Reserve and Provision

RESERVE After going through this chapter you should be After going through this chapter you should be

able toable toUnderstanding the meaning of reserve.Understanding the classification of reserve.Understanding the difference between capital and

revenue reserve. Understanding the meaning of provision.Difference between reserve and provision.

MEANING

All liabilities in future both known as well as unknown, it is desirable that some portion of the profit is kept in the business itself in the form of reserve and provisions. The term reserve and provisions are used in different senses in accounting.

Reserve

Reserve means that part of the profit of

the business which has been kept for

future use or contingency.

According to the company act 1956:

Reserve means an amount set aside out of profits which are not designed to meet any liability, contingency .

it is not a charge against profits and is not meant to cover any existing liability or depreciation in the value of assets.

Features of reserve -It created out of net profitIt is also known retained earningCreation of reserve is not a legal necessity.It is recorded on the liabilities side of the

balance sheet.When the amount of reserve is invested in

outside securities, it is known as reserve fund.

Importance of reserves.Helpful in strengthening the financial

position of the business:- it is acts as a sources of internal financing for the purpose of expansion business, like ploughing back of profit

Helpful in meeting the unforeseen loss- any abnormal loss arises in future.

.

Conti..Helpful in equalizing dividend over

the period- goodwill of the company depends upon maintaining a uniform rate of dividend over the year. To achieve this dividend equalization reserve is created to equalise the rate of dividend

Classification of reserves:Reserve may be classified as…

Reserve

Revenue Reserve

Capital Reserve

Revenue reserve The profits earned by a business

through its routine activities is calculated at the end of the year through profit and loss account.

the portion of such profit which is not distributed among the owners but kept apart, known as reserve fund

Types of revenue reserve

(a)General reserve:

(b)Specific reserve

(c)Secret reserve

General reserve.Which is created without any specific purpose but strengthening the financial position of the business. It is created only when sufficient profit are their in an enterprise

Specific ReserveThe reserve which is created for particular

or specific purpose, is known as specific reserve

For example: (a) dividend equalization reserve

(b) investment fluctuation reserve

(c) debenture redemption reserve

(d) reserve for replacement of assets

Secret ReserveA secret reserve is a reserve which

is not disclosed in the balance sheet. Its also called hidden reserve.

Generally , banking & insurance companies create secret reserve with a view to strengthen the financial position.

.

Secret reserveExample: by charging capital

expenditure by depreciation on fixed

assets by creating provision for

bad debt & other contingencies

Capital reserveThe reserve created out of capital profits are

known as capital reserve, such reserve are not available for distribution as

cash dividend among the shareholdersExample: (a) profit on sale of fixed assets (b) profit on revaluation of fixed

assets (c) profit prior to incorporation of

the company (d) profit on redemption of

debenture

provisionAccording to company act 1956 the

term provision’ refer as.. the amount retained by way of

providing for any known liabilities, of which the amount cannot be determined with substantial accuracy

provisionProvision is an amount charged against

profit to provide for depreciation, renewal of assets or to meet a liability.

example: (a) provision for bad debts (b) provision for discount on

debtors (c) provision for taxation (d) provision for depreciation

Features of provisionIt is a charge against profit.It is made to meet a known liabilityIt is not available for distribution

among shareholders.

Note: if the provision exceeds the required amount, the excess is treated as reserve.

Difference between Reserve & ProvisionReserve Provision

It is created to meet an unknown liability

It is created to meet a known liability

Reserve is an appropriation of profit

Provision is a charge against profits

it is shown on the liabilities side under the head ‘reserve and surplus’

Either shown on assets side by way of deduction from the particular assets or as a distinct item on the liabilities side.

Conti..Creation of reserve is discretionary

Creation of provision is a legal necessity

It may be invested outside of business

It is never invested outside of business

Dividend can be paid out of it

Dividend cannot be paid out of it

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