The amount saved is set aside for any of the following five purposes:
(a) for meeting future liability or loss;
(b) for strengthening the financial position of the business;
(c) for fulfilling some specific purpose;
(d) for redeeming a liability;
(e) for replacing a wasting asset.
(f) There are two ways in which the amount available for distribution as profit can be reduced:
(1) Indirectly, i.e. Out of gross profit or by debiting profit and loss account.
(2) alternatively, directly. i.e., out of divisible profits by debiting profit and loss appropriation account.
Profit and loss account is debited only when the object is either to meet an anticipated or future contingent liability or loss or to replace a wasting asset. In all other cases, profit and loss appropriation account are debited.
(3) The sum that is set aside mayor may not be invested; and if invested, it may be invested inside or outside the business. This depends upon the object that is sought to be served. It is usual to invest the money outside the business when the object is to redeem a liability or to replace a wasting asset. Money may be invested outside or inside the business at one’s option, if the object is to strengthen the financial position of the company.
Meaning of the terms:
1. Fund. If an amount equal to the reserve is invested in outside securities, the reserve will be termed as ‘Reserve Fund’.
2. Reserve. If amount set aside from profit is not invested in outside securities, it is termed as ‘Reserve’.
3. Provision. If amount set aside as charge against profits or surplus to meet:
(a) Depreciation for renewal of the asset.
(b) Any known liability, the amount of which cannot be ascertained with accuracy. Provisions are generally, created by debiting the profit and loss account. Provisions are also sometimes termed as ‘Specific Reserves’ by the accountants.
Provisions are created even when there are no profits in the business. Provisions are not surplus. They are not available for distribution amongst the proprietors or shareholders. However, provision more than a requirement is a surplus. When any provision becomes redundant, it should be credited back to profit and loss appropriation account.
It should be noted that sums set aside to meet known liabilities, the amount of which can be determined with accuracy do not fall within the definition of a provision and should, therefore, be called as accrued liabilities. For example, outstanding rent, interest, etc. are accrued liabilities and not provisions.
Types of Provisions (Specific Reserves)
As already stated, the provisions are of following types:
(i) Provision for doubtful debts ;
(ii) Reserve for discount on debtors;
(iii) Reserve for discount on creditors;
(iv) Reserve for repairs and renewals.
Reserves are retained profits. They are part of the surplus. They are the amount kept aside from profits. There can be no reserves if there are no profits. Reserves are undistributed profits. They are appropriations of profits. While provisions are pre-profit matters, reserves are post-profit matters. One cannot talk of creating reserves, without first finding out profits.
It is a good business policy to create reserves. They strengthen’ the’ financial position of the business. Reserves are created for different purposes. They may be for the expansion of business; they may be for equalisation of dividends, or they may be for the redemption of debentures or loans. Again, reserves may be created out of capital profits or out of revenue profits. The reserves created out of capital profits are called capital reserves, whereas, others are called revenue reserves.
Capital reserves are created out of capital profits. Capital profits are not regular trading profits. They are profits on rare transactions. Capital reserves are generally not available for distribution as dividend. They are set aside to strengthen the financial position of the business or to meet capital losses. The following are the examples of capital profits :
(i) Profit on sale of fixed’ assets.
(ii) Profit before incorporation.
(iii) Profit on redemption of debentures.
(iv) The premium on issue of shares or debentures.
(v) Profit on forfeiture of shares.
(vii) Profit on the acquisition of the business.
(viii) The profit which has not been earned in the regular course of business.
Capital reserves can be utilised in the following ways:
(a) The issue of bonus shares.
(b) Writing off goodwill.
(c) Writing off preliminary expenses.
(d) Writing off shares/debentures issue expenses.
(e) Writing off losses before incorporation.
Revenue reserves are created out of revenue profits. They are available for distribution as dividend. Revenue reserves are of two types-those immediately so available for distribution and those not immediately so available.
(a) General reserve
This reserve is created by setting aside revenue profits. The object is to strengthen the general financial position of the business. It is not for a specific purpose. It is a free reserve. It acts as a safety cushion against all unforeseen contingencies in the future. It is immediately available for distribution as dividend profit.
(b) Specific reserve
This too is created by setting aside revenue profits. However, it is for a specific purpose. This is not immediately available for distribution. For example, reserve created for the redemption of debentures. During the period of liability, this reserve is not available for distribution. It becomes a general reserve on the redemption of debentures. Similarly, a reserve may be created for
equalization of the dividend.