Here are the Provision and Reserves class 11 notes. According to the Companies Act, the term ‘Provision’ refers to any of the following amounts:
- The amount written off or retained by way of providing for depreciation, renewals, or diminution in 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.
Topics Discussed
Examples of Provisions
Provisions are created for the fulfillment of various objectives:
- Provision for Depreciation of Assets
- Provision for Taxation
- Provision for Bad and Doubtful Debts
- Provision for Discount on Debtors
- Provision for Repairs and Renewals of Assets
Features of Provisions
- Provision is made to meet a known liability.
- The liability is known but the amount of such liability cannot be determined with reasonable accuracy.
- Provision is a charge against profits and as such reduces the profits of the year in which it is created.
Importance of Provisions
1) To ascertain the true net profit of the business
In order to ascertain the true profit of a business it is necessary that all expenses pertaining to that year, must be debited to the Profit and Loss account and a provision should also be made for expenses or liabilities should also be made for expenses or liabilities amount of which cannot be estimated with reasonable accuracy.
2) 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 only if adequate provision is made for all the anticipated losses and expenses.
3) To provide for known losses in the future
Funds will be required to meet the losses and liabilities that are likely to occur in the near future.
Meaning of Reserves
Reserves mean amounts set aside out of profits and other surplus to meet future uncertainties. In other words, a reserve is meant to meet any unknown liability or loss in the future.
According to William Pickles, “Reserves mean the amounts set aside out of profits and other surpluses, which are not earmarked in any way to meet any particular liability, known to exist on the date of the balance sheet”.
Examples of Reserves
Here are the following types of reserves:
- General Reserve
- Capital Reserve
- Dividend Equalisation Reserve
- Investment Fluctuation Reserve
- Workmen Compensation Reserve
- Reserve for Redemption of Debentures
Features of Reserves
- It is created out of net profits or divisible profits. As such the reserves are also termed as ‘Retained Earnings’ or ‘Undistributed Profits’.
- The creation of reserves is not a legal necessity.
- Normally, it is not created to meet any known liability or depreciation in the value of assets but to meet an unknown liability or loss in the future.
- Reserves represent accumulated or undistributed profits and as such they belong to the proprietors just as capital does.
- When the reserve amount is invested in outside securities, it is known as a ‘reserve fund’.
Importance of Reserves
1) Helpful in meeting the unforeseen liability or loss
If any unforeseen or abnormal loss arises in the future, reserves can be utilized to meet such eventualities.
2) Helpful in strengthening the financial position of the business
Reserves are undistributed or accumulated profits and are technically known as ‘ploughing back of profits’.
3) Equalization of dividends over the years
The goodwill of a company depends upon maintaining a uniform rate of dividend from year to year and also increasing the dividend steadily.
4) To provide funds for meeting a specific liability
Sometimes a reserve is created for a specific purpose such as a ‘Debenture Redemption Fund’ for the payment of debentures.
Difference between Provision and Reserves
| Basis | Provision | Reserves |
| Meaning | It is created to meet a known liability. | It is created to meet an unknown liability. |
| Necessity | The creation of a provision is a legal necessity. Provision has to be provided for even if there are no profits. Thus, provision is a charge against profits. | The creation of reserves is discretionary. It can be earned. Thus, the reserve is an appropriation of profit. |
| Object | The object is to provide for depreciation, doubtful debts, and other specific liabilities. | The object of reserves is to strengthen the financial position of the business. |
| Mode of Creation | It is created by debiting to P & L A/c, hence net profit cannot be calculated unless all provisions have been debited to P & L A/c. | It is created not by debiting to P & L A/c but through P & L Appropriation A/c. As such, it is created after the calculation of net profit. |
| Investment outside the business | Provisions are never invested outside the business. | Reserves may be invested outside the business. |
| Presentation in Balance Sheet | It is either shown on the assets side by way of deduction from the asset for which it is created or as a distinct item on the liabilities side. | It is shown on the liabilities side under the head ‘Reserves and Surplus’. |
| Utilization in Balance Sheet | It cannot be utilized for distribution as dividends among shareholders. | It can be utilized as dividends among shareholders. |
| Utilization for other purposes | It is created to provide for a specific loss and hence can only be used for meeting that loss. | It is not created to provide for a specific loss and hence can only be used for any purpose. |
Goods and Services Tax Class 11 Notes
Types of Reserves
1) Revenue Reserves
These reserves come into existence out of profits that have been earned in the course of day-to-day business operations.
There are two types of revenue reserves which are as follows:
a) General Reserve
Usually, the businessmen do not withdraw the entire profits from the business but retain a part of it in the business to meet unforeseen future uncertainties. Profits do so retained in the business for a rainy day are known as ‘General Reserve’.
Similarly, companies also do not distribute the entire profits as dividends but keep aside a part of it in the form of a General Reserve.
Such reserves are also termed ‘Contingency Reserves’ or ‘Free Reserves’ because these are not created for any specific purpose and can be freely used for any purpose.
b) Specific Reserves
Such a reserve is created for a specific purpose and can be utilized only for that purpose. Examples of specific reserves are:
- Dividend Equalization Reserve: Such a reserve is created to maintain a steady rate of dividends.
- Reserve for Replacement of Asset: Such a reserve is created to provide finances for the replacement of an asset at the end of its serviceable life.
- Investment Fluctuation Fund: It is created to provide for the decline in the value of investments due to market fluctuations.
- Workmen Compensation Fund: It is created to meet compensation payable to workers in case of unexpected or unknown events of an accident.
- Debenture Redemption Reserve: It is created to provide funds for the redemption i.e., repayment of debentures.
2) Capital Reserve
In addition to the normal profits, capital profits are also earned in the business from many sources. The reserves created out of such capital profits are known as Capital Reserves.
Such reserves generally, are not available for distribution as cash dividends among the shareholders of a company.
- Profits on the sale of fixed assets.
- Profits on the revaluation of fixed assets and liabilities.
- Premiums received on the issue of shares or debentures.
- Profit on the purchase of a running business.
- Profit prior to the incorporation of a company.
- Profit from the reissue of forfeited shares.
- Profit on redemption of debentures.
Difference between Revenue and Capital Reserves
| Basis | Revenue Reserves | Capital Reserves |
| Source of Creation | These reserves are created out of revenue profits that arise from the normal operating activities of the business and are otherwise available for the distribution of dividends. | These reserves are created out of capital profits, which do not arise from the normal operating activities of the business and are not available for the distribution of dividends. |
| Usage | A specific reserve can be utilized only for the earmarked purpose while a general reserve can be utilized for any purpose including the distribution of dividends to shareholders without any pre-conditions. | Normally, these reserves cannot be utilized for the distribution of dividends to shareholders. However, some capital reserves can be utilized to distribute dividends subject to the fulfillment of certain conditions laid down by the Companies Act. |
| Purpose | These reserves are created to meet unforeseen losses and to strengthen the financial position of the business. | These reserves are created to meet capital losses or may be used for purposes laid down by the Companies Act. |
Secret Reserve
A secret reserve is one which is not disclosed by the Balance Sheet. These reserves are created by showing a profit at a figure much lower than the actual and by showing the assets at a lower figure and liabilities at a higher figure.
When secret reserves exist, the actual position of the firm is much better than what is disclosed by the balance sheet.
Secret reserves may be created in the following ways:
- Writing off excessive depreciation
- Charging capital expenditure (such as addition to assets) to the Profit and Loss Account
- Treating a revenue receipt as a capital receipt (such as rent received credited to the Building Account)
- Undervaluation of Assets (such as undervaluation of closing stock)
- Showing an actual asset as a contingent asset
- Showing a contingent liability as an actual liability
- Suppressing the sale
- Creating excessive or unnecessary provisions for doubtful debts and other contingencies
Advantages of Secret Reserve
1) Financial Stability
The creation of secret reserves strengthens the financial position of the enterprise without disclosing this fact to the shareholders or the public.
2) Helpful in Absorbing Unforeseen Losses
The presence of secret reserves enables such concerns to absorb any unexpected losses without any public discomfiture.
3) Regularity of Dividends
Such reserves help the enterprise maintain the rate of dividend during adverse trading conditions without disclosing this fact to shareholders or the public.
4) Avoidance of Competition
Because of the concealment of the actual profitability of the enterprise, the entry of the competition firms in the particular line of business is avoided.
Disadvantages of Secret Reserve
1) Unfair Presentation of Financial Statements
Statement of Profit & Loss fails to disclose true profit and the balance sheet fails to disclose a true and fair view of the financial position of the enterprise.
2) Loss to Shareholders
Shareholders who wish to sell their shares may not get the actual price of their shares because of the understatement of profits and the financial position of the enterprise.
3) Misuse by Management
Fraudulent management may take undue advantage by creating secret reserves.
4) Cover for Misdeeds of Management
Secret reserves may be utilized by management to cover their mistakes or misdeeds.
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