounting standards or actual wear and tear).
- Writing off assets like Goodwill or Patents prematurely.
- Valuing closing stock at a value lower than cost or market price.
- Not recording income or assets.
Overstating Liabilities or Expenses:
- Creating excessive provisions for doubtful debts or other contingencies.
- Showing liabilities at a higher amount than actually due.
- Charging capital expenditure as revenue expenditure (e.g., cost of a new machine included in repairs).

The existence of a secret reserve means that the Balance Sheet does not present a true and fair view of the financial position, and the Profit and Loss Account does not show the true profit.

Implications of Secret Reserves:

Violation of Full Disclosure: It contradicts the Full Disclosure concept as material information about the true financial position is concealed.
Misleading to Users: Investors, creditors, and other users are misled about the actual profitability and net worth of the business.
Manipulation of Profits: Secret reserves can be used to smooth out reported profits (e.g., drawing from the secret reserve in a bad year to show higher profit, or adding to it in a good year to show lower profit).

For public companies, the creation of secret reserves is generally considered unethical and prohibited by accounting standards and company law (like the Companies Act, 2013 in India) because it violates the principle of presenting a true and fair view. However, some degree of "prudence" in accounting estimates might inadvertently lead to a slight understatement of profits/assets, which is different from intentionally creating large secret reserves.

In small businesses or sole proprietorships not subject to stringent regulations or audits, secret reserves might sometimes be created, but it undermines the reliability of financial statements.