Provisions and Reserves
- Explain what a provision is and create a provision for doubtful debts
- Explain what a reserve is and transfer profit to a general reserve
- Distinguish provision from reserve, and revenue reserve from capital reserve
- Explain secret reserve, how it is created and why it is controversial
A careful shopkeeper does two smart things with money. First, before he even calls his profit “profit”, he keeps aside an amount for losses he can already see coming, such as customers who will probably never pay. That is a provision. Second, after the profit is known, he does not take all of it home; he keeps some of it in the business for a rainy day or for expansion. That is a reserve. Both words sound alike, and the board exam loves to ask the difference. Today we learn both, with entries, and then peek at a “hidden” reserve that does not show up in the balance sheet at all.
1. What is a provision?
Gupta Stationers of Khurja sells notebooks and pens on credit to 40 schools and coaching centres. On 31 March 2027, customers owe it ₹1,20,000. Mr Gupta knows from experience that a small part of this money never comes back: a coaching centre closes, a customer shifts city. He cannot say exactly who will not pay or how much, but he is sure some loss belongs to this year’s sales. If he ignores it, this year’s profit looks bigger than it really is.
Provision: an amount charged against the profit of the current year for a known liability, expense or loss that relates to this year but whose exact amount is not certain.
It is created by debiting the Profit and Loss Account, so it reduces the profit of the year. It follows the concept of prudence (conservatism): provide for all expected losses. It also ensures proper matching of revenue and expenses.
Common examples of provisions:
- Provision for depreciation (Lesson 3)
- Provision for bad and doubtful debts
- Provision for taxation
- Provision for discount on debtors
- Provision for repairs and renewals
1.1 Where does a provision appear in the balance sheet?
| Way of showing | Examples |
|---|---|
| Deducted from the related asset on the assets side | Provision for doubtful debts (from debtors); provision for depreciation (from the fixed asset) |
| On the liabilities side, along with current liabilities | Provision for taxation; provision for repairs and renewals |
A provision must be made even if the business has a loss for the year. The expected loss is real whether profits are high or low; ignoring it would hide the true position.
2. Provision for doubtful debts, step by step
Debtors (customers who owe us money) fall into three groups:
- Good debts: collection is certain.
- Bad debts: collection is impossible, a certain loss. They are written off: Bad Debts A/c Dr. To Debtor’s A/c; later Profit and Loss A/c Dr. To Bad Debts A/c.
- Doubtful debts: the customer may pay, but the business is not sure of the full amount. Based on experience, a percentage of debtors is treated as doubtful.
Provision for doubtful debts is calculated as a % of debtors after deducting the bad debts not yet written off.
Profit and Loss A/c Dr. To Provision for Doubtful Debts A/c
In the balance sheet: Debtors (after bad debts) − Provision for doubtful debts.
Calculating the % on the debtors figure before removing the new bad debts. A debtor already known to be bad is no longer “doubtful”; it is gone. Always deduct first, then take the percentage.
- Write off the bad debt: Bad Debts A/c Dr. To Sundry Debtors A/c ₹5,000. Debtors become 1,20,000 − 5,000 = ₹1,15,000.
- Close Bad Debts to Profit and Loss: ₹5,000.
- Provision = 5% of 1,15,000 = ₹5,750: Profit and Loss A/c Dr. To Provision for Doubtful Debts A/c.
- Balance sheet: Sundry Debtors 1,15,000 less Provision 5,750 = ₹1,09,250. Total charge to Profit and Loss = 5,000 + 5,750 = ₹10,750.
| Date | Particulars | L.F. | Dr (₹) | Cr (₹) |
|---|---|---|---|---|
| 2027 Mar 31 | Bad Debts A/c Dr. | 5,000 | ||
| To Sundry Debtors A/c | 5,000 | |||
| (Being bad debts written off) | ||||
| Mar 31 | Profit and Loss A/c Dr. | 5,000 | ||
| To Bad Debts A/c | 5,000 | |||
| (Being bad debts transferred to Profit and Loss Account) | ||||
| Mar 31 | Profit and Loss A/c Dr. | 5,750 | ||
| To Provision for Doubtful Debts A/c | 5,750 | |||
| (Being provision created at 5% on ₹1,15,000) | ||||
| Total | 15,750 | 15,750 |
At the year end, Verma Mobile Store decides to create a provision for doubtful debts of ₹3,200. Pass the entry.
| Date | Particulars | L.F. | Dr (₹) | Cr (₹) |
|---|---|---|---|---|
| 2027 Mar 31 | Profit and Loss A/c Dr. | 3,200 | ||
| To Provision for Doubtful Debts A/c | 3,200 | |||
| (Being provision for doubtful debts created) |
Sundry debtors on 31 March 2027 are ₹90,000. Further bad debts of ₹6,000 are to be written off and a provision for doubtful debts is to be kept at 10% of debtors. What is the amount of the provision (in ₹)?
3. What is a reserve?
Suppose Gupta Stationers earns a net profit of ₹4,00,000 this year, after all expenses and provisions. Mr Gupta plans to open a second shop in two years. Instead of withdrawing the whole profit, he decides to keep 10% of it in the business. That ₹40,000 is not an expense and no loss is expected; it is simply profit held back to make the business stronger. This is a reserve.
Reserve: a part of the profit that is set aside and retained in the business for future needs such as growth, expansion, or meeting unknown future contingencies.
A reserve is an appropriation of profit, not a charge against profit. It is made after net profit is found, and only when there is profit. It is shown on the liabilities side under Reserves and Surplus, after capital.
Profit and Loss A/c Dr. To General Reserve A/c
Examples of reserves: general reserve, workmen compensation fund, investment fluctuation fund, capital reserve, dividend equalisation reserve, debenture redemption reserve.
- Provisions are charges, so they come first: net profit = 5,00,000 − 20,000 − 80,000 = ₹4,00,000.
- Reserve is an appropriation of this net profit: 10% of 4,00,000 = ₹40,000.
- Profit left for the owner = 4,00,000 − 40,000 = ₹3,60,000.
Gupta Stationers transfers ₹40,000 out of this year’s profit to General Reserve. Pass the entry.
| Date | Particulars | L.F. | Dr (₹) | Cr (₹) |
|---|---|---|---|---|
| 2027 Mar 31 | Profit and Loss A/c Dr. | 40,000 | ||
| To General Reserve A/c | 40,000 | |||
| (Being profit transferred to general reserve) |
Profit before provisions is ₹6,00,000. Provision for taxation ₹1,50,000 and provision for depreciation ₹50,000 are to be made, and then 10% of the net profit is transferred to General Reserve. How much profit is left for the owner (in ₹)?
Provision comes Pre-profit (charged before net profit is known). Reserve is Retained profit (kept back after net profit is known).
4. Provision vs reserve
| Basis | Provision | Reserve |
|---|---|---|
| Basic nature | Charge against profit; net profit cannot be found until it is debited | Appropriation of profit; created after net profit is found |
| Purpose | For a known liability or expense of the current period whose amount is uncertain | To strengthen the financial position; some reserves are required by law |
| Effect on taxable profit | Reduces taxable profit | No effect (made out of profit after tax) |
| Balance sheet | Deducted from the related asset, or shown with current liabilities | Liabilities side under Reserves and Surplus, after capital |
| Compulsion | Must be made (prudence), even if there is a loss | Generally at management’s choice; cannot be made without profit (some, like Debenture Redemption Reserve, are required by law) |
| Dividend | Cannot be used to pay dividend | General reserve can be used to pay dividend |
- It is created only when there is a profit
- It is a charge against profit and reduces taxable profit
- It is shown under Reserves and Surplus after capital
- It can be used to pay dividend
5. Types of reserves
5.1 By purpose: general and specific
- General reserve (free reserve): no particular purpose is fixed, so management can use it for any purpose. It strengthens the business’s overall financial position.
- Specific reserve: made for one stated purpose and usable only for that purpose:
- Dividend equalisation reserve: money set aside in high-profit years to keep the dividend rate steady in low-profit years.
- Workmen compensation fund: to meet workers’ claims, for example after an accident.
- Investment fluctuation fund: to cover a fall in the market value of investments.
- Debenture redemption reserve: to provide funds for repaying debentures.
5.2 By source of profit: revenue and capital
- Revenue reserve: created out of revenue profits, i.e. profits from normal operating activities (buying, selling, providing services). Such profits are otherwise free for dividend. Examples: general reserve, workmen compensation fund, investment fluctuation fund, dividend equalisation reserve, debenture redemption reserve.
- Capital reserve: created mainly out of capital profits, profits that do not come from normal operations and are not available for dividend. Examples of capital profits: premium on issue of shares or debentures, profit on sale of fixed assets, profit on redemption of debentures, profit on revaluation of fixed assets and liabilities, profits prior to incorporation, profit on reissue of forfeited shares. A capital reserve can be used to write off capital losses or, in a company, to issue bonus shares.
| Basis | Revenue reserve | Capital reserve |
|---|---|---|
| Source | Revenue profits from normal operations, otherwise available for dividend | Mainly capital profits, not from normal operations, not available for dividend (revenue profits may also be used) |
| Purpose | Strengthen financial position, meet unforeseen contingencies or a specific purpose | Comply with legal requirements or accounting practice |
| Usage | Specific reserve only for its purpose; general reserve for any purpose including dividend | Only for purposes allowed by law, e.g. writing off capital losses, issuing bonus shares |
Dividend equalisation reserve is a specific revenue reserve, not a general reserve, even though its money came from ordinary profits. And “capital reserve” is not the same as the owner’s “capital”; it is profit of a capital nature kept in the business.
5.3 Why reserves matter
Reserves protect the business against unknown future expenses and losses, conserve resources for big needs such as expansion (instead of the owners withdrawing everything), and help repay long-term liabilities like debentures. In short, reserves are the business’s savings.
6. Secret reserve
Secret reserve: a reserve that does not appear in the balance sheet. The business deliberately shows its assets lower (or liabilities higher) than their true value, so the profit and the net worth shown are lower than the real ones. Outsiders cannot see it, hence “secret”.
It can be created by:
- charging more depreciation than required;
- undervaluing inventory (stock);
- charging capital expenditure to the Profit and Loss Account;
- making excessive provision for doubtful debts;
- showing contingent liabilities as actual liabilities.
Why would anyone hide profit? It lowers the disclosed profit (and so the tax), and in a bad year the hidden amount can be brought back into profits to show a better result. It also keeps competitors from seeing how profitable the business really is. Within reasonable limits it is defended on grounds of prudence and expediency; beyond that it misleads users of the accounts, which is why the size of secret reserves is a sensitive audit issue.
- Excess depreciation = 25% of 4,00,000 − 10% of 4,00,000 = 1,00,000 − 40,000 = ₹60,000.
- Excess provision = 10% of 60,000 − 5% of 60,000 = 6,000 − 3,000 = ₹3,000.
- Undervaluation of stock = 1,50,000 − 1,30,000 = ₹20,000.
- Valuing closing stock below its cost and market price
- Writing off a new computer as office expense
- Creating a provision for doubtful debts much larger than needed
- Transferring ₹50,000 of profit to General Reserve
📌 Points to remember (Quick Revision)
- Provision: charge against profit for a known liability/loss of this year whose amount is uncertain; Profit and Loss A/c Dr. To Provision A/c; required by prudence even in a loss year.
- Provision for doubtful debts = % of debtors after writing off further bad debts; deducted from debtors in the balance sheet.
- Reserve: appropriation of profit retained for future needs; Profit and Loss A/c Dr. To General Reserve A/c; shown under Reserves and Surplus.
- Provision reduces taxable profit and cannot pay dividend; reserve does not affect taxable profit and a general reserve can pay dividend.
- Reserves: general vs specific; revenue (from operating profits) vs capital (from capital profits, not for dividend).
- Secret reserve: hidden by understating assets or profit (extra depreciation, low stock value, excess provisions).
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