UNIT 22 PROVISIONS AND RESERVES

Structure
22% Objectives
22.1 Introduction
22.2 What is a Provision?
22.3 What is a Reserve?
22.4 .,Distinction between Provision and Reserve
32.9. " Types of Reserves
22.5.1 Open Reserves
22.5.2 Secret Reserves
22.6 Let Us Sum Up
22.7 Key Words
22.8 Some Useful Books
22.9 Answers to Check Your Progress
22.10 Terminal Questions/Exercises

22.0 OBJECTIVES

After going through this unit, you Should be able to :

o explain the meaning of term 'provision' and 'reserve"
@ distinguish between provision and reserve

e prepare provision for repairs and renewals account

o describe the nature of different types of reserves.

22.1 INTRODUCTION

Business firms maintain their accounts as going concerns on the assumption that the
business will continue to exist indefinitely, Hence, at the end of each accounting
year, they must also take into account the future contingencies and the requirements
of funds before determining the amount of net profit available for distribution
among the owners. Provisions and reserves actually relate to the future needs for
which a part of the current earning has to be set aside. In this unit you will learn
about the meaning of provision and reserve, the difference between provision and
reserve, and also the various types of reserves which are usually created before
distribution of profits.

22.2 WHAT IS A PROVISION?

It is a generally accepted accounting principle that while measuring income for an

%
accounting year, all possible losses and expenses must be taken into account. Hence
we usually provide for depreciation on fixed assets and their repairs, renewal etc.
Similarly, there may be certain liabilities/losses the amounts of which cannot be
ascertained with substantial accuracy such as dispute claims for damages, bad debts,
and so on. We must charge their estimated amounts to Profit and LOSSAccount
before working out the net profit. Such charge to the Profit and Loss Account is
called 'Provision', The Indian Companies Act has defined it as "any amount written
off or retained by way o f providing for depreciation, renewal diminution in the value
of'assersor retained by way of for any known liability of which the amount
1 cannot be determined with substantial accuracy"

Thus, provisions are the amounts set aside out of profits and other surpluses to
provide for (i) depreciation, renewals, or diminutionin the value of assets, and
(ii) any known liability of which the amount Gannot be determined with suhstantial
accuracy.
I Accounts of No~trading It must be noted that any kitom 3iabXty the &mmnt of which can bedetenninea
Concerns, Depreciation, accurately does not fall within the definition (sf a provision and should be desc%ib&'
Provisions and Reserves as 'accrual' or 'accrued liabilities'. In other words, provision for outstanding salaries,
.rent, etc., in the strict sense of the term, cannot be called provisions. They will be
termed as 'accruals'.
The provisions are usually created by debiting the Profit and Loss Account and are
either shown on the liabilities side of the Balance Sheet or deducted from the
concerned asset. You learnt about the provision for bad and doubtful debts,
provision for discount on debtors and provision for depreciation in Unit 7. Let us
now study about the provision for repairs and renewals.
Provision for Repairs and Renewals : Certain assets used for business purposes need
repairs and renewals which may not be significant in initial years when any asset is
purchased, but it may increase with its constant use and passage of time. To equalise
the charge on Profit and Loss Account over the year in respect of repairs and
renewals, we make a provision for repairs and renewals by debiting the Profit and
I a s s Account and crediting the Provision for Repairs and Renewals Account. The
actual expenditure incurred on repairs and renewals is charged to the Provision for
Repairs and Renewals Account every year. Look at Illustration 1 and see how this
account appears in books.
Iil~~stration
1
A business concern decided to provide Rs. 10001-every year for the repairs and
renewals of a machine used in the process of manufacture from the year 1981. In the
first five years the amount spent on repairs was Rs. 3001-, Rs. 3251-, Rs. 4801-,
Rs. 7001-, Rs. 1,2001-. Prepare a Provision for Repairs and Renewals Account for
five years.
Solution :
Provisions for Repei.rs,andRenewals Alc
Dr. Cr.
Date Parlic~~lar Amount Dnte Particulars Amount

1981 Rs. 1981 Rs.

Dec. 31
., 31 I To Repair Ale
To BaIawc Yd
1,000

1982 .
Dec. 31 To Repair Ale By Balance b/d 700
,, 31 To Balance cld ByP&LA/c

1983
Dec. 31 To Repair A/c By Balance bld 1,375
,, 31 To Balance cld ByP&LA/c

2,375

1984 1984
Dcc. 31 To Repair N c 700 Jan. 1 By Balance bld 1,895
,, 31 To Balance c/d 2,195 Dec. 31 ByP&LA/c

2,895 2,895

1985 1985
Dee. 31 To Repair A/c 1,200 Jan. 1 By Balance bld 2,195 ,
,, 31 To Balance cld 1,995 Dec. 31 ByP&LA/c

3,195
--. ---
--
 22.3 WHAT IS A RESERVE?
The term reserve refers to the amount. set aside out of profits and other surplus
which are not designed to meet any liability or diminution in value of adsets known .
to exist at the date of the Balance Sheet. The Indian Companies Act has not given
any clear definition of the term 'Reserve'. It states, however, that "the expression
'reserve' shall not........ include any amount written off or- retained by way of
providing for depreciation, renewal or diminution in value of an asset, ,or retained b y
way ofproviding for any known liability. In other words, any amount set aside out of
profits to meet unexpected future losses and liabilities is called reserve. Not only
that if any amount retained by way of providing for any known liability in excess of
the amount actually needed for the purpose, shall also be treated as reserve and not
a provision.
The basic p&pose of creating a reserve is to provide for unexpected losses in future
and also retain profits within business (not distribute them to the owners or
shareholders) to providefunds for expansion ,ofthe business. Most well managed
companies make it a point not to distribute the whole of their profits to the
shareholders. They retain good portion of their profit in the form,of general reserve
(also called contingency reserve). This also enables them to pay dividend even
during the year when the profits are low or there are losses.
b

Reserves are created by debiting their amounts to the Profit and Loss Appropriation
Account. But reserve is not a compulsory charge on profits. It is purely voluntary
and is regarded as an appropriation of profits. It means that reserve represents an
undistributed portion of net profit and not a loss or expense which ought to have
been charged before calculating the net profit, as is done in case of the provisions.
Reserve Fund : The term 'reserve fund' is used for the amount of reserve which has
been invested in outside securities. The instructions given in the Companies Act for
the preparation of Balance Sheet, the word 'fund' in relatioil to any reserve can b e
used only when such reserve is specifically represented by earmarked investments.
Examples of Reserve fund are employees' welfare fund, pension fund, gratuity fund,
debenture redemption fund, etc. If, however, the amount of reserve is being utilized
by the business itself and not invested in some outside securities, it cannot be called
reserve fund.

22.4, DISTINCTIONBETWEEN PROVISION AND

RESERVE,
, You have learnt the meaning and purpose of creating a provision and also a reserve.
Various points of distinction between the two can be summarised as follows :

1 Provision 'is made to meet a known 1 Reserve is created to meet unexpected

liability for depreciation/renewal of contingencies likely to arise in future.
, ,a$sets.

2 The amount set aside is used only to meet 2 Amount can be used for any liability o r
the specific purpose for which provision loss.
was made.
3 Provision is to be made even if there are no 3 It is created only when there are sufficient
profits. profits,
4 It is a charge on ptofits and must be 4 it is an appropriation of profits and
debited before arriving at the figure of represents undistributed profits.
net profit.
5

6
It qannot be used for the payment of
dividends.
It cannot be invested outside the
I 5

6
~ x c ein~ some
t enses, it can be used for
payment of dividends. .
It can be invested outside th'e business,
business. when created For a specific purpose.
 Accounts of Non-trading check Yo& Progress A
Concerns, Depreciation,
Provisions and Wcserves 1 Define Provision.

2 Which of the following statements aretrue and which are false.

i) Provision for discount on debtors is a charge on Profit and Loss
Account. ......
. .
ii) Creation of reserve may lead to reduction of net profit. ......
iii) Provision made can be distributed among shareholders,if the
directors so decide. .....
iv) Reserves are always-invested outside the business. ......
v) Amount set aside out of profits is known as reserve if it is created
for meeting unexpected future contiagencies. ......
vi) Reserve is a charge on net profit. ......
' 3 How is 'Reserve Fund' different from 'Reserve'?

22.5 TYPES OF RESERVES

To have a clear understanding of the nature and purpose of reserves we may.classify .
them into different categories as follows:
Reserve
J

op%n
I
Reserve Secret geserve
u
Capltal
4
Revenue e
I

Reserve Reserve
~ e n e rReserve
i specificSeserve

22.5.1 Open Reserves .

I

There are two ways of reating reseves: (1)by debiting the amount to Profit and
1
Loss Account and clear y showing it in the Balance Sheet in one form or the other,
and (2) by undervaluation of assets or overproviding for losses. The first category'of
reserves can be easily identified from the financial statements and are termed as
open reserves. The second category of reserves cannot be identified by the reader of
financial statements. They are known only to the management. Shch reserves are
called 'secret reserves'. These will be discussed later in this unit.
Open reserves are further classified as capital reserves and revenue reserves
depending on the nature of profit out of which they are created.
Capital Reserve : A reserve created out of capital profits is called 'Capital Reserve'.
Capital profits may arise on account of revaluation or sale of fixed assets. In case of
companies the following items are also regarded as capital profits.
i) credit balance left in Forefeited Shares Account after the re-issue of such
shares,
ii) premium received on issue of shares on debentures, " 1 .
iii) profit realised onthe purchase of company's own debentures Eiom the market,
and . ,
84 . , iv) profits made prior to incorporation. ~,.
 it it alp to fits cannot normally be usedforadistributi6n of dividends land Provisions and Reserves
therefore are transferred to capital reserve. If at all the company, at some stage,
wants to utilize capital reserve for the distribution of dividends, it has to satisfy
certain specified conditions.
you should note that reserve capital is not the same thing as capital reserve. The
reserve capital refcrs to the uncalled amount of share capital which can be called
only in the event of liquidation of the company. You will !earn about this in a
separate course (ECO-04 Accountancy 11).
Revenue Reserve : Any reserve other than capital reserve can be called a revenue
reserve. Revenue reserves are usually created out of business profits which are
available for distribution of dividends. They are meant for specific purposes or
genkral purposes and are accordingly known as specific reserves or a 'general
reserve'. The specific purposes for which t'hey are usually created are dividend
equalisation (known as dividend equalization reserve), redemption of debenture
(known as debenture redemption fund), workmen's compensation (known as
workman's compensation fund); etc. A general reserve, on the other hand, is meant
for meeting the unforseen contingencies and to strengthen the financial position of
the business. All these reserves are debited to the Profit and Loss Appropriation
Account and shown on the liabilities side under the head 'Reserves and Surplus'. As
a matter of fact, they reflect the undistributed profits of the busine.ss.
Distinction between Capital Reserve and Revenue Reserve
The capital reserves and revenue reserves differ in many respects. The main points
of distinction are as follows :
*

Capital Reserve I Revenue Reserve

1 It is created out of capitill Profits.

( 1
it is created out of business profits.

2 It can be used for distribution of 2 It can be used for distribr~tionof

dividends only if the company satisfies dividends without any pre-condition.
certain conditions' prescribed by'the
. Coqpanies Act.
3 It is created for meeting capital losses 3 It is created for strengthening the financial
or to be used for purposes specified by position, and meeting the unforeseen
Companies Act. contingencies or some specific purpose.
I

Sinking Fund : A.sinking fund is a specific reserve created with the object of
providing f ~ n dfor
s the redemption of long term liabilities like redeemable
debenture. It is created by setting aside a fixed sum out of profits every year for a
definite period. Such a sum is invested at a compound interest so that at the end of
the period, the annual amounts with accumulated interest will be sufficient to
discharge the liability. If, for example, a company has to redeem debentures worth
Rs, 1,00,000 at the end of ten years, it may set aside certain amount of profits every
year and invest it in some securities carrying certain rate of interest. The interest
earned every year is also re-invested. At the end of ten years, the total amount of
investment (including interest) will be equal to the amount needed for redemption
i.e., Rs. l,OD,MX).The securities are then sold and the amount so realized is used for
the redemption of the debenture. The amount of yearly instalment can be
determined by reference to the sinking fund table. The same is debited to Profit and
Loss Appropriation Account and credited to the Debenture Redemption Fund.
, The term sinking fund is also used for the provision made for the replacement of 2
I
fixed asset. In that case, it is called Depreciation Fund which, in fact, is not a reserve
in the stiict sense of the term. You learnt about the depreciation fund in Unit 21.
The journal entries for creation of debenture redonption fund are more or less the
I
I
same m those of depreciationfund. (You will study in detajl about the accounting
I treatment of debenture redemption fund in a separate course ECO-04 Accountancy
11).
The sinking fuhd to redeem a'liability (debenture redemption fund) and the sinking
fund to replace an asset (depreciation fund), however, differ in various ways. Look
at Chart 22.1 and not the main points of diffxence. , 85
1 Accounts of Nun-tradiy: Chart 22.1
Concerns, Depreciation, Distinction Between Sinking Fund for Redemption of Liability and Sinking Fund for Replacoplent of
, , Provisiurls and Reserves an Assct ,

Sinking Fund for redemption of liability ( Sinking Fund for replacement of an asset 1
1 The purpose is the redemptionof a 1 The purpye is the replacement of a
long term liability. fixed asset.
2 It is designated as 'Debenture 2 It is designated as 'Machinery Replacement +'

Redemption Fund' or 'Loan Redemption Fund' or 'Depreciation Fund'.

Fund'. I

3 It is an appropriation of profit and so 3 It is a charge on profit and so debited to

is debited to the Profit & Loss Profit and Loss Account.
Appropriation Account.
4 At the time of redemption the 4 At the time of replacement the
accumulated fund is transferredto the accumulated fund is transferred to the
credit of General Reserve. credit of the concernedasset account.

Dividend Equdisatior~Fund : This fund is created by setting aside a portion of

distributable profits during prosperous years as a provision for lean period so that
company is able to declare usual dividend even if sufficient profits are not there. The
amount representing this fund need not be invested in outside securities. Even if
there is no specific dividend equrllisation fund, a company can always use its reserves,
if any, for the purpose of equalislng dividends.
lpvestment ~luctuationFund : This is a reserve created to provide fbr the loss by way
of fluciiation in the values of investments made by the company in outside securities.
This is generally provided by banks and insurance companies who inyest huge funds
in goverrlment securities.
Workman's Compensation Fund : Under Workmen Compensation Act, the workers
are entitled to certain arnount of compensation in case of accidents in the factory.
When an accident takes place, the amount of compensation involved may be heavy.
Hence, in,prder t o avoid such loss being charged to the Profit and Loss Account of
the year i~pyhichit occurs, the companies set aside a portion of profits every year
and create &specialfund for this purpose. It is called, 'Workmen's Compensatiolh
Fund'. As and when some compensation is pa'id, the same can be debited to this
fund.

22.5.2 Secret Reserves I

The term 'Secret Reserve' is abblied to reserve, the existence of which does not
appear on the face of the Balance Sheet. When secret reserves exist, the financial
position of the business is better than what may appear on the face of the balance .
sheet.
. The mairr purpose of creating secret reserve is to reduce the disclosed profit so that'
during bad period this hidden profit, or a portion of it, may be merged into the
earnings and thus help in equaljsing the dividends. a

Methods of creating Secret Reserves : Secret Reserves may be created in one of the
following ways :
i) Writing off excessible depreciation
ii) Uad6rvaluation of closlng stock '

iig Charging capital expenditure toProIit and Loss Agount

iv) Making excessive provision for bad and doubtful debts
v) Showing contingent liabilities as actual liabilities
vi) Retaining appreciating assets at cost price
t

In all the above cases the value of the assets are reduced without disclosing the fact
in the financial statements, As such they become 'secret' and are known only to the
managehent.

Merits and Demerits : Creation of secret reserves, within certain limits, is justifiable
86' on the ground of expediency and p,yudence. Secret Reserves enable the business to
 meet extra-ordinary losses without the same being disclosed and thus prevent the providcns and Reserves
public confidence being shaken. The conceiilment of huge profits is also essential in
order to prevent competition from other firms.
Despite certain merits, the following objections are raised against the practice of
creating secret reserves.
i) Secret Reserves prevent the financial statements from showing the true and fair
position of the business. The Profit and Loss -4ccount charged with fictitious
amount in respect of excessive depreciation, doubtful debts, or repairs etc, fails
to disclose the true profits. Similarly, when the value of certain asset is
understated or some liabilities are overstated, the Balance Shet cannot be said to
represent the true state of affairs of the business. Thus, the financial statements
become unreliable.
ii) The shareholders cannot assess the value of their holding correctly.
iii) Management can conceal its inefficiency by making use of secret reserves.
iv) It permits misuse of secret reserves for personal gain by managers. Sometimes
the management, or those close to them, having knowledge of wilful suppression
of net profits, inay indulge in certai~inialpractices in the stock markets.
Before the enactment of the Conipanies Act, 1956, there were no restrictio~ison
the creation of secret reserves. But, at present such reserves cannot be created
by a company because t& auditor has to certify that the Balance Sheet of the
company gives a true and fair view of the state of affairs of the company. In case
some secret reserves have been created, the auditor cannot give such a report
without disclosing the extent of such reserves.
e. - - . - - .-.*- - -
e ~ i e c Your
t progross u
1 Fill in the blanks
i) Open reserves can be of two broad categories.. ............and.. ...............
ii) Capital Profits may arise on the sale of.. .....................
iii) Tf the a~noulitof reserve is invested outside the business it is knowxi as., .:.......
iv) Premium received on issue of shares is treated as.. ..........reserve .
v) Secret reserve can be created by treating ...........expet~diture
as...........expenditure.
2 Which of the following stateinents are True and which arc False.
i) ~ i v i h e n dequalisation reserve is a type of capital reserve ......
ii) Keserve fund is only that part of reserve which is invested outside the
busiqess. ......
iii) Rever~uereserves of company can he distributed as profits. ......
. iv) A sinking fund may or rnay not be inve'sted outside the business. ......
' v) Secret reserves affect the credibility of financial statements. .....,

%Ls
* . - - -.- -
22.6 LET US SUM ?k
Provision means any amount set aside from current earnings for depreciation.
repairs and renewals, ctc. or for meeting a known liability the amount of which
cannot be determined with substantial accuracy. It is a charge on profits and must
r
fckthe ascertairinient of true profits of the business. *
The term 'reserve' refers to the amount set aside out of profits for meeting
Cnforeseen cor~tingenciesand provide funds for business expansion. Reserves can be
classified into two broad categories : (1) open reserves a r ~ d(ii) secret reserves.
Open reserves are reserves which are clearly shown in the books of account, and
may be in the nature of capital reserve o r revenue reserve. Capital reserves are those
reserves which are created out of capital profits.'Such reserves cannot be nornially
useafor the distribution of dividendpi Kevenue reserves, o n the other hand, are
created out of normal business profits and are allowed to be used fur the distribution
of dividends. They may be created for general purposes (meet an. co~itingencyin
future) or for specific purposes. Dividend Equalization Fund, Debenture
Redemption Fund (Sinking Fund), Investment Fluctuation Fund, Workmen's
Compensation Fund are' some examples of-specific reserves.
t
 Accounts of Non-trading Secret reserves refer to such reserves that are not disclosed in the ?dance Sheet.
Concerns, Depreciation, They are created by providing excessive depreciation undervaluation of closing stock
hovisions and Reserves or by charging capit J expenditure to Profit and Loss Account. Such rkserves may be
justified on grounds of Prudence and discouraging competitors from entering the
market. But, they prevent disclosure of true and fair view of the financial position of
the business and are likely to be misused by management:

22.7 KEY WORDS

Capita Reserve : Reserve created out of capital profits.
Open Reserves : Reserves which are clearly shown in the financial statements.
Provision : Amount set aside of current earnings of a business for depreciation,
repairs or renewals or meeting a known liability the amount of whichjs uncertain.
Reserve :Amount set aside out of profits or surplus to meet unexpected
contingencies or provide funds for growth.
Revenue Reserve : Reserve created out of normal business profits.
Reserve Fund : That part of reserve which is invested outside the business.
Sinking Fund : A fund created out of earnings to repay a long term liability or
replace an asset.
Secret Reserves : Reserves, the existence of which is not revealed in the fina6cial
statements.

22.8 SOME USEFUL BOOKS

Mahrsshwari S.N. 1986. Introductiorl to Accountmg, Vikas Publishing House :
New Delhi. (Chapter 13)
Patil, V.A. and J.S. Korlahalli, 1%6. Principles and Practice of Accounting,
R,Chand & Co., New Delhi. (Chapter 4 V)
Shukla, M.C, and T.S. Grewal, 1987. Advanced Accounts, S. Chand & Co., .
New Delhi. (Chapter 7)
William Pickles. 1982. Accountancy, E.L.B.S. and Pitman London.
(Chapter 7)

2'2.9 ANSWERS TO CHECK YOUR PROGRESS :

A 2 i) True ii).False iii) False iv) False v) True vi) False
B 1 i) Capital reserve and revenue reserve ii) fixed asset (iii) reserve fund ,
iv) capital v),capital, revenue I

s' 2 i) False ii) True iii) True iv) False v) True.

-
I

22.10 TERMINAL QETESTPONSIEXERCISES

1 What is a reserve? Examine critically the policy of some concerns in building up
huge reserves and others totally ignoring it. I

2 Distinguish between : +
a) Reserve and Provision I

b) Capital Reserve and Revenue Reserve

c) Specific Reserve and General Reserve I

d) Sinking fund to repay a liability and sinking fund to replace an asset

3 What is a secret reserve? Enumerate methods employed by a firm to create secret I

reserves. Critically evaluate the practice from the viewpoint of general investors
and shareholders. I
I

4 I n a concern where the current expenditure on repairs is comparatively less bQt ,)

*.- where it is known that the expenditure at a subsequent period will be considerable:
you find that a Provision for Repairs Account is created and credited every year .
, with Rs. 90,000. What is the object of creating such an account, and how i s the ,,
amount of Rs. 90,000 ascertained.
If the actual repairs amounted to Rs. 9,000 in the first year, Rs. 21,000 in the
second year, and Rs. 33,000 in the third year, what could be the Revenue Charges
for the respective years?
. 88
' Show the Provision for Kepairs Account for the three yegrs.
L
b
 Course Components
-

BLOC14 UNIT NO. PRINT MATE

B Accouna~ngFundamentals
1 Basic Concepts of Accounting
2 The Accounting Process
3 Cash Book and Bank Reconciliation
4 Other Subsidiary Books
5 Bills of Exchange

2 Final Accounts
6 Concepts Relating to Final Accounts
7 Final Accounts-I
8 Final Accounts-I1
9 Errors and their Rectification

3 Consignments and Joint Ven taerm

10 Consignment Accounts-1
11 Consignment Accounts-ll
12 ' Consignment Accounts-111
13 Joint Venture Accounts
L

Acco~nasfrom Incomplete Records

14 Self' Ralanci~igSystem
15 Accounting from Incomplete Records-I
10 Accounting from Incomplete Records-ll
17 Accounting from Incon~pleteRecords-1 I I

Accounts of Non-trading Concerns, Depreciation,

Provisions and Reserves
18 .4ccounts of Non-trdng Concerns-1
19 .4ccounts of Non-trading Concerns-I1
30 Depreciation-1 .
31 Depreciation-I1
-7-
7 Provisions and Reserves