Chapter 6: Accounting for Reserves and Provisions
6.1 Concept of Reserve
6.1.1 Meaning and Characteristics
A Reserve is an appropriation of divisible net profit retained in the business to strengthen its financial position, finance future expansion, equalize dividends, or meet unknown/unexpected future contingencies.
Key Characteristics of a Reserve:
- Appropriation of Profit: Created only when the business earns a net profit (Profit & Loss Appropriation A/c Dr. To Reserve A/c). If there is a net loss, no reserve is created.
- Meets Unknown Contingencies: Created for unquantified future risks or internal growth rather than a known current liability.
- Part of Owner’s Equity (Shareholders’ Fund): Shown on the Liabilities/Equity side of the Balance Sheet under Reserves and Surplus.
- Voluntary / Discretionary: Except for statutory reserves (like mandatory bank reserves under Nepal Rastra Bank rules), creating a reserve is a matter of financial prudence.
6.1.2 Objectives / Importance of Reserves
- Strengthening Financial Position & Working Capital: Retains liquid resources inside the business without borrowing externally.
- Meeting Unforeseen Contingencies: Absorbs sudden future trade shocks or abnormal losses.
- Uniformity in Dividend Distribution: Enables companies to pay steady dividends even in lean profit years (via Dividend Equalization Reserve).
- Redemption of Long-Term Liabilities or Asset Replacement: Accumulates funds to repay debentures (Debenture Redemption Reserve) or replace obsolete plant.
6.2 Classification (Types) of Reserves
| Category | Sub-Type | Meaning, Creation & Utilization |
|---|---|---|
| 1. Revenue Reserves | (Created out of normal operating/trading profits) | |
| (a) General Reserve (Free Reserve) | Created out of operating profits without tying it to any single specific purpose. Freely available for meeting any future contingency, expanding business, or distributing dividends. | |
| (b) Specific Reserve | Created and earmarked for a definite, specified purpose (cannot be used for other purposes until that objective is met). • Examples: Dividend Equalization Reserve, Debenture Redemption Reserve (DRR), Workmen Compensation Fund, Investment Fluctuation Fund. | |
| (c) Reserve Fund | When the amount of a General or Specific Reserve is invested outside the business in safe, readily marketable securities (e.g., NRB Development Bonds or Fixed Deposits), it is called a Reserve Fund (Sinking Fund). | |
| 2. Capital Reserves | (Created out of non-operating / capital profits) | Created out of capital gains rather than normal trading profits. Generally not available for distribution as cash dividends, but can be used to write off capital losses or issue bonus shares. • Sources of Capital Reserve: 1. Profit on sale of fixed assets (above original cost). 2. Profit on revaluation of fixed assets and liabilities. 3. Premium received on issue of shares or debentures. 4. Profit on forfeiture and re-issue of shares. 5. Profit on redemption of debentures at a discount. |
| 3. Secret Reserve (Hidden Reserve) | (Not disclosed on the face of the Balance Sheet) | A reserve whose existence and amount are concealed from the Balance Sheet so the actual net worth of the business is higher than what is disclosed. • How Created: Charging excessive depreciation, undervaluing closing stock, treating capital expenditure as revenue expense, or overstating provisions for bad debts. • Status under NAS/NFRS: Prohibited for general companies as it violates Full Disclosure and True & Fair View. |
6.3 Concept of Provision
6.3.1 Meaning and Characteristics
A Provision is an amount written off or retained by way of providing for depreciation, renewals, or diminution in the value of assets, or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy on the Balance Sheet date.
- Examples of Provisions:
- Provision for Bad and Doubtful Debts
- Provision for Discount on Debtors
- Provision for Depreciation
- Provision for Taxation
- Provision for Repairs and Renewals
Key Characteristics of a Provision:
- Charge Against Profit: Must be created compulsorily whether the business earns a profit or suffers a loss (Profit & Loss A/c Dr. To Provision A/c).
- Known Liability or Asset Diminution with Uncertain Amount: The event/loss is certain or highly probable, though the exact rupee figure is an estimate.
- Balance Sheet Presentation: Shown either by deducting from the concerned asset on the Assets side (e.g., Provision for Doubtful Debts deducted from Sundry Debtors) or under Short-Term Provisions (Current Liabilities) (e.g., Provision for Taxation).
6.3.2 Difference Between Reserve and Provision
| Basis of Difference | Provision | Reserve |
|---|---|---|
| 1. Nature | It is a charge against profit (operating expense/loss). | It is an appropriation of profit (retained earnings). |
| 2. Purpose | Created to meet a known liability or specific asset diminution whose exact amount is uncertain. | Created to meet unknown future contingencies and strengthen the general financial position. |
| 3. Compulsion | Must be created even if the business incurs a Net Loss (mandatory under Prudence & Matching concepts). | Created only when there is sufficient Net Profit. |
| 4. Accounting Stage | Debited to the Profit and Loss Account (Income Statement). | Debited to the Profit and Loss Appropriation Account. |
| 5. Presentation in Balance Sheet | Deducted from the respective asset on the Assets side or shown under Current Liabilities. | Shown on the Equity & Liabilities side under the head Reserves and Surplus. |
| 6. Dividend Distribution | Can never be distributed as dividend to shareholders. | General Reserve can be utilized to distribute dividends. |
6.3.3 Difference Between Revenue Reserve and Capital Reserve
| Basis of Difference | Revenue Reserve | Capital Reserve |
|---|---|---|
| 1. Source of Creation | Created out of normal operating/revenue profits earned from ordinary trading activities. | Created out of capital profits/gains (e.g., share premium, profit on sale of fixed assets, revaluation gain). |
| 2. Dividend Distribution | Available for distribution as cash dividends to shareholders (if general reserve). | Generally cannot be distributed as cash dividends. |
| 3. Primary Usage | Used to strengthen working capital, equalize dividends, and meet general business contingencies. | Used to write off capital losses, preliminary expenses, or issue fully paid bonus shares. |
6.4 Accounting for Provision for Bad and Doubtful Debts (as per NAS)
6.4.1 Concept of Bad Debts vs. Doubtful Debts
- Good Debts: Debtors from whom collection is 100% certain.
- Bad Debts: Irrecoverable debts definitely lost due to insolvency, death, or disappearance of a debtor (an actual loss).
- Doubtful Debts: Debts whose recovery is uncertain at year-end; following the Convention of Conservatism and NAS, a percentage of Closing Good Debtors (Sundry Debtors - Further Bad Debts) is provided as New Provision for Bad and Doubtful Debts.
6.4.2 Standard Formula for Profit & Loss Account and Balance Sheet
In Profit & Loss Account (Dr. side):
Net Charge to P&L A/c = Bad Debts (in Trial Balance) + Further Bad Debts (in Adjustment) + New Provision Required - Old Provision (in Trial Balance)
In Balance Sheet (Assets side under Current Assets):
Net Realizable Debtors = Closing Sundry Debtors - Further Bad Debts (Adjustment) - New Provision for Doubtful Debts
6.4.3 Worked Numerical Example (NEB 5-Mark Standard)
Illustration 6.1:
On 1st Shrawan 2081, the Provision for Bad and Doubtful Debts Account of Koshi Traders had an opening credit balance of Rs. 12,000.
During the year 2081/82, Bad Debts written off amounted to Rs. 7,000. On the last day of Ashadh 2082, Sundry Debtors stood at Rs. 2,15,000, out of which Rs. 15,000 was found irrecoverable (further bad debts). The firm maintains a Provision for Doubtful Debts @ 5% on good debtors.
Required: Prepare (a) Bad Debts Account, (b) Provision for Bad and Doubtful Debts Account, and (c) Balance Sheet extract as on the last day of Ashadh 2082.
Solution:
Working Notes:
- Total Bad Debts for 2081/82: Rs. 7,000 (during year) + Rs. 15,000 (further bad debts) = Rs. 22,000.
- Good Debtors on the last day of Ashadh 2082: Rs. 2,15,000 - Rs. 15,000 = Rs. 2,00,000.
- New Provision Required (@ 5% on Rs. 2,00,000): 5% of Rs. 2,00,000 = Rs. 10,000.
- Amount to be Debited to Profit & Loss A/c: Total Bad Debts (22,000) + New Provision (10,000) - Old Provision (12,000) = Rs. 20,000.
(a) Bad Debts Account
| Dr. Date | Particulars | Amount (Rs.) | Cr. Date | Particulars | Amount (Rs.) |
|---|---|---|---|---|---|
| 2082 Ashadh end | To Balance b/d (During year) | 7,000 | 2082 Ashadh end | By Provision for Bad & Doubtful Debts A/c (Transferred) | 22,000 |
| 2082 Ashadh end | To Sundry Debtors A/c (Further) | 15,000 | |||
| Total | 22,000 | Total | 22,000 |
(b) Provision for Bad and Doubtful Debts Account
| Dr. Date | Particulars | Amount (Rs.) | Cr. Date | Particulars | Amount (Rs.) |
|---|---|---|---|---|---|
| 2082 Ashadh end | To Bad Debts A/c (Total transferred) | 22,000 | 2081-04-01 | By Balance b/d (Old Provision) | 12,000 |
| 2082 Ashadh end | To Balance c/d (New Provision 5% of 2,00,000) | 10,000 | 2082 Ashadh end | By Profit & Loss A/c (Balancing Charge) | 20,000 |
| Total | 32,000 | Total | 32,000 | ||
| 2082-04-01 | By Balance b/d | 10,000 |
(c) Balance Sheet Extract (As on the Last Day of Ashadh 2082)
- Current Assets:
- Sundry Debtors: Rs. 2,15,000
- Less: Further Bad Debts: (Rs. 15,000) → Rs. 2,00,000
- Less: New Provision for Doubtful Debts @ 5%: (Rs. 10,000) = Rs. 1,90,000
6.5 NEB Board Exam Practice Questions
Group A: Very Short Answer Questions (1 Mark Each)
- Define a Reserve in one sentence.
- What is meant by a Reserve Fund?
- Define Secret Reserve and state any two ways of creating it.
- Why is a Provision called a charge against profit?
- Give any two examples of Capital Reserve.
Group B: Short Answer & Numerical Questions (5 Marks Each)
- Distinguish between Reserve and Provision on any five bases.
- Differentiate between Revenue Reserve and Capital Reserve with suitable examples.
- Numerical Problem: On 1st Baishakh 2082, the Provision for Doubtful Debts stood at Rs. 15,000. During the year 2082, bad debts written off were Rs. 6,000. On 30th Chaitra 2082, Sundry Debtors amounted to Rs. 1,64,000, out of which Rs. 4,000 were further bad debts. Prepare the Provision for Doubtful Debts Account assuming the firm maintains provision @ 10% on debtors. (Ans: Good Debtors = Rs. 1,60,000; New Provision = Rs. 16,000; Charge to P&L A/c = 6,000 + 4,000 + 16,000 - 15,000 = Rs. 11,000)
Worked answers to these exercises are in Chapter 6 Solutions.