What is a Reserve and Provisions?
What is an Accounting Reserve and Provisions?Advantages of reserve fund and ProvisionsIntroduction
The two words "reserve" and "provision" are used synchronously in actual practice. For example. We can see the use of the terms reserve for doubtful, reserve for discount on debtors instead of provision for doubtful debts provision for discount on debtors etc. but in fact, there is sharp distinction between in two terms. Let's discuses these two terms respectively.
Reserve
Reserve is an amount set aside out of the profit and other surplus to strengthen the financial position of the business to meet future contingencies and losses. In other words, the amount of profit or surplus which is kept safe for the smooth operation of an organization and to pay different kinds of liabilities is called reserve. It is also called undistributed profit or retained earnings. Sometimes, it can be distributed to the shareholders as dividend. So we can say that reserve is that part of profit. Which is undistributed for the prupose of business use in furere.
Objective or importance of reserve
Reserve helps the business in strengthening its financial position. It also helps to meet unexpected loses without any reduction in owner's capital. Reserves establish a source of cost free capital of the business because it consists of pouching of profit. The reserves may be created for achieving any of the following objectives:
a. To strengthen the financial position of a firm.
b. To increase working capital of a firm.
c. To meet future contingencies of a firm.
d. To meet any unknown liabilities or losses of firm.
e. To replace a wasting assets of a firm.
f. To make uniform declaration of divided form year, in case of companies go to expansion of business through internal sources i.e. ploughing back of profit.
Reserve helps the business in strengthening its financial position. It also helps to meet unexpected loses without any reduction in owner's capital. Reserves establish a source of cost free capital of the business because it consists of pouching of profit. The reserves may be created for achieving any of the following objectives:
a. To strengthen the financial position of a firm.
b. To increase working capital of a firm.
c. To meet future contingencies of a firm.
d. To meet any unknown liabilities or losses of firm.
e. To replace a wasting assets of a firm.
f. To make uniform declaration of divided form year, in case of companies go to expansion of business through internal sources i.e. ploughing back of profit.
Features or characteristics of reserve
The main features of reserves are as follows:
• Reserves are created for meeting unknown liabilities or losses.
• Reserves are created out of profit.
• Reserves are recorded on the liabilities side of balance sheet.
• Reserve may be classified as general reserve, specific reserve.
• Reserve amount are invested outside the business in purchase of securities from 'reserve fund'.
Open/published reserves
Those reserves which are specifically created by debiting the profit and loss account and shown specifically on the liabilities side of balance sheet are called 'open/published reserve' those are classified into two groups i.e. capital reserve and revenue reserve.
Capital reserve
A reserve which is created/generated out of capital profit. It is usually not available for payment to shareholder. It is utilized for meeting capital losses of the firm. 'The expression capital reserve shall not include any amount regarded as free for distribution through the profit and loss account. Such profit is earned in the following ways:
• Sale of fixed assets
• Revaluation of assets and liabilities
• Issue of shares and debenture at premium
• Forfeiture and re-issue of shares
• Redemption of debenture at discount
• Profit made in purchase of running business
• Profit on sale of investment etc.
Advantage of capital reserve
The advantages of capital reserve are as follows:
• It helps to strengthen the financial position of an enterprise.
• It helps to supply additional requirement of working capital.
• It can meet unknown and unforeseen crisis.
• It helps in the issue of fully paid bonus shares to the existing shareholders.
Disadvantages of capital reserve
The disadvantages of capital reserve are as follows:
• Shareholders can not get fair dividend for its distribution.
• Difficultly to determine such reserve fund.
• No reflection of the real profit on business organization.
• All business organization can not make this provision necessarily.
Revenue reserve
A revenue which is created out of the revenue profit. Revenue profit earned from its normal activities of a business at the ended year. The portion of such profit which is not paid to the owner, but kept apart is known as 'revenue reserve'. Such profit is earned in the following ways:
• Profit on sales of goods or services
• Commission received
• Rent received
• Interest received etc.
It is classified into two groups:
a. General reserve
b. Specific reserve
General reserve
A reserve which is created not for any specific purpose, but for strengthening the financial position of the business is known as general reserve e.g. reserve, reserve fund or contingency fund etc.
This types of reserve is created out of regular or normal profit of the business. So the proprietor of the business is free to get it as share of his profit. That is why; it is also known a ' free reserve'.
Objective or advantage of general reserve
The following are the objectives or advantages of general reserve:
• To strengthen the financial position of the business.
• The meet unknown and unexpected liabilities and future losses.
• To provide financial sources for further expansion of business.
• To distribute equal rate of dividend to shareholders in case of joint stock company.
Accounting treatment of general reserve
General reserve is created out of undistributed profit therefore; accounting treatments are as, following for different cases.
1. In case of sole trading or partnership business
Profit and loss a/c dr.
To: general reserve a/c
2. In the case of joint stock company
Profit and loss appropriation a/c dr.
To: general reserve a/c
Specific reserve
A reserve is created for any special purpose is known as 'specific' i.e. dividend equalization fund, sinking fund, debenture sinking fund research and development fund etc. this reserve is utilizen for special purpose. Such reserve can not be unlizen for any purpose other than specified. For example: a company generally creates debentures sinking fund for the purpose of repayment of debenture. Such fund be utilized only for the purposes of respoying debenture, it is also called 'special reserve'.
It have classified into different groups. They are:
a. Sinking fund
b. Dividend equalization fund
c. Research and development fund
Sinking fund
A sinking fund is a fund which created for the purpose of repayment of liabilities (redemption of debentures) and replacing fixed assets. Every year a fixed amount either charged against profit or loss account or appropriated out of the profit and loss appropriation account. The same amount is withdraw from business in each year and invested on investments. The interest received on these investments is re-invested again to earn compound interest every year. When the debentures are due for redemption, the investments are sold and debentures are redeemed. Any profit on sale of investment is credited in sinking fund account whereas loss is demented to the same account.
There are two types of sinnkng fund. they are:
a. Sinking fund for redeeming liabilities: it is created for the purpose of repayment of liabilities or redemption from its creations is knows as sinking fund for redeeming liabities.
b. Sinking fund for replacing fixed assets: it is created for the purpose of replacing old assets by creating fund of the company at the end life of fixed assets is called sinking fund for replacing fixed assets.
Advantages or objectives of sinking fund
The following advantage or objectives of sinking fund are as follows:
• It provided adequate fund for the redemption of debenture or other loans.
• It provides adequate fund for the redemption of old fixed assets at the end of its useful life for new assets.
• It helps to invest in outside securities which will increase sum of reserve.
• It helps to maintain strong to be distributed to the shareholders.
Disadvantages of sinking fund
• It is impossible to collect sufficient fund for replacing old assets for new immediately.
• It reduces the divisible profit to be distributed to the shareholders.
Dividend equalization fund
It is a specific fund which is created out of profit in order to maintain equal dividend over years. Declaration of fixed rate of divided over years is good sign for long term stability and financial soundness of the company. Therefore, every prudent and systematic company declared fixed rate of dividend when the profit are high to equalize the dividend in future, when the profit are low, the fund originated by such transfer is called dividend equalization fund which insured that the fixed rate of divided declared during the period of prosperity can be utilized even during the period of crisis.
Advantages of divided equalization fund
The following advantages are:
• Helps to declare to distribute equal rate of dividend to shareholders even there is loss in the business.
• Due to the uniformity of divided over years. The market value of shares does not fluctuate abnormally.
• Helps to maintain the stability of the business.
Disadvantage of divided equalization fund
• It reduces the amount of dividend.
• Small scale organization can not able to create such fund.
• Due to the equal distribution of dividend it cannot help to measure working efficient of the management over years.
Research and development fund
It is essential for creating new product or for developing new design for the any product. It is also created out of profit to meet heavy expenditures of research and development work for new product in launching at the market. In the perfect competition market of business era. All the businessmen required to spend for the research and development work for new product. These are maintained by research and development fund.
Advantages of research and development fund
• It helps to manage required amount for research and development of new product.
• It helps to complete and lead highly competitive marketing environment.
• It helps to earn profit due to invention of new and better product in the market.
Disadvantages of research and development fund
• It is not suitable for small scale business organizations.
• Reserve and development works can be maintained if hugs amount of profit is earned.
• It reduces divisible profit of the shareholders.
Secret reserve
Reserve is created to strengthen the financial position of the firm without disclosing reserve to the public. It is not shown In the balance sheet. Such reserves are usually maintained by bank insurance company and other financial institutions. It is created by showing the figures of net profit and less than actual. It may be done by any of the following ways:
• By providing excessive depreciation.
• By undervaluing of current assets.
• By overvaluing the liabilities.
• By charging capital expenditure to revenue.
• By making accrued income or treating income as liability.
• By ignoring accrued income or treating income as liability.
• By including a fictitious liability.
• By under valuation of closing stock etc.
Advantage of stock reserve
• It helps to strengthen the financial position of business.
• If provident additional working capital.
• It helps to meet the exception losses.
• If helps to eliminate competition.
Disadvantage of secret reserve
• True financial position of the business can not be disclosed.
• Profit shown by financial statement is not accurate.
• No record is maintained and as such not disclose in the balance sheet.
Reserve fund
When the mount of reserve is invested outside the business in government securities, it is called reserve fund. Thus amount of reserved which is not invested outside the business is only called reserve. However, in actual practice no distinction is usually drawn between the two i.e. reserve and reserve fund.
Advantages of reserve fund
The following advantages are given below:
• Regular income earned for securities.
• The amount of reserve is quite safe because investment have been made in government securities.
• There may be profit on sale of investment if market price of securities rises. There may also be loses, if market price falls.
Provisions
Provisions mean providing for possible losses or liabilities. The amount of which cannot be determined exactly. It is create to meet specific losses or liabilities which may be expected but not yet incurred. Provisions are usually created by debiting the profit and loss account. They are either deducted on assets side of balance sheet or shown on the liabilities under appropriate heading. The examples of some provision are:
a. Provision for doubtful on debtors.
b. Provision for discount on debtors.
c. Provision for taxation
d. Provision for repairs and renewals
e. Provision for depreciation
f. Provision for fluctuation in investments
Objectives of provisions
The following objectives of provisions are:
a. Provision is created to cover loss in the value of assets.
b. Provision is created to meet anticipated losses and liabilities such as provision for doubtful debts, provision for taxation etc.
c. Provision is created to show correct financial statement and to report true profit and position of business.
Preparation of provision for doubtful debts account
While preparing provision for doubtful debts account, the following procedures should be following:
Step 1 any provision for bad depts. Papering in credit column of trial balance should be treated as opening balance and should be brought forward on the credit side of provision for doubtful debt amount.
Step 2 bad debts to be written off (outside trial balance) should be written off with the help of the following entries.
Step 3 now total debit balance of bad debts account (which includes bad debts written off during the year as well as written off now) is transferred to provision for doubtful debts account by recording the following entries:
Step 4 the new provision for doubtful debts required for next year’s (as per adjustment) in put out on the debt side of the provision for doubtful debts accounts as ‘To balance c/d’.
Step 5 the balance figure of provision for doubtful debts account is teetered to profit and loss account.
Effect in final accounts
1. In profit and loss account
When amount of bad debts written off its more than amount of provision for doubtful debts
2. When amount of bad debts written off is less than amount of provision for doubtful debts
The main features of reserves are as follows:
• Reserves are created for meeting unknown liabilities or losses.
• Reserves are created out of profit.
• Reserves are recorded on the liabilities side of balance sheet.
• Reserve may be classified as general reserve, specific reserve.
• Reserve amount are invested outside the business in purchase of securities from 'reserve fund'.
Open/published reserves
Those reserves which are specifically created by debiting the profit and loss account and shown specifically on the liabilities side of balance sheet are called 'open/published reserve' those are classified into two groups i.e. capital reserve and revenue reserve.
Capital reserve
A reserve which is created/generated out of capital profit. It is usually not available for payment to shareholder. It is utilized for meeting capital losses of the firm. 'The expression capital reserve shall not include any amount regarded as free for distribution through the profit and loss account. Such profit is earned in the following ways:
• Sale of fixed assets
• Revaluation of assets and liabilities
• Issue of shares and debenture at premium
• Forfeiture and re-issue of shares
• Redemption of debenture at discount
• Profit made in purchase of running business
• Profit on sale of investment etc.
Advantage of capital reserve
The advantages of capital reserve are as follows:
• It helps to strengthen the financial position of an enterprise.
• It helps to supply additional requirement of working capital.
• It can meet unknown and unforeseen crisis.
• It helps in the issue of fully paid bonus shares to the existing shareholders.
Disadvantages of capital reserve
The disadvantages of capital reserve are as follows:
• Shareholders can not get fair dividend for its distribution.
• Difficultly to determine such reserve fund.
• No reflection of the real profit on business organization.
• All business organization can not make this provision necessarily.
Revenue reserve
A revenue which is created out of the revenue profit. Revenue profit earned from its normal activities of a business at the ended year. The portion of such profit which is not paid to the owner, but kept apart is known as 'revenue reserve'. Such profit is earned in the following ways:
• Profit on sales of goods or services
• Commission received
• Rent received
• Interest received etc.
It is classified into two groups:
a. General reserve
b. Specific reserve
General reserve
A reserve which is created not for any specific purpose, but for strengthening the financial position of the business is known as general reserve e.g. reserve, reserve fund or contingency fund etc.
This types of reserve is created out of regular or normal profit of the business. So the proprietor of the business is free to get it as share of his profit. That is why; it is also known a ' free reserve'.
Objective or advantage of general reserve
The following are the objectives or advantages of general reserve:
• To strengthen the financial position of the business.
• The meet unknown and unexpected liabilities and future losses.
• To provide financial sources for further expansion of business.
• To distribute equal rate of dividend to shareholders in case of joint stock company.
Accounting treatment of general reserve
General reserve is created out of undistributed profit therefore; accounting treatments are as, following for different cases.
1. In case of sole trading or partnership business
Profit and loss a/c dr.
To: general reserve a/c
2. In the case of joint stock company
Profit and loss appropriation a/c dr.
To: general reserve a/c
Specific reserve
A reserve is created for any special purpose is known as 'specific' i.e. dividend equalization fund, sinking fund, debenture sinking fund research and development fund etc. this reserve is utilizen for special purpose. Such reserve can not be unlizen for any purpose other than specified. For example: a company generally creates debentures sinking fund for the purpose of repayment of debenture. Such fund be utilized only for the purposes of respoying debenture, it is also called 'special reserve'.
It have classified into different groups. They are:
a. Sinking fund
b. Dividend equalization fund
c. Research and development fund
Sinking fund
A sinking fund is a fund which created for the purpose of repayment of liabilities (redemption of debentures) and replacing fixed assets. Every year a fixed amount either charged against profit or loss account or appropriated out of the profit and loss appropriation account. The same amount is withdraw from business in each year and invested on investments. The interest received on these investments is re-invested again to earn compound interest every year. When the debentures are due for redemption, the investments are sold and debentures are redeemed. Any profit on sale of investment is credited in sinking fund account whereas loss is demented to the same account.
There are two types of sinnkng fund. they are:
a. Sinking fund for redeeming liabilities: it is created for the purpose of repayment of liabilities or redemption from its creations is knows as sinking fund for redeeming liabities.
b. Sinking fund for replacing fixed assets: it is created for the purpose of replacing old assets by creating fund of the company at the end life of fixed assets is called sinking fund for replacing fixed assets.
Advantages or objectives of sinking fund
The following advantage or objectives of sinking fund are as follows:
• It provided adequate fund for the redemption of debenture or other loans.
• It provides adequate fund for the redemption of old fixed assets at the end of its useful life for new assets.
• It helps to invest in outside securities which will increase sum of reserve.
• It helps to maintain strong to be distributed to the shareholders.
Disadvantages of sinking fund
• It is impossible to collect sufficient fund for replacing old assets for new immediately.
• It reduces the divisible profit to be distributed to the shareholders.
Dividend equalization fund
It is a specific fund which is created out of profit in order to maintain equal dividend over years. Declaration of fixed rate of divided over years is good sign for long term stability and financial soundness of the company. Therefore, every prudent and systematic company declared fixed rate of dividend when the profit are high to equalize the dividend in future, when the profit are low, the fund originated by such transfer is called dividend equalization fund which insured that the fixed rate of divided declared during the period of prosperity can be utilized even during the period of crisis.
Advantages of divided equalization fund
The following advantages are:
• Helps to declare to distribute equal rate of dividend to shareholders even there is loss in the business.
• Due to the uniformity of divided over years. The market value of shares does not fluctuate abnormally.
• Helps to maintain the stability of the business.
Disadvantage of divided equalization fund
• It reduces the amount of dividend.
• Small scale organization can not able to create such fund.
• Due to the equal distribution of dividend it cannot help to measure working efficient of the management over years.
Research and development fund
It is essential for creating new product or for developing new design for the any product. It is also created out of profit to meet heavy expenditures of research and development work for new product in launching at the market. In the perfect competition market of business era. All the businessmen required to spend for the research and development work for new product. These are maintained by research and development fund.
Advantages of research and development fund
• It helps to manage required amount for research and development of new product.
• It helps to complete and lead highly competitive marketing environment.
• It helps to earn profit due to invention of new and better product in the market.
Disadvantages of research and development fund
• It is not suitable for small scale business organizations.
• Reserve and development works can be maintained if hugs amount of profit is earned.
• It reduces divisible profit of the shareholders.
Secret reserve
Reserve is created to strengthen the financial position of the firm without disclosing reserve to the public. It is not shown In the balance sheet. Such reserves are usually maintained by bank insurance company and other financial institutions. It is created by showing the figures of net profit and less than actual. It may be done by any of the following ways:
• By providing excessive depreciation.
• By undervaluing of current assets.
• By overvaluing the liabilities.
• By charging capital expenditure to revenue.
• By making accrued income or treating income as liability.
• By ignoring accrued income or treating income as liability.
• By including a fictitious liability.
• By under valuation of closing stock etc.
Advantage of stock reserve
• It helps to strengthen the financial position of business.
• If provident additional working capital.
• It helps to meet the exception losses.
• If helps to eliminate competition.
Disadvantage of secret reserve
• True financial position of the business can not be disclosed.
• Profit shown by financial statement is not accurate.
• No record is maintained and as such not disclose in the balance sheet.
Reserve fund
When the mount of reserve is invested outside the business in government securities, it is called reserve fund. Thus amount of reserved which is not invested outside the business is only called reserve. However, in actual practice no distinction is usually drawn between the two i.e. reserve and reserve fund.
Advantages of reserve fund
The following advantages are given below:
• Regular income earned for securities.
• The amount of reserve is quite safe because investment have been made in government securities.
• There may be profit on sale of investment if market price of securities rises. There may also be loses, if market price falls.
Provisions
Provisions mean providing for possible losses or liabilities. The amount of which cannot be determined exactly. It is create to meet specific losses or liabilities which may be expected but not yet incurred. Provisions are usually created by debiting the profit and loss account. They are either deducted on assets side of balance sheet or shown on the liabilities under appropriate heading. The examples of some provision are:
a. Provision for doubtful on debtors.
b. Provision for discount on debtors.
c. Provision for taxation
d. Provision for repairs and renewals
e. Provision for depreciation
f. Provision for fluctuation in investments
Objectives of provisions
The following objectives of provisions are:
a. Provision is created to cover loss in the value of assets.
b. Provision is created to meet anticipated losses and liabilities such as provision for doubtful debts, provision for taxation etc.
c. Provision is created to show correct financial statement and to report true profit and position of business.
Preparation of provision for doubtful debts account
While preparing provision for doubtful debts account, the following procedures should be following:
Step 1 any provision for bad depts. Papering in credit column of trial balance should be treated as opening balance and should be brought forward on the credit side of provision for doubtful debt amount.
Step 2 bad debts to be written off (outside trial balance) should be written off with the help of the following entries.
Step 3 now total debit balance of bad debts account (which includes bad debts written off during the year as well as written off now) is transferred to provision for doubtful debts account by recording the following entries:
Step 4 the new provision for doubtful debts required for next year’s (as per adjustment) in put out on the debt side of the provision for doubtful debts accounts as ‘To balance c/d’.
Step 5 the balance figure of provision for doubtful debts account is teetered to profit and loss account.
Effect in final accounts
1. In profit and loss account
When amount of bad debts written off its more than amount of provision for doubtful debts
2. When amount of bad debts written off is less than amount of provision for doubtful debts
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