Chapter 6 Solutions: Accounting for Reserves and Provisions
Answers to the Chapter 6 exercises. Each answer is as long as its marks call for: a sentence or two for 1 mark, five clear points or a five-row table for 5 marks, and full working for numerical problems.
Group A: Very Short Answer Questions (1 Mark Each)
1. Define a Reserve in one sentence.
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 future contingencies.
2. What is meant by a Reserve Fund?
When the amount of a General or Specific Reserve is invested outside the business in safe, readily marketable securities, such as fixed deposits or development bonds, the reserve is called a Reserve Fund.
3. Define Secret Reserve and state any two ways of creating it.
A Secret Reserve is a reserve whose existence and amount are not disclosed in the Balance Sheet, so the actual net worth of the business is higher than the net worth shown. It can be created by (1) charging excessive depreciation on fixed assets and (2) undervaluing the closing stock.
4. Why is a Provision called a charge against profit?
A Provision is called a charge against profit because it is debited to the Profit and Loss Account as an expense or loss, for a known liability or a fall in the value of an asset, before the net profit is found, and it must be made whether the business earns a profit or suffers a loss.
5. Give any two examples of Capital Reserve.
Two examples of Capital Reserve are (1) the premium received on the issue of shares or debentures and (2) the profit on revaluation of fixed assets and liabilities.
Group B: Short Answer & Numerical Questions (5 Marks Each)
1. Distinguish between Reserve and Provision on any five bases.
A Reserve is an appropriation of divisible net profit retained in the business, for example General Reserve or Dividend Equalization Reserve. A Provision is an amount set aside out of profit for depreciation, for a fall in the value of an asset, or for a known liability whose amount cannot be determined accurately, for example Provision for Doubtful Debts or Provision for Taxation. They differ as follows:
| Basis of Difference | Reserve | Provision |
|---|---|---|
| Nature | An appropriation of profit, retained in the business | A charge against profit, treated as an expense or loss |
| Purpose | To meet unknown future contingencies and strengthen the general financial position | To meet a known liability or a known fall in the value of an asset whose exact amount is uncertain |
| Compulsion | Created only when there is sufficient net profit | Must be created even when the business suffers a net loss, under the prudence and matching concepts |
| Account debited | Debited to the Profit and Loss Appropriation Account (P&L Appropriation A/c Dr. To Reserve A/c) | Debited to the Profit and Loss Account (P&L A/c Dr. To Provision A/c) |
| Presentation in the Balance Sheet | Shown on the Equity and Liabilities side under Reserves and Surplus | Deducted from the asset concerned on the Assets side, or shown under current liabilities |
A further difference is that a General Reserve can be used to pay dividends to shareholders, while a provision can never be distributed as a dividend.
2. Differentiate between Revenue Reserve and Capital Reserve with suitable examples.
A Revenue Reserve is created out of the normal operating (revenue) profits of the business, for example General Reserve, Dividend Equalization Reserve and Debenture Redemption Reserve. A Capital Reserve is created out of capital profits that do not arise from ordinary trading, for example the premium received on the issue of shares or debentures and the profit on revaluation of fixed assets and liabilities. They differ as follows:
| Basis of Difference | Revenue Reserve | Capital Reserve |
|---|---|---|
| Source of creation | Normal operating or revenue profits earned from ordinary trading activities | Capital profits or gains, such as share premium, profit on sale of fixed assets above original cost and revaluation gains |
| Regularity | Can be created year after year out of current trading profits, at the discretion of the management | Arises only when a capital gain is made, which happens only occasionally |
| Dividend distribution | A General Reserve is available for distribution as cash dividend | Generally cannot be distributed as cash dividend |
| Use | To strengthen working capital, equalize dividends, redeem debentures and meet general business contingencies | To write off capital losses or preliminary expenses, or to issue fully paid bonus shares |
| Examples | General Reserve, Dividend Equalization Reserve, Debenture Redemption Reserve, Workmen Compensation Fund | Share Premium, profit on revaluation of fixed assets and liabilities, profit on forfeiture and reissue of shares, profit on redemption of debentures at a discount |
Both kinds of reserve belong to the owners and are shown under Reserves and Surplus in the Balance Sheet; they differ in where the profit comes from and in how it may be used.
3. 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.
The firm in this question closes its accounts on 30th Chaitra, so its own year (1st Baishakh to 30th Chaitra 2082) is used in the account. As the chapter teaches, the provision is calculated on good debtors, after the further bad debts are written off.
Working Notes:
- Total bad debts for 2082: Rs. 6,000 (during the year) + Rs. 4,000 (further bad debts) = Rs. 10,000, transferred from Bad Debts Account to Provision for Doubtful Debts Account.
- Good debtors on 30th Chaitra 2082: Rs. 1,64,000 - Rs. 4,000 = Rs. 1,60,000.
- New provision required (@ 10% on Rs. 1,60,000): 10% of Rs. 1,60,000 = Rs. 16,000.
- Amount charged to Profit & Loss A/c: Bad debts during the year (6,000) + Further bad debts (4,000) + New provision (16,000) - Old provision (15,000) = Rs. 11,000.
Provision for Doubtful Debts Account
| Dr. Date | Particulars | Amount (Rs.) | Cr. Date | Particulars | Amount (Rs.) |
|---|---|---|---|---|---|
| 2082 Chaitra 30 | To Bad Debts A/c (6,000 + 4,000 transferred) | 10,000 | 2082 Baishakh 1 | By Balance b/d (Old Provision) | 15,000 |
| 2082 Chaitra 30 | To Balance c/d (New Provision 10% of 1,60,000) | 16,000 | 2082 Chaitra 30 | By Profit & Loss A/c (Balancing Charge) | 11,000 |
| Total | 26,000 | Total | 26,000 | ||
| 2083 Baishakh 1 | By Balance b/d | 16,000 |
Answer: Good Debtors = Rs. 1,60,000; New Provision = Rs. 16,000; Charge to Profit & Loss A/c = 6,000 + 4,000 + 16,000 - 15,000 = Rs. 11,000.
In the Balance Sheet on 30th Chaitra 2082, Sundry Debtors are shown at 1,64,000 - 4,000 - 16,000 = 1,44,000, that is Rs. 1,44,000, after deducting the further bad debts and the new provision.