Provision AND Reserve PDF

Preview

Summary

Download Provision AND Reserve PDF

Description

PROVISION AND RESERVE • Meaning of Provision Provision is a charge against profit to meet certain known liabilities or contingencies. The True profit of a business can be known properly if all the expenses and losses incurred are deducted from the revenue of the period. This deduction of expenses/losses from revenue is calling charging of expenses against profits. There are times when we are not able to exactly calculate the amount of expense/loss, for which the liability may arise later. In that case, we estimate the amount of expense and debit that to Profit & Loss Account of the Current year and create a Provision. For example, a consumer has filed a suit in court again your company's product and has asked for a compensation of ¢10,000. You as a Manager feel that the decision of Court may go in the favour of consumer and you will have to pay him ¢10,000. If you wish to show the true picture of financial results and health of your company, you will definitely like to treat this as an expense in the current year and show as a liability in the current year's Balance Sheet. Your entry will be: Dr. Profit & Loss A/c with 10,000, and credit provision for compensation to consumer’s a/c with 10,000. Due to the above entry, your profits of the current year have reduced by ¢10000, this is called charging against the profits. In the current year's balance sheet this provision will come on the liability side. There are a number of provisions in financial accounting but we shall limit our discussion to only four of them as full topics in separate sessions in this write-up: provision for discount allowed, provision for bad and doubtful debts, provision for unrealized profit, and provision for depreciation of noncurrent assets. 1.2.1 Meaning of Reserve Reserve means the amount set aside out of profits which are not earmarked in any way to meet any particular known liability on the date of balance sheet .it is part of profit retained for any unknown contingency, liability / decrease in the value of asset. Reserve is not an expense; it is saving left after making expenses or provision for them. In a business, from the revenue (sales) all expenses and provisions are deducted, then we get profit. A part of this profit is distributed among owners and the rest is transferred to Reserves. So, it is a kind of saving. Let us take the example of an average household. For example, if a man is getting ¢50,000 as salary and out of this he is regularly putting ¢10,000 in Fixed Deposit with the bank. Why is he saving? He is saving because in future he may have to pay for higher studies of his children or may be for his old age or to meet sudden medical expenses etc. Similarly, a business also puts aside a part of its profits for its future growth needs or to meet some unknown contingencies (future is always uncertain). This putting aside of a part of profits is called appropriation of profits and the amount put aside is called reserve. Ledger entry for that will be: DR Profit & Loss Appropriation a/c and CR Reserve a/c. With this entry, the profit available for distribution as dividends will reduce and in Balance Sheet Reserve will be shown on the liability side. Table 1 The Main Differences Between Reserve and Provision Reserves Provisions 1 It is created by debiting the profit and loss It is created by debiting the profit and loss appropriation account. account.

2 It is created to meet an unknown liability, or It is created to meet a known liability or a to strengthen the financial position of the specific contingency, e.g. provision for company or for equalization of dividends etc. bad and doubtful debts, or provision for depreciation etc. 3 A reserve is created only when there is profit A provision is created irrespective of in the business. whether there is profit or loss in the business. 4 It can be distributed among shareholders as It is not available for distribution as dividend dividend among shareholders. 5 The reserve is created without taking into A provision is made for a definite amount consideration the actual amount required and, therefore, a definite sum is set aside except in the case of redemption of every year to meet the known contingency debentures when a definite sum is set aside. 6 Creation of reserve depends upon the Making of a provision is a must to meet financial policy of the business and known liability or contingency discretion of its management 7 It is usually shown on the liability side of the The provision is generally shown on the assets side of the balance sheet balance sheet as it is not a specific reserve

1.2.2 Types of Reserves: basically, there are two main types of reserves, namely capital reserves and revenue reserves which are recognized under the companies’ code of 1963, Act 179 of Ghana. Capital reserves may arise from transactions such as profit on redemption of debentures, profit from sales of fixed asset, profit on forfeiture of shares, profit accrued before incorporation of a company, premium on shares or debentures, surplus on revaluation of assets and liabilities, capital redemption reserve funds. These reserves are not meant for distribution as dividend. Revenue reserves are of two types, namely general and specific. They are the reserves that may be either immediately or not immediately available to be distributed as dividend through the income statement. General reserve is created when appropriated to strengthen the general financial position of the entity. This reserve may be used to supplement profit to be distributed when profit the year is not enough to meet the proposed dividend for the year. It is therefore a free reserve because of the flexibility in it application. An example is reserve fund. Specific reserves are profit appropriated for specific or special purposed or obligation. Although they are not meant for distribution even when profit is not enough, they are required by law to disclose them in the financial position. One example is sinking fund Table 2 Distinction between General Reserve and Specific Reserve Specific reserve General Reserve 1 It is created for a specific purpose It is created not for any specific purpose but for meeting future contingencies 2 It is utilized for that specific purpose, for which it It can be utilized for meeting any was created future loss 3 Whether profit or no profits, it must be created It is created only when there are

4 It is necessary to create in order to ascertain profit 5 It is shown on the debit side of profit and loss account 6 Net profits are reduced because of it

sufficient profits They are created only when there are profits i.e. they depend upon profits It is shown on the debit side of profit and loss appropriation account Only distributable profits are reduced because of it

1.2.3 Reserve fund: Profit set aside and used in the business is a reserve fund. But profit set aside and invested outside the business is a sinking fund. Thus, the use of the term 'fund' indicates investment of reserve outside the business. Sinking Fund: A sinking fund is a fund built up by annual contributions. The contributions are invested outside the business in readily realizable securities. Interest received on investments is reinvested in the same securities. A sinking fund may be (i) for replacement of fixed assets or (ii) for the redemption of debentures or repayment of loan. A sinking fund for the replacement of a fixed asset is a provision. But a sinking fund for redemption of debentures or repayment of loan is an appropriation of profits. A sinking fund represents amount invested outside the business. Table 3 Distinction between reserve fund and sinking fund Reserve Fund Sinking Fund Investments are not for definite Investments are for a definite period period It is created always out of It is not always out of divisible profit e.g. sinking fund divisible profits for replacement of asset is provision for depreciation, it must be created even if there are no profits. Interest received on investments In case of sinking fund, interest is always re-invested representing reserve fund may not be re-invested...