Provisions and reserves

Start with a simple picture. Income for the year is ₹10 lakh and expenses ₹6 lakh, so profit is ₹4 lakh. But a loss may be coming, say some customers may not pay, and you do not know the exact amount. Prudence says: provide for it now. So you show one more charge, a provision of ₹1 lakh, and profit becomes ₹3 lakh. No cash has left the business.

A provision is a charge against profit for a liability or loss that is known, but whose amount is not certain. It is made before profit is worked out, in the profit and loss account. Examples: provision for doubtful debts, for depreciation, for taxation, for repairs.

Provision for doubtful debts. First write off the bad debts (money you know is lost). Then make a provision as a percentage of the debtors that remain. Trehan Traders have debtors of ₹68,000, bad debts of ₹8,000 and a 10% provision: 10% of 60,000 = ₹6,000. Next year, bad debts are set against the old provision, and only the difference needed to bring the provision to its new level goes to the profit and loss account. You still try to collect the money.

A reserve is different. After profit is worked out, the owners decide how much to take out and how much to keep in the business to make it stronger, for expansion or for a bad year. The amount kept is a reserve. It is an appropriation of profit: a way of using profit, not a charge against it. So it does not reduce profit or taxable profit.

• Revenue reserves come from ordinary profit: a general reserve (for no particular purpose) or specific reserves, like a dividend equalisation reserve (to keep dividends steady) or a debenture redemption reserve.
• Capital reserves come from capital profits, which do not come from normal trading, like the premium received on issuing shares or a profit on selling a fixed asset.

A secret reserve is one that does not appear in the balance sheet. It is created by deliberately showing profit and assets lower than they really are, for example by charging too much depreciation.