Amity Business School

Reserves and
Provisions

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Reserves

Reserves - Reserves means amounts set aside out of

profits . It is the appropriation of profits or accumulated
profits.
Examples of Reserves are: General Reserve, Capital
Reserve, Reserve for Equalization of Dividends, Reserves
for expansion etc.
Purpose or Importance of Reserves
Reserves are important in strengthening the financial
position of the business and helpful in meeting the
unforeseen liability or loss or for expansion.

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TYPES OF RESERVES

Revenue Reserves: Revenue reserves are created out of

revenue

profits

which

are

available

for

distribution

as

dividend. For example: general reserve, dividend equalisation

Reserve, Debenture Redemption Reserve etc.

Capital Reserve: Capital Reserves are created out of capital

profits are normally not available for distribution as dividend.
For Example: profit prior to incorporation , premium on issue
of shares or debentures, profit on sale of fixed assets, profit on
revaluation of fixed assets.

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TYPES OF RESERVES

General Reserve: General reserve is the amount that is set

aside out of profits which is not created for specific purpose. It
is available for future expansion or contingencies. For
example : General Reserve

Special Reserve: Special Reserve is that reserve which is

created for a specific purpose and can be utilized only for that
purpose. For example: Dividend Equalisation Reserve

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RESERVE FUND

RESERVE FUND: If reserves are invested in outside securities

and such securities are earmarked for the particular purpose
denoted by the reserve, the reserve will be called Reserve
Fund.

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PROVISIONS
Provision means an estimated amount to meet a loss or expense in
future whose amount as yet is not certain.
The Companies Act defines the term Provision as:
a) Any amount written off or retained by way of providing for
depreciation, renewals, or diminution in the value of assets; or
b) Retained by way of providing for any known liability of which the
amount cannot be determined with substantial accuracy.
Examples of Provisions are:
1) Provision for Depreciation, Repair and Renewals of Assets
2) Provision for Taxation
3) Provision for Bad and Doubtful Debts
4) Provision for discount on Debtors

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Difference between Reserve and Provision

Basis of Difference
Reserve
Provision
It is created to meet an unknown It is created to meet a known
Meaning
liability
liability
Creation of reserves is
Creation of provision is a legal
discretionary. It can be created
necessity. Provisions have to be
Necessity
only if adequate profits have been provided for even if there are no
earned
profits.
Object

The object of reserves is to

strengthen the financial position
of the business.

The object is to provide for

depreciation, doubtful debts and
other specific liabilities.

Mode of Creation

It is created through P&L

Appropriation A/c. As such its
creation does not reduce the net
profits but the divisible profit.

It is created by debiting to P&L A/c

and its creation reduces the net
profit.

Investment outside the Reserves may be invested outside Provisions are never invested
business
the business.
outside the business.
It is shown on the liabilities side
Presentation in Balance
under the head 'Reserves and
Sheet
Surplus'.
Utilisation for
Dividends

It is either shown on the assets side

by way of deduction from the asset
for which it is created or as a
distinct item on the liability side.

It can be utilized for distribution as It cannot be utilized for distribution

dividends among shareholders.
as dividends among shareholders.

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DEPRECIATION

Depreciation means a fall in the value of an asset because of

usage or with efflux of time or due to obsolescence .

Non cash expense

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DEPRECIATION AND OTHER

RELATED CONCEPTS
DEPLETION: The term Depletion is used in respect of the
extraction of natural resources like quarries, mines etc.

OBSOLESCENCE: Obsolescence refers to the decrease in

usefulness caused on account of the asset becoming out of
date, old fashioned etc.

AMORTIZATION: amortization refers to writing off the

proportionate value of the intangible assets like goodwill,
copyright, patents etc.

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CAUSES OF DEPRECIATION

Physical Wear and Tear because of usage of asset

Efflux of time

Obsolescence

Expiration of legal rights

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NEED FOR CHARGING

DEPRECIATION

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BASIS OF PROVIDING
DEPRECIATION
The factors for calculating the amount of Depreciation are:
a) Original (Historical ) Cost of Asset = Purchase Price +
freight + Installation Cost
b) Estimated Residual or Scrap value at the end of assets
life
c) Estimated Life of the asset

a) If rate of depreciation is given with words p.a

The date of acquisition is given
The date of acquisition not given
b) If rate of depreciation is given without the words p.a

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METHODS OF DEPRECIATION

Two methods of Depreciation

a) Fixed Percentage on Original Cost or Fixed Installment or
Straight Line Method
b) Fixed Percentage on Diminishing Balance or Reducing
Installment or Written Down value method

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Straight Line Method

Under this method, a percentage of original cost of the asset is written

off every year. The amount of depreciation is calculated by dividing
the cost of the asset less its salvage price by the number of years of
its economic life. Under this method, deprecation is charged on
historical cost i.e., actual cost and no future variations in costs are

taken into consideration.

Cost Salvage price

Depreciation = ---------------------------------------- Economic Life of the Asset

Amount of Depreciation
Rate of Depreciation = ----------------------------------------- *
100

Original cost

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Written Down Value Method

Under this method, Depreciation is charged at a fixed rate on

the reducing balance (i.e Cost less Depreciation) every year.
Under this method, depreciation is charged at a fixed rate
every year but on reducing balance i.e., on balance reduced
each year during the economic life of the asset by the amount
of depreciation till the asset is reduced to its scrap value.

For example, if the cost of the asset is Rs. 1,000 the rate of
depreciation is 10 % on Rs. 1,000 i.e., Rs. 100, in the second
year, it will be 10 % on Rs 900 i.e., Rs. 90 is the third year, it
will be 10 % on Rs 810 (900-90) i.e., Rs. 81 and so on.

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METHODS OF RECORDING
DEPRECIATION

In accounting, Depreciation can be recorded by two methods

When depreciation is charged to the assets account

When Provision for Depreciation / Accumulated Depreciation Account is

maintained

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When depreciation is charged to the

assets account
-

When depreciation is charged to the assets account

Depreciation A/c

Dr

To Asset Account
Profit and Loss A/c Dr
To depreciation A/c

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When Provision for Depreciation / Accumulated

Depreciation Account is maintained

When Provision for Depreciation / Accumulated Depreciation Account is

maintained
Depreciation A/c

Dr

To Provision for Depreciation A/c

Profit and Loss A/c

To Depreciation Ac/c

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Illustration

Mr Ramesh purchased a machinery by cheque for Rs 1,00,000 on July

1, 2007. Another machine was purchased for Rs 60,000 by cheque on
Jan 1st, 2009. Depreciation is charged at 10% p.a by the Straight line
method. Accounts are closed each year on Dec 31. You are required to
show

Machinery

Accounts,

depreciation

accounts,

Provision

depreciation a/c (where relevant) and the Balance Sheet:

a) when provision for Depreciation Account is not maintained
b) when provision for Depreciation is maintained.

for