RESERVES AND PROVISIONS

CONCEPT OF RESERVE—The part of the profit which is not distributed among the owners of
the business, rather set aside for strengthening its financial position or meeting for any
unknown future contingency is called ‘reserve’.
While defining ‘reserve’, the American Institute of Accountants stated that, “the use of the
term ‘reserve’ be limited to indicate that an undivided portion of the assets is being held or
retained for general and specific purpose”.
Reserve is an appropriation of profit and is popularly known as ploughing back of profit. It is
created by debiting Profit and Loss Appropriation Account. Therefore, unless profit is
earned, question of creation of ‘reserve’ does not arise. Only after ascertaining the amount
of profit, decision is taken regarding the quantum of reserve to be created before
distribution of profit as dividend among owners. Several factors (e.g., future need of the
business, legal requirement, agreement with debt providers, etc.) are considered for
deciding the necessity and amount of reserve. As the profit is retained within the business
under the head(s) of reserve(s), so it gets invested in different assets of the business. Hence
‘reserve’ is the most convenient source of fund to finance the source of business.

FEATURES OF RESERVES—The different features of reserves are :--

(i) It is an appropriation of profit
(ii)It is created by debiting profit and loss appropriation account
(iii) It represents profit set aside for meeting any future known/contingent purposes which
may / may not arise during the course of business operation.
(iv) Barring ‘statutory reserve’, it is not obligatory on the part of the management to create
‘reserves’.
(v) It can be utilised for distribution of dividend or for maintaining stability in the dividend
policy.
(vi) It strengthens the financial position of the business.
(vii) It is the most convenient source of fund to finance the growth of the business.
 TYPES OF RESERVES

RESERVES .
PUBLISHED UNPUBLISHED or SECRET

I .
Capital Revenue
Nature Nature
I I .
(i)Capital Reserve General Special
(ii)Capital Redemption Reserve Reserve Reserve
(iii) Securities Premium Reserve (i)Debenture Redemption Reserve
(iv) Revaluation Reserve (ii) Dividend Equalisation Reserve
(iii) Labour Welfare Reserve
(iv) Reserve created under Tax Laws
(v) Amalgamation Reserve
(vi) Hedging Reserve,etc.

GENERAL RESERVE ---It is one type of ‘reserve’ which is created by setting aside a part of the
profit arising out of the result of normal trading activities. This reserve is usually utilised for
any future purpose e.g., dividend payment, contingency of unknown nature, financing
growth, etc. Since this reserve can be utilised unrestrictedly for any purpose so it is also
known as ‘free reserve’. However, it should be noted that creation of ‘general reserve’ in
any year is completely dependent upon the earning of profit in the same year. Further, as it
is optional to create ‘general reserve’, so it is sole discretion of the management that how
much quantum of profit earned, out of normal course of business, will be appropriated/
transferred to ‘general reserve’.
It is to be noted that as per first proviso to Section 123(1) of the companies act, 2013, a
company may, before declaration of dividend in any financial year, transfer such percentage
of profits for that financial year, transfer such percentage of profits for that financial year to
the ‘reserves’ of the company, as it may consider appropriate.

PURPOSE OF GENERAL RESERVE ---- As it is clear that ‘general reserve’ can be utilised
unrestrictedly for any purpose and it is the sole discretion of the management to decide the
purpose(s). Generally, ‘general reserve’ serves the following objectives:
(i)Strengthening the Financial Position—In the present competitive business world, strength
in the financial position is imperative for survival. One of the means to strengthen the
financial position of the business is to build up ‘free reserve’.
(ii)Augmentation of Working Capital --- Very often it is observed that normal operation of
the business is found to be suffering a setback due to paucity of Working Capital. But in an
organisation having ‘general reserve’, it is observed that the fund representing ‘general
reserve’ remains primarily invested in ‘Working Capital’. This ensures smooth functioning of
business operation.
(iii) Meeting Contingency in future----The possibility of loss/setback in the business due to
unforeseen contingency can not be ruled out. So, it is always wise to build up general
reserve so that unforeseen can be tackled easily.
(iv)Maintaining stability in dividend---Maintaining stability in rate of dividend is sign of
better corporate governance and reduce the volatility in Share price. So, when there is
insufficient profit in the current year, then ‘reserve’ created in earlier year(s) plays an
important role in maintaining the dividend rate.
(v)Expansion of business----For the financial growth of the enterprise, management, as and
when needed, can avail fund out of ‘General Reserve’ (i.e., retained earnings) created by
setting aside a part of earlier year(s) profit arising out of normal trading activities.
(vi) Enhancement of goodwill---The huge amount of ‘General Reserve’ (i.e., retained
earnings) created by setting aside a part of earlier year(s) profit ensures unrestricted flow of
business operations and thereby management becomes capable to meet its every
commitment on time. This smooth functioning enhances goodwill of the business.

RESERVE FUND----‘Reserve’(i.e., retained earnings) is created by setting aside a part of the

profit arising out of the result of normal trading activities. When this reserve is kept invested
within the business by utilising it unrestrictedly for any purpose e.g., dividend payment,
contingency of unknown nature, financing growth, etc. then it is called ‘General Reserve’.
But when this ‘Reserve’ is specifically represented by earmarked investment(s) outside the
business (i.e., not kept invested within the business) is termed as ‘Reserve Fund’. The
investments are made in some readily realisable marketable securities outside the business.
The objective of creating ‘reserve fund’ is to make sure the availability of cash in need which
may not be possible to be averaged if the undistributed profit (i.e., retained earnings) is kept
invested within the business. The absence of investment opportunity within the business
may also warrant the necessity to create the ‘reserve fund’. ‘Reserve Fund’ is disclosed in
the Balance Sheet in the same way as ‘Reserves’. Simultaneously, ‘Investment’ represented
by ‘Sinking Fund’ is shown in the ‘Assets’ portion of the Balance Sheet under the head
‘Current Assets’ and subhead ‘Current Investments’.
Difference between ‘Reserve’ and Reserve Fund

Points of Reserves Reserve Fund

Distinction
Nature of The amount of reserves remains absorbed in different The amount of reserve fund remains invested in some
assets within the business or is used for carrying out earmarked investment outside the business.
investment different business activities.
Effect on It helps to augment the working capital of the business. Reserve Fund has no impact on the working capital of
Working Capital the business.

Ensuring As the amount of remains absorbed in different kinds of The amount of reserve fund can be easily realised in
assets of business, they can not readily ensure cash by selling the earmarked securities.
Liquidity availability of cash when it is actually needed.
Disclosure in ‘Reserves’ are shown under the head ‘Shareholders’ ‘Reserve Fund’ is disclosed in the Balance Sheet in the
Fund’ and sub-head ‘Reserves & Surplus’ in the Balance same way as ‘Reserves’. Simultaneously, ‘Investment’
Balance Sheet. represented by ‘Sinking Fund’ is shown in the ‘Assets’
portion of the Balance Sheet under the head ‘Current
Sheet Assets’ and subhead ‘Current Investments’.

CAPITAL RESERVE----The reserve which is created out of capital profit is called capital
reserve. Capital profits are those profits which do not arise in the normal course of the
business rather arising out of activities not incidental to business. Thus, Capital Profits would
arise where a company sells part of its fixed assets at a price higher than the original cost of
such assets or where it receives premium on issue of shares, etc. Such profits may be
realised or take the form of book figures only created by such matters as revaluation.
Capital Reserve is not created by debiting profit and loss appropriation account. So, capital
profit whenever arises should not be credited to profit & loss account and instead it should
be credited to capital reserve account. The capital reserve should be shown separately from
general/revenue reserve in the Balance Sheet. The capital profit can be utilised for dividend
payment only when (i)such capital profit is realised in cash and (ii)such distribution is
permitted its by Articles of Association’ and (iii)also exists as surplus after revaluation of
other assets and liabilities. It is also to be remembered that utilisation of Capital reserve
should be as per provisions of the Companies Act,2013 and ‘generally accepted accounting
principles’ (GAAP). Except in few cases it is not available for distribution as dividend.

Means of creation of Capital Reserve—Capital Reserve can be created in the following

manner:---
(i)Profit earned on sale of Fixed Assets.
(ii) Profit on revaluation of all fixed assets.
(iii) Profit on revaluation of liabilities
(iv) Profit on re-issue of forfeited shares
(v)Profit earned prior to incorporation of a company
(vi) Profit arising on purchase of a business undertaking i.e., excess of fair value of net assets
acquired over purchase consideration paid.
(vii) Premium received on issue of Shares or Debentures.
(viii) Profit on redemption of debentures at a discount.

DIFFERENCE BETWEEN REVENUE RESERVE AND CAPITAL RESERVE

Points of REVENUE RESERVE CAPITAL RESERVE

distinction
(i)Nature This reserve is created with profit arising out of normal
activities of the business. It is actually undistributed
profit.
(ii)Importance This reserve indicates the actual profitability and financial
strength of the business. This reserve can not be created
unless there is existence of regular normal profit.
(iii)Utilisation Revenue Reserve is used for augmenting working capital,
financing the expansion, writing off revenue loss,
meeting unforeseen contingencies, etc.
(iv)Mode of This reserve is created by debiting profit and loss
creation appropriation account and crediting ‘revenue reserve’.
(v) Dividend Free revenue reserve can be used for distribution of
payment dividend.
Capital Reserve is created with profit arising out of
peripheral (i.e., not normal)activities of the business, such
as profit on sale of assets .
The Capital Reserve is created out of windfall gain. It does
not indicate the profit earning capacity of the business.
Capital reserve is used for writing off preliminary
expenses, cost of issue of shares and debentures, capital
loss,etc.
Capital profit whenever arises should be credited to
capital reserve account.
Normally this reserve is not available for dividend
payment. However, as decided in two cases, i.e.,(i)
Lubbock v. The British Bank of South America(1892) and
(ii) Foster v. The New Trinidad Lake Asphalte Co. Ltd.
(1901), the capital reserve (profit) can be utilised for
dividend payment only when following three conditions
are fulfilled: (i) such distribution is permitted by its
Articles of Association (ii)when capital profit is realised in
cash and (iii) when such surplus exists even after
revaluation of other assets and liabilities.

Payment of Dividend out of Capital Reserve---The question whether Capital Reserve can be
appropriated for distribution as dividend or not has not been specifically dealt with by the
Companies Act. However from the decisions of two cases, i.e.,(i) Lubbock v. The British Bank
of South America(1892) and (ii) Foster v. The New Trinidad Lake Asphalte Co. Ltd. (1901).
The following three conditions can be stipulated for fulfilment before distribution of ‘capital
reserve’ as dividend :
(i)The Articles of Association (A.O.A.) must authorise such distribution.
(ii)The Capital Reserve to be used for dividend payment must be created out of profit
realised in cash on actual sale of fixed assets. Capital Reserve arose out of mere revaluation
of fixed assets is not available for dividend purpose.
(iii) The Capital Profits must exist as surplus after revaluation of other assets and liabilities of
the business.
 So, capital reserve created out of following income is not available for dividend payment :
(a)Share premium the distribution of which as dividend is specifically prohibited u/s.52 of
the Companies Act,2013.
(b) Capital Redemption Reserve
(c)Profit on re-issue of forfeited shares
(d) Profit prior to incorporation
(e)Profit on redeeming debentures at discount
(f)Profit on purchase of business.

Capitalisation of Reserve---The process by which reserve (capital and/or revenue) is

permanently retained by the company by way of issuing bonus Share is called the
‘capitalisation of reserve’. It is one of the methods of financing the growth of the business
and is popularly known as ploughing back of profit. It is to be noted that ‘capitalisation of
reserve’ does not enhance the effective capital of the company. Capitalisation of reserve
does not increase the assets of the business. Only there is some re-organisation of capital
structure of the company. On the ‘Liabilities’ side of the Balance Sheet, under the head
“Shareholders’ Fund”, there are two ‘subheads’ viz., (i) Share Capital and (ii) Reserves and
Surplus (Schedule III of the Companies Act, 2013). So for the capitalisation of reserve,
capital structure of the company undergoes some change due to merger of ‘reserves’
(capital and/or revenue) of “Reserves and Surplus” with the ‘paid-up share capital’ of “Share
Capital”.
In respect of ‘capitalisation of reserve’, following guidelines of SEBI has to be adhered to:--
(i)Bonus Share has to be issued out of (a) free reserves created out of profit arising from the
result of normal trading activities or (b) Securities Premium (a, capital reserve) collected in
cash only.
(ii)Reserves created out of revaluation of assets should not be utilised for ‘capitalisation of
reserve’.
(iii) Proposal for ‘Capitalisation of Reserve’ will be taken up if it can be ensured that the
company has not been defaulter in payment of (a) interest and principal in respect of public
deposit and debentures and (b) statutory dues of employees like provident fund, bonus,etc.
(iv) There has been provision in the Articles of Association (A.O.A.) authorising the company
to issue bonus shares.
(v) The extended capital (i.e., total of existing ‘share capital’ + fresh bonus shares issued
now) should be within the limit of ‘authorised capital’.
Apart from above SEBI guidelines, it will have to be ensured that in respect of
‘Capitalisation of Reserve’ all accounting entries have been made in financial book and all
proper recording have been made in the Share Register.
ADVANTAGES OF CAPITALISATION OF RESERVE
Advantages of Capitalisation of Reserve from the view-point of company are as follows:--
(A)Accumulated profit can be distributed without disturbing the liquidity position of the
organisation as and when it is felt necessary.
(B)Growth of the organisation is ensured by permanently keeping the reserve in the
business.
(C)The fact that company is issuing bonus shares indicates its satisfactory profit earning
capacity and hence reputation of the company is enhanced.
(D)By way of capitalisation of reserve, disparity between effective capital and book capital
can be eliminated and balance sheet can be presented in more meaningful way.
(E)For a highly growing company, dividend rate can be kept under check although
shareholders earning is increased. This is necessary to curb demand for wage hike and
government interference.
(F) Shareholders are benefitted in the following ways:--
(i)They receive profit of the company without affecting its liquidity position. If they think
it necessary, shares can be converted into cash by selling in the market.
(ii)Income in the form of Bonus Share does not attract income tax.
(iii)The Shareholders get additional shares without investing any capital.
(iv)This provides opportunity to Shareholders to invest in prosperous company which
would not be possible except procuring shares from market at a high premium.

DISTINCTION BETWEEN CAPITAL RESERVE AND CAPITALISATION OF RESERVE

CAPITAL RESERVE
(i)It is created out of Capital
Profit only
(ii) Capital reserve can be
created from various type of
capital profit [e.g.,{ profit on
( sale of fixed asset, revaluation
of fixed asset, re-issue of
forfeited share, redemption of
debenture at discount )},
{earned prior to incorporation},
{arising on purchase of
business},{premium received on
issue of shares or debentures},
etc.] as and when they arise.
(iii)Creation of Capital Reserve is
accompanied by the increase of
CAPITALISATION OF RESERVE
(i) It is done either out of capital reserve or out of revenue reserve as and when it is necessitated
(ii)SEBI has imposed certain restrictions on ‘Capitalisation of Reserve’, which are:---- (a)Bonus Share
has to be issued out of (a) free reserves created out of profit arising from the result of normal trading
activities or (b) Securities Premium (a, capital reserve) collected in cash only.
(b)Reserves created out of revaluation of assets should not be utilised for ‘capitalisation of reserve’.
(c) Proposal for ‘Capitalisation of Reserve’ will be taken up if it can be ensured that the company has
not been defaulter in payment of (a) interest and principal in respect of public deposit and
debentures and (b) statutory dues of employees like provident fund, bonus,etc.
(d) There has been provision in the Articles of Association (A.O.A.) authorising the company to issue
bonus shares.
(e) The extended capital (i.e., total of existing ‘share capital’ + fresh bonus shares issued now) should
be within the limit of ‘authorised capital’.
(iii) Capitalisation of Reserve does not increase the assets of the business.
Only there is some re-organisation of capital structure of the company. On the ‘Liabilities’ side of the Balance Sheet, under the head

the assets of the business. “Shareholders’ Fund”, there are two ‘subheads’ viz., (i) Share Capital and (ii) Reserves and Surplus (Schedule III of the Companies Act, 2013).

So for the capitalisation of reserve, capital structure of the company undergoes some change due to merger of ‘reserves’ (capital and/or

revenue) of “Reserves and Surplus” with the ‘paid-up share capital’ of “Share Capital”.
SPECIAL/SPECIFIC RESERVE
When a reserve is created out of revenue profit for some definite purpose, it is called
Special/Specific Reserve. This reserve can not be used for any purpose other than that for
which it has been created. It is to be noted that Special/Specific Reserve is not a charge
against profit rather is an appropriation of profit and its creation depends upon the
availability of profit. Creation of Special/Specific Reserve should be as per provision of
Articles of Association (A.O.A.). If in any Board of Directors Meeting, any decision has been
taken for creation of Special/Specific Reserve, then it will have to see whether the same has
been implemented or not. All Special/Specific Reserve(s) has to be shown in the Balance
Sheet according to requirement of Schedule III of the Companies Act,2013. If company has
issued Debentures, then it should be ensured that Debenture Redemption Fund has been
created according to the provision of the Debenture Trust Deed.

PURPOSES OF Creation of Special/Specific Reserve

The purpose of Special/Specific Reserve may be anything connected with the business which
the Articles of Association (A.O.A.) of the company or management (i.e., B.O.D.) wants to be
provided for. Some of the important purposes for which it is created are as follows:
(i)Redemption of Debenture: In order to redeem Debenture, sometime Debenture Trust
Deed provides for creation of Sinking Fund or Debenture Redemption Fund. This ‘fund’ is
built up by transferring equal amount of profit year after year from Profit & Loss
Appropriation A/c. till the redemption of Debenture is over.
(ii) Equalisation of the rate of Dividend : Sometimes for ensuring stability in the rate of
dividend, a reserve known as ‘Dividend Equalisation of Reserve’ is created out of Profit. This
reserves enables the company to pay dividend at normal rate even in the year in which the
company makes insufficient profit.
(iii) Capital Redemption Reserve : Preference Shares shall be redeemed out of the profits of
the company which would otherwise be available for distribution as dividend[Sec.55(2)] or
out of fresh issue of share made for the purpose of such redemption i.e., both sources can
be utilised simultaneously. Hence, to the extent the preference shares are redeemed out of
profits then after such redemption an amount equal to the nominal value of such shares
redeemed are to be transferred to the credit of “Capital Redemption Reserve A/c.”
(C.R.R.A/c.) by debiting ‘General Reserve’ and/or ‘Profit & Loss A/c.’ and/or other accounts
e.g., ‘Dividend Equalisation Reserve’, if any, showing profit otherwise available for
distribution of dividend. Balance in C.R.R. A/c. can be utilised for issue of fully paid bonus
shares Sec.55(4) .
(iv)Development Rebate Reserve : For enjoying the benefit of development rebate available
under Income Tax Act, this reserve is to be created compulsorily.
(v) Labour Welfare Reserve: This reserve is created for undertaking various welfare activities
for the benefit of workers.
SECRET RESERVE: The reserve which is not apparent on the face of the Balance Sheet is
called Secret Reserve. It is also known as hidden reserve as it does not come to light i.e., not
appearing in Balance Sheet as such. Secret Reserve is created either by way of
overstatement of liabilities and/or understatement of assets which ultimately artificially
result in understatement of net worth or capital of the organisation. Accordingly, creation of
Secret Reserve makes the company weaker though actually it is not.
Objectives of creation of Secret Reserve :
Secret Reserve is created only with the following objectives:
(a)To meet any extraordinary loss in future without disclosing the facts to Shareholders.
(b)To mislead the competitors about the financial position of the organisation.
(c)To maintain a steady rate of dividend.
(d)To strengthen the financial position of the business.
(e)To manipulate Share price with some ulterior motives.

Creation of Secret Reserve :

Secret Reserve may be created in the following ways:
(i)By charging capital expenditure as revenue expenditure;
(ii) By providing for more depreciation on fixed Assets;
(iii)By making excessive provision for doubtful debts;
(iv)By undervaluation of Stock-in-Trade;

(v)By writing off the genuine goodwill of the business;

(vi)By omitting some of assets altogether from the assets;
(vii)By making an excessive provision even though it is not required;
(viii)By overhauling the liabilities or by showing imaginary liabilities.

Distinction between Reserve and Provision

Points of Reserve Provision

distinction

1.Mode of Reserve is an allocation of profit ; It is a charged against profit ; hence it is created

creation Hence its is created by debiting Profit & by debiting Profit & loss A/c.
Loss Appropriation account [ in the
company balance sheet  under the
head reserves and surplus(under
“shareholders’ funds”) from profit
and loss account transfer is made to
general reserves). So reserve is created
by appropriating profit of the current
 year.
2.Relationship The Quantum of reserve depends upon
with Profit availability of profit. Higher the amount of
profit , larger will be the Quantum of
reserve.
3.Purpose The purpose of creation of reserve are:
i).to strengthen the financial position of the
business.
ii).to support additional working capital
requirement.
iii).to redeem debentures.
iv).to maintain a steady rate of dividend.
v).to meet any unknown contingencies.
4.Compulsion Baring from some statutory requirements
like transfer of profit to reserve before
declaration of dividend or requirement of
Articles, the creation of reserve is
discretionary on the part of management.
5.Nature A reserve is always reserve till it is fully
utilised. Even if it is more than requirement,
it will not change its nature.
6.Disclosure The reserve in the Balance Sheet of the
company has to be shown under the head
‘Reserves and Surplus’ under
‘Shareholders’ Funds’ as per Part I of
Schedule III of The Companies Act, 2013.
7.Dividend Past reserve can be utilised for dividend
Payment payment subject to fulfilment of some
conditions.
8.Relationship The auditor need not devote much time for
with ‘True verification of reserve as it does not affect
and Fair’ the true and fair view of the financial
view position of the business. Only he is required
to see the compliance of provision of the
Companies Act regarding the creation of
reserve before payment of dividend and
requirements of Articles, if any.
There is an inverse relationship between profit
and provision. Higher the amount of provision,
lower is the amount of profit.
Provision is created for:
i).to meet loss in value of assets, e.g.
depreciation.
ii).to meet a suspected contingency like non-
recovery of doubtful debts, liability for a
disputed claim, etc.
iii).to meet any known liability the exact
amount of which is yet to be ascertained.
There is no place of discretion in the creation of
provision. It has to be created if the situation so
warrants.
Provision in exccess of requirement can be
treated as reserve.
In the Balance Sheet, provision will be shown
as follows:
i).Provision for depreciation will be shown by
way of deduction from the concerned fixed
asset.
ii).Provision for doubtful debts will be shown
by way of deduction from ‘Trade Receivables’.
iii).Other provisions will be shown under the
head ‘Non-Current Liabilities’ as ‘Long-Term
Provisions’ or ‘Current Liabilities’’ as ‘Short-
Term Provisions’.
Provision can never be utilised for dividend
payment. Only excess provision written back
can be used for dividend purpose.
The auditor must be very careful and cautious
while examining the adequacy of provision in
as much as inadequate or over provision will
affect the true and fair view of the financial
results and financial position of the business.