Page 244 - DMGT104_FINANCIAL_ACCOUNTING

Financial Accounting

Notes 10.4 Provision and Reserves

Every business enterprise, irrespective of its form of organization, likes to conduct its operations
in a prudent manner so as to be able to meet all eventualities—both expected and unexpected.
This is done, among other things, by making provisions, and creating reserves, at the time of the
preparation of financial statements.

10.4.1 Meaning of Provisions

The term ‘provision’ means an amount, which is: written off, or retained, by way of providing for
depreciation, renewals, diminution in the value of assets; or retained by way of providing for any
unknown future liability of which the amount cannot be determined with reasonable accuracy.
Obviously, where the amount of a liability is known, or can be ascertained, a definite liability
should be created, e.g., liability for outstanding interest. Examples of provisions are provision for
doubtful debts, provision for depreciation, provision for repairs, provision for discount on debtors,
provision for taxation, and provision for legal damages likely to arise from a pending suit.
Provision is a charge against the profit of the year and hence, it is debited to profit and loss
account before calculating the net profit for the year, and is shown in the balance sheet after the
certain liabilities on the liability side. It is to be noted that provision has to be made irrespective
of the fact whether a firm make a profit or not, otherwise it leads to breach of prudential
business behaviour.

10.4.2 Meaning of Reserves

Reserve means amount set aside out of profits (as calculated by the profit and loss account) or
other surpluses which are not meant to cover any liability, contingency, commitment or legal
requirement. Thus, reserve covers the case of amount which is neither a liability nor a provision.
It is allocation of the profit and not a charge against the current revenues.

It, in fact, belongs to the proprietors over and above the capital contributed by them. In case
amount equal to a reserve is invested in outside securities, it is called ‘Reserve Fund’ but the
absence of this conditions entitles it to be called simply ‘reserve’.

When it is called fund and meant for a given purpose, it is called “Specific Reserve”, otherwise
“General Reserve”. Examples of reserves are Capital Reserve, General Reserve, Contingency
Reserve, Dividend Equalization Reserve, Debenture Redemption Fund, etc.
10.4.3 Importance of Provisions and Reserves

A business firm in general, and a corporate enterprise in particular may consider it proper to set
up some mechanism to protect itself from the consequences of known liabilities and losses it
may be required to bear in future. It may also regard it as more appropriate in certain cases to
reduce the amount that can be drawn by the proprietors as profit in order to conserve business
resources to meet certain significant demands for them in future. An example of such a demand
is the much - needed expansion in the scale of business operations. This is presented as the
justification for the role of provisions and reserves in business activities and in accounting.
The amount so set aside may be meant for the purpose of:
 Fulfilling some specific requirements like repairs and renewals of an asset;
 Meeting a future liability or loss;
 Strengthening the general financial position of undertaking;
 Redeeming a long-term liability like debentures.

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