A business may like to provide for contingencies as per the concept of conservatism. These contingencies can broadly be classified into two categories:
(i) Unforeseen contingencies i.e. contingencies of which the business is neither sure of their nature nor of their amounts e.g. amounts set apart for preventing reduction in dividend rate due to possible fall in profits.
(ii) Expected contingencies i.e. contingencies are known to the business but whose amounts cannot be ascertained with reasonable accuracy e.g. amounts set apart for meeting possible loss on account of bad debts, discounts to debtors, etc.
The amounts set apart for the first type of contingencies are known as ‘Reserves’ while for the other they are known as ‘Provisions’.
Meaning of Reserves and Provisions
The terms reserves and provisions 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. It may be noted that thought the provisions of the Companies Act are applicable to only companies registered under that Act, it is proposed in this article to deal with reserves and provisions on the lines of definitions given in that Act.
Definition of Reserve
The term reserve has not been defined as the profits retained in 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 Moreover, the provision in excess of the amount considered necessary for the purpose it was originally made is also considered as a reserve.
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 cannot be called reserve fund.
Kinds of reserves
Reserves can be classified into the following categories:
(i) Revenue reserves. These reserves are created out of revenue profits of the business. They can be categorised as follows:
- 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. reserves created for redemption of debentures etc.
- General reserves. These are reserves created only to strengthen the financial position of 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 A/C. (after considering debit balance, if any) also comes within this category.
(ii) Capital reserves. These reserves are created out of capital profits. The following are some of the examples of capital profits, out of the which such reserves are created.
- Profit on sale of fixed assets. It should be noted that capital profit is only excess of sale price over the cost of fixed asset and not entire the surplus over the book value of the asset.
- Profits prior to incorporation.
- Premium on issue of shares of debentures.
- Profits on redemption of debentures, profits on forfeiture of shares.
- Surplus on revaluation of fixed assets or fixed libilities.
- Amount transferred out of profits to Capital Redemption Reserve on redemption of redeemable preference shares.
Capital profits are generally not available for distribution by way of dividend among the shareholders of a company. However, some of the capital profits are available for dividend if certain conditions are satisfied. For example, in the case of Lubbock vs. The British Bank of South America Ltd. (1882), and in Foster vs. The New Trinidad Lake Asphalte Co. Ltd. (1900), it was held that profit on sale of fixed assets can be utilised for declaration of dividends if the following conditions are satisfied:
(i) The articles of the company do not prohibit such distribution.
(ii) The profits have been actually realised in cash.
(iii) 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, the premium on issue shares can be utilised only for the following purposes:
(i) Issue of fully paid bonus shares to the members of the company.
(ii) 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 debentures or redeemable 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.
Definition of Provision
The term Provision has been defined as follows:
Provision usually means any amount written off or retained by way of providing depreciation, renewals or diminution in the value of assets or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy.
Thus, provisions are amounts set aside out of profits and other surpluses for:
(a) Depreciation, renewals or diminution 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 bc 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, Provision for Taxation, etc.
Accounting for Reserves and Provisions
Accounting for Reserves
The reserves are appropriation of profits hence for creating a Resave, the following journal entry is passed:
The Reserves are shown on the liabilities side of the Balance sheet under proper heading or sub-heading. In case of a company, they are shown under the heading “Reserves and Surplus” as given below:
…… Co. Ltd
Extracts from Balance Sheet as on …….
Accounting for Provisions
The provisions are created by debiting the Profit and Loss Account. They are either deducted on the assets side of the Balance Sheet (as is the case with provision for depreciation or bad and doubtful debts) or shown on the liabilities under appropriate heading, sub-heading. Extracts from a proforma profit and loss account and balance sheet are given below for better clarity.
Extract from Profit and Loss Account (Debit Side)
Extract from Balace Sheet of a Company