Nature of Funds-Reserves or Provisions
The amount saved is reserved for any of the following five purposes:
(a) to meet future liabilities or losses;
(b) to strengthen the financial position of the business;
(c) to fulfill any specific purpose;
(d) to redeem a liability;
(e) to replace an asset that is wasted.
(f) There are two ways in which the amount available to distribute as a benefit can be reduced:
(1) Indirectly, ie. charged to gross profit or charged to the profit and loss account.
(2) or, directly. that is, from divisible profits charged to the profit and loss appropriation account.
The profit and loss account is debited only when the purpose is to cover an anticipated or future liability or contingent loss or to replace an asset that is wasted. In all other cases, the profit and loss appropriation account is debited.
(3) The sum that is set aside larger cannot be invested; and if it is invested, it can be invested inside or outside the business. This depends on the object that is sought to serve. It is common to invest money outside of the business when the object is to redeem a liability or replace an asset that is wasted. The money can be invested outside or inside the business at the choice of each one, if the objective is to strengthen the financial position of the business.
Meaning of the terms:
1. Background. If an amount equal to the reserve is invested in foreign securities, the reserve will be called the “Reserve Fund”.
2. Reserve. If the amount set aside from earnings is not invested in outside securities, it is called ‘Reserve’.
3. Layout. If amount allocated charged to profits or surpluses to satisfy:
(a) Depreciation for renewal of the asset.
(b) Any known liability, the amount of which cannot be accurately determined. Provisions are generally created with a charge to the profit and loss account. Accountants sometimes also refer to provisions as ‘Specific Reserves’. Provisions are created even when there are no profits in the business. The provisions are not surplus. They are not available for distribution to owners or shareholders. However, the provision in excess of the requirement is a surplus. When any provision becomes redundant, it should be credited back to the profit and loss appropriation account.
It should be noted that amounts set aside to meet known liabilities, the amount of which can be precisely determined, do not fall within the definition of a provision and, therefore, should be called accrued liabilities. For example, pending rent, interest, etc. they are accrued liabilities and not provisions.
Types of Provisions (Specific Reserves)
As already stated, the provisions are of the following types:
(i) Provision for bad debts;
(ii) Reserve for debtor discount;
(iii) Reserve for creditor discount;
(iv) Reserve for repairs and renovations.
general reserve
Reserves are retained earnings. They are part of the surplus. They are the amount that is kept apart from profits. There can be no reserves if there are no benefits. Reserves are retained earnings. They are profit grabs. While provisions are pre-earnings matters, reserves are post-earnings matters. You cannot talk about creating reserves without first finding out the benefits. It is good company policy to create reserves. They strengthen the financial position of the business. Reserves are created for different purposes. They can be for business expansion; They can be for the equalization of dividends or they can be for the redemption of obligations or loans. Again, reserves can be created from capital gains or income gains. Reserves created from capital gains are called capital reserves, while others are called income reserves.
capital reserves
Capital reserves are created from capital gains. Capital gains are not regular business gains. They are profits in rare transactions. Capital reserves are generally not available for distribution as a dividend. They are reserved to strengthen the financial position of the company or to cover capital losses. The following are examples of capital gains:
(i) Profit on sale of fixed assets.
(ii) Profit before incorporation.
(iii) Benefit from amortization of debentures.
(iv) Premium on issuance of shares or bonds.
(v) Profit from extinction of shares.
(vii) Benefit on business acquisition.
(viii) Profit that has not been obtained in the normal course of business.
Capital reserves can be used in the following ways:
(a) Issuance of bonus shares.
(b) Cancellation of goodwill.
(c) Cancellation of preliminary expenses.
(d) Cancellation of share/debenture issuance expenses.
(e) Cancellation of losses before incorporation.
income reserve
Income reserves are created from income earnings. They are available for distribution as a dividend. Income reserves are of two types: those that are immediately available for distribution and those that are not immediately available.
a) General reserve
This reserve is created by setting aside profits from income. The objective is to strengthen the overall financial position of the company. It is not for a specific purpose. It is a free reservation. It acts as a safety cushion against all unforeseen contingencies in the future. It is immediately available for distribution as dividend income.
(b) Specific reservation
This is also created by leaving out earnings from income. But it is for a specific purpose. This is not immediately available for distribution. For example, reserve created for redemption of debentures. During the liability period, this reserve is not available for distribution. It becomes a general reserve in the redemption of debentures. Likewise, a reserve may be created for
dividend equalization.