Provisions

Provision refers to the setting aside of certain amount  to meet some contingencies which may be expected but not yet incurred. In other words, provision usually means any amount written of or retained by way of providing depreciation, renewal or diminution in the value of assets. It is a charge to the profit and loss account. Some examples of provision are as:

1. Provision for bad and doubtful debt.
2. Provision for discount on debtors.
3. Provision for taxation.
4. Provision for depreciation.
5. Provision for repairs and renewals etc.

Provisions are either shown as deductions from assets in the balance sheet or on the liability side of balance sheet. When provision is no longer required, it is treated as a profit.

Features:

1. Provisions are made for expected contingencies.
2. It is a charge to the profit and loss account.
3. They are always made for a specific purpose.

Importance:

1. To ascertain the true net profit or loss.
2. To know the true financial position of the business.
3. To cover the loss in value of assets.

Secret Reserves

Secret reserve is created to strengthen the financial position of the firm without disclosing reserves to the public. They are not shown in the balance sheet. Such reserves are usually maintained by banks, insurance companies etc. Generally, it is created by showing lower profit than what actual is. It may be done in any of the following ways:

1. By undervaluing the closing stock.
2. By providing excessive depreciation.
3. By overvaluing liabilities.
4. By making excessive provisions or losses.

Advantages:

1. It helps to strengthen the financial position of business.
2. It helps to meet the exceptional losses.

Disadvantages:

1. Profit shown by the financial statement is not accurate.
2. True financial position of the business can not be disclosed.

Reserve for Redemption of Liabilities

The firm requires to manage big amount to redeem long term liabilities like debentures. Thus, a reserve is created out of profit for the redemption of liabilities which is called reserve for redemption of liabilities.

Advantages:

1. Loan can be repaid in specific date which increases the creditability of the business.
2. It helps to avoid the financial crises of repaying liabilities.

Disadvantages:

1. It reduces the amount of divisible profit of shareholders.

Dividend Equilization Fund

It is created for maintaining equal dividend over years. In other words, sometime a company may not have sufficient profit to distribute as dividend. At that time, the company can utilize such fund.

Advantages:

1. It helps to distribute same rate of dividend even there is loss in the business.
2. Due to the uniformity of dividend over years, the market value of shares does not fluctuate abnormally.

Disadvantages:

1. Creation of dividend equilization fund reduces the amount of divisible profit.
2. Small organization having poor financial position may not be able to create such fund. 
   

Research and Development Fund

This fund is also created out of profit. It is a specific  reserve which is created to meet heavy expenditures of research and development of new product in the market. In this perfect competition business world, all most all the businesses require to spend for research of new product.

Advantages:

1. It helps to research and develop the new product.
2. It helps to earn good profit due to the invention of new and better product in the market.

Disadvantages:

1. It reduces the divisible profits of the shareholders.
2. Small organization having poor financial position may not be able to create such fund.

Sinking Fund

Sinking fund is a specific reserve set aside for redemption of a long term debt or the replacement of a wasting assets. The distinct feature of sinking fund is that the amount of it is invested in outside securities to earn the interest. The investment is collected before the use of specific purpose.

Advantages of sinking fund:

• There will be no problem of collecting funds for the purchases of new assets.
• Sinking fund is also created to repay the long term loan, therefore company will not face the problem of managing fund from outsiders.
• It can be invested in outside securities which will increase sum of reserve.

Disadvantages of sinking fund:

• A big amount of divisible profit is utilized for sinking fund.
• The fund may not fulfill its purpose if the invested amount has not been collected in time.

Revenue Reserve

Revenue reserve are created out of revenue profit. Revenue profits refer to the profit that is earned by operating the business. Profit on sales of goods, discount received etc. are revenue profits. There are two types of revenue reserves:

1. General Reserve
2. Specific Reserve

General Reserve:

A general reserve is also known as "Free Reserve" which is created only when there is a  profit or when the management desires to create. This reserve is created by setting aside a prat of the profits in order to strengthen the general financial position of the business. The aim of creating such reserve is not a specific purposes.

• To meet unknown future losses.
• To expand the business as additional working capital.
• To equalize rate of dividend over years in case of joint stock company.
• To strengthen the financial position of the business.

Specific Reserve:

These reserves are created for specific or definite purposes. It must be created even there is loss. Generally, the followings are some purposes of creating specific reserves.

• To equalize  the dividend over years - Dividend Equalization Reserve.
• To meet the repayment of debentures - Debenture Redemption Reserve.
• To provide funds for the replacement of assets - Reserve for Replacement of Assets.

Types of Reserves

1. Capital Reserve
2. Revenue Reserve

1. Capital Reserve:

Capital reserves are those reserves, which are not created out of operating profit. In other words, these reserves are created out of capital profits. Profit on sale or revaluation on fixed assets is capital profit, which are generally not available for distribution among the shareholders of the company. The following are some examples of capital profits, which are the sources of creating capital profits which are the sources of creating capital reserves.

• Profit on sale of revaluation of fixed assets.
• Profit on repayment of debentures.
• Profit earned through the issue of shares at premium.
• Profit earned through forfeiture and re-issue of shares.
• Profit on the purchase of running business etc.

Utilization of Capital Reserves:

• To meet future capital losses
• To issue as fully paid bonus shares
• To strengthen the financial position of the business.

Reserve

The term 'reserve' denotes something kept for future use. In accounting sense, it denotes the amount set aside out of profit for the purpose of strengthening the financial position of the business. It is created for meeting unknown liability or loss in the future. Thus, it is not an expenses or loss in real sense.

According to William Pickles,"Reserves mean the amounts set aside out of profits and other surpluses, which are not earmarked in any way to meet any particular liability, known to exist on the date of the balance sheet".

Features of Reserves:

1. It is created for meeting unknown liability or losses.
2. It is created out of net profits.
3. It is not created compulsorily.
4. It is a part of undistributed profit, so it is shown in balance sheet until is is used.

Objectives of Reserves:

• It works as an additional capital for the expansion of business through internal resources.
• It strengthens the financial position of business.
• It helps to meet any unknown liabilities, looses or contingencies in the future.
• It provides funds for the repayment of debentures, preference share capital.
• It helps to equalize in the rate of dividend in case of company.

Factors affecting the amount of Depreciation

a) Original cost of the assets: Original cost includes the purchase price of the asset plus freight and installation expenses. Depreciation is charged on cost of asset so, it is found as:

Cost of Asset = Purchase price + Freight (Transportation expenses) + Installation (erection) expenses

b) Estimated working life of the asset: All the fixed assets have their working life which can be estimated but not predetermined. After this period, the assets will be worthless or scrap. The working life of asset plays vital role in the determination of depreciable amount.

c) Scrap value: Scrap value is also called as salvage or residual or terminal value which means to the value that will be realized by selling the asset after the expiry of the estimated working life. Such amount must be deducted in cost of assets in the calculation of depreciation.

Objectives for providing depreciation

1. For the replacement of assets: The fund equal to the amount of the depreciation is created which will remain in the firm. After the expiry of the life of asset, the same fund can be utilized to replace the new asset.
2. For the determination of true profit or loss: Depreciation is also an expense like repair and maintenance which must be included in profit and loss account to ascertain the correct profit or loss of a business for the year.
3. For the presentation of assets in the balance sheet at their proper value: Depreciation must be charged to each fixed asset for the true and fair presentation of assets in the balance sheet. The depreciation is deducted from the cost or book value of assets each year.
4. For the determination of correct cost of production: Correct cost of production can not be ascertained if the depreciation is not charged to the fixed assets. Thus, it is necessary to include amount of depreciation in the calculation of cost of each product.
   

Causes of Depreciation

1. Wears and Tears: The value of an asset declines due to its constant use in the business. Generally, fixed assets are depreciated due to wear and tears which means reduction in the efficiency and value of an asset caused from vibration, friction, accident, movement, erosion etc.
2. Innovation: Due to the development of science and technology, the new and improved automatic machines may be invented. Such invention reduces in the value of old and existing machinery.
3. Expiry of Time: The value of some assets like patent right, copy-right, lease hold property etc. decrease with the passage of time. The right of such assets is predetermined for certain duration. After its expiry, there is no value even it is not used.
4. Exhaustion: The value of some assets like mines and quarries go on declining with the continuous use.
5. Fall in market price: Another reason of depreciation is permanent fall in the price of an asset. The value of asset reduces as the market price of an asset continuously goes on declining.

Depreciation

The non-trading fixed assets of a business like land, building, machinery, furniture etc. may be get depreciated in value due to various reasons. In other words, the value of such assets reduces each year due to use. Such gradual ad permanent reduction in the value of the assets due to wear and tear or from any other causes is called Depreciation. The word depreciation is derived from a Latin work 'Depretium' which is composed of two words 'De' and 'Pretium', where 'De' denotes decrease and 'Pretium' denotes price. Thus, the word depreciation means decrease in the price. It indicates a fail in the value of an asset which is a loss or an expense for a business and shown in the debit side of profit and loss account. It must be deducted from the respective assets in the balance sheet.

According to J.R. Batliboi,"Depreciation means permanent decline in the value of assets due to wear and tear or from any other cause."

According to R.G. Williams,"Depreciation may be dfined as a gradual deterioration in value of assets due to use."