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 company;
(c) to fulfill a specific purpose;
(d) to amortize a liability;
(e) to replace a wasted asset.
(f) There are two ways to reduce the amount available to distribute as profit:
(1) Indirectly, that is. charged to gross profit or charged to profit and loss account.
(2) or, directly. that is, of the divisible profits debiting the profit and loss appropriation account.
The profit and loss account is charged only when the object is to meet an anticipated or future contingent liability or loss or to replace an asset that is wasted. In all other cases, the profit and loss appropriation account is debited.
(3) The amount that is mostly separated may not be invested; And if it is invested, it can be invested in or out of business. This depends on the object to be served. It is common to invest money out of business when the goal is to salvage a liability or replace an asset that goes to waste. The money can be invested outside or within the company at one’s choice, if the objective is to strengthen the financial position of the company.
Meaning of the terms:
1. Background. If an amount equal to the reserve is invested in external securities, the reserve will be referred to as the “Reserve Fund”.
2. Reserve. If the amount set aside from the earnings is not invested in external securities, it is called a “Reserve”.
3. Provision. If the amount is reserved as a charge against earnings or surplus to cover:
(a) Depreciation for renewal of the asset.
(b) Any known liability, the amount of which cannot be precisely determined. Provisions are generally created against the profit and loss account. Provisions are also sometimes referred to as “Specific Reserves” by accountants. Provisions are created even when there is no profit in the business. Provisions are not surplus. They are not available for distribution to owners or shareholders. However, the provision that exceeds the need is a surplus. When a provision becomes redundant, it must be credited back to the profit and loss appropriation account.
It should be noted that the amounts set aside to meet known liabilities, the amount of which can be determined with precision, do not fall within the definition of a provision and, therefore, should be called increased liabilities. For example, pending rent, interest, etc. they are increased liabilities and not provisions.
Types of provisions (specific reserves)
As already said, the provisions are of the following types:
(i) Provision for doubtful debts;
(ii) Reserve for discount on debtors;
(iii) Reserve for discount on creditors;
(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 separate from earnings. There can be no reserves if there are no earnings. Reserves are undistributed earnings. They are appropriations of benefits. While provisions are pre-profit matters, reserves are post-profit matters. You cannot talk about creating reserves without first knowing the earnings. It is good business policy to create reserves. They strengthen “the” financial position of the company. Reservations 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. The 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 earnings 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 face capital losses. The following are examples of capital gains:
(i) Profit from sale of fixed assets.
(ii) Profit prior to incorporation.
(iii) Benefit from amortization of debentures.
(iv) Premium for issuance of shares or bonds.
(v) Profit from share forfeiture.
(vii) Result from business acquisition.
(viii) Profits that have 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 / bond issue expenses.
(e) Cancellation of losses before incorporation.
Income reserve
Income reserves are created from the profits of the income. They are available for distribution as a dividend. Revenue 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 the benefits from the income. The object is to strengthen the general financial situation 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 a dividend benefit.
(b) Specific reserve
This is also created by setting aside profit from income. But it is for a specific purpose. This is not immediately available for distribution. For example, reserve created for the exchange of obligations. During the period of responsibility, this reserve is not available for distribution. It becomes a general reserve for the exchange of obligations. Similarly, you can create a reservation for
dividend matching.
