Provisions and Reserves

  • Provisions is an amount set aside by charging it to profit to meet a known liability, the amount of which is not determined and is accounted by making best estimate.
  • Types of provisions include provision for depreciation, provision for bad and doubtful debts, provision for discount on debtors, provision for discount on creditors, provision for taxation and provision for repairs and renewals.
  • Provision for depreciation is created for accounting for depreciation on fixed assets. It is shown by way of deduction from concerned asset or on the liabilities side of the Balance Sheet.
  • Provision for doubtful debts is shown on the debit side of profit and loss account and is also shown as deduction from debtors on the assets side of the balance sheet.
  • When prompt payment is made to creditors, discount is received from them. The provision for such discount is Provision for discount on Creditors.
  • Provision for taxation is created to meet future tax liability.
  • Provision for repairs and renewals is made to meet the repair and renewal expenses of machinery.
  • Reserves are the part of profit kept aside and retained in the business to provide for certain future needs like growth and expansion.
  • Reserves are appropriations of profit to strengthen the financial position of the business and as such are not shown in the Profit and Loss account.
  • Reserves may be further classified as capital reserve and revenue reserve.Revenue reserves are created from revenue profits, which arise out of the normal operating activities of the business and are otherwise freely available for distribution as dividend.
  • Revenue reserves can be further classified as general reserve and specific reserve.
  • General reserve is not created for any specific purpose and can be used freely.
  • Specific reserves are created for specific purpose and they can be further classified as dividend equalisation reserve, debenture redemption reserve, investment fluctuation fund, reserve for replacement of asset and workmen compensation fund.
  • When the amount of reserve is invested outside business, it is called reserve fund.
  • Sinking fund is created for payment of future liability and is invested outside business.
  • Capital reserves are created out of capital profits and are generally not available for distribution as dividend.
  • Secret reserves are not allowed by the Companies Act, since it does not disclose true and fair financial position of the business.

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  • Q1

    Matter of prudence out of profits is created by

    Marks:1
    Answer:

    reserve.

    Explanation:
    Creation of reserves out of profits is a matter of prudence. This principle states that a part of profits should be kept aside for long term growth and development and for emergency cases.
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  • Q2

    Define Debenture Redemption Reserve and Dividend Equalisation Reserve.

    Marks:2
    Answer:

    Debenture Redemption Reserve:

    It refers to reserve representing retention of profits made for the purpose of redemption of debentures, created as per requirement of Companies Act 2013.

    Debenture Redemption Reserve is a Specific Reserve.

    Dividend Equalisation Reserve:

    It refers to the amount retained from earnings to provide for distribution of a minimum dividend in business periods with inadequate profits.

    Dividend Equalisation Reserve is a Specific Reserve.

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  • Q3

    Explain Investment Fluctuation Reserve and Workmen Compensation Fund.

    Marks:2
    Answer:

    Investment Fluctuation Reserve:

    It is a specific reserve and created to provide for decline in the value of investment due to market fluctuations. The purpose is to maintain value of investments.

    Workmen Compensation Fund:
    It is a specific reserve and created to meet compensation payable to workers in case of unexpected or unknown event of an accident. The purpose of creation is to maintain funds for compensating the employees’ claims.

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  • Q4

    What are Revenue Reserve?

    Marks:1
    Answer:

    Revenue Reserves are such type of reserves which are created out of revenue profits earned from daily operations.

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  • Q5

    What is Reserve Fund?

    Marks:1
    Answer:

    The term ‘Reserve Fund’ means reserves which have been invested in outside securities.

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