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What-are-the-Provisions-and-Reserves

 

What are the Provisions and Reserves

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Provisions-

Provisions refer to any of the following amounts-

  • The amount written off or retained by way of providing for depreciation, renewals or diminution in the value of assets; or
  • The amount retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy.
 
Purpose for creating provisions-
  • Provision for Depreciation of Assets
  • Provision for Taxation
  • Provision for Discount on Debtors
  • Provision for Bad and Doubtful Debts
  • Provision for Repair and Renewals of Assets
 
Benefits of Provisions-
  • To ascertain the true net profit of the business- To ascertain the true net profit of a business it is necessary that all expenses pertaining to that year, whether paid or outstanding, must be debited to Profit & Loss account and a provision should be made for expenses or liabilities the amount of which cannot be estimated with reasonable accuracy. Provision should be made for provision for doubtful debts etc.
  • To ascertain the true financial position of the business- The Balance sheet will depict the true and fair view of the financial position of the business.
  • To provide for known losses in the future- The provisions are made to provide funds for meeting those losses such as provision for taxation, provisions for repair etc.
  • For equitable distribution of expenses- For equitable distribution of expenses over the life of an asset, provision should be made.
   
Reserves-

Reserves mean amounts set aside out of profits and other surpluses to meet future uncertainties. In other words, a reserve is meant for meeting any unknown liability or loss in the future. Reserve does not represent any expense or loss and as such it is not debited to Profit & Loss Account. Creation of reserve does not reduce the net profits but only reduces the divisible profits.

 
Purpose for creating Reserves-
  • Helpful in meeting the unforeseen liability or loss.
  • Helpful in strengthening the financial position of the business
  • To provide funds for meeting a specific liability
  • Equalisation of dividends over the years
 
Types of Reserves-

A. Revenue Reserve- Revenue Reserve as “that portion, or any detail thereof, of the net worth or total equity of an enterprise representing retained earnings available for withdrawal by proprietors.” Revenue reserves are of two types-

  1. General Reserve- Retain a part of profit in the business for “a rainy day” are known as General Reserves. These reserves are not created for any specific purpose and can be used for any purpose.
  2. Specific Reserve- These reserve is created for specific purpose and can be utilized only for that purpose, these are as under-
  • Dividend Equalisation Reserve- It is created to maintain steady rate of dividend, i.e. in which year the profits are sufficient, a part of the profit is transferred to such reserve and it is utilized to keep the dividend up in the year in which the profits are insufficient.
  • Reserve for Replacement of Asset- It is created to provide finances for the replacement of an asset. The amount of annual depreciation charged on assets is only capable of providing the original cost of the asset but the replacement of the asset will require a large sum of money due to the inflationary trend of prices. Such reserve for replacement of asset is created to provide for the extra amount required for the purchase of the new asset. The amount of replacement reserve is either kept and utilized in the business itself or is invested in outside securities bearing interest at a pre-determined rate. When this reserve is invested in outside securities it is known as reserve fund
  • Investment Fluctuation Fund- It is created to provide for decline in the value of investment due to market fluctuation.
  • Debenture Redemption fund- It is created to provide funds for the redemption i.e. repayment of debentures.
  • Workmen Compensation fund- It is created to meet compensation payable to workers in case if unexpected or unknown event of an accident.
   

B. Capital Reserve- In addition to the normal profit, capital profits are also earned in the business for many sources. The reserves created out of such capital profits are known as Capital Reserves. Profits received from the following sources are termed as fixed assets are treated as Capital Reserves. These are as below-

  • Profits on the sale of fixed assets
  • Profits on the revaluation of fixed assets and liabilities
  • Premium received on issue of Shares or business.
  • Profit from the reissue of forfeited shares.
  • Profit on redemption of debentures
  • Profit prior to the incorporation of a company
 

Capital Reserves are used to write off Capital losses and for the issue of fully paid bonus shares. Usually, Capital Reserves are not available for distribution as cash dividends. Some capital reserves can however be utilized to distribute dividends subject to fulfillment of the following conditions-

  • Articles of the company must not prohibit such dividend.
  • Capital profits must have been realized in cash.
  • Such profit remains after a fair revaluation of assets and liabilities.
 



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