SlideShare a Scribd company logo
1 of 21
FINANCIAL ACCOUNTING
551/552 AC 46
Unit 1
Dr. J. Mexon P. Rayan
Depreciation
Depreciation is the process of spreading the cost of
fixed assets over the different periods which derive
the benefit from their use. Depreciation is a
permanent decline in the value of an asset. The
gradual decrease, both in the value and usefulness, of
an asset due to its nature and usage is termed as
depreciation.
It is common experience that whenever an asset is
used it reduce in value. The net result of depreciation
is that sooner or later, the asset becomes useless. So,
it can be stated that depreciation is that portion of the
cost of an asset which is reduced from revenues for
the services of the asset in the operation of a
business.
Definitions
•According to spicer and pegler “Depreciation is the
measure of the exhaustion of the effective life of an
asset from any cause during a given period”.
•According to International Accounting Standards
Committee “Depreciation is the allocation of the
depreciable amount of an asset over its estimated
useful life. Depreciation for the accounting period is
charged to income either directly or indirectly”.
Causes of Depreciation
•Constant use:
•Obsolescence:
• Expiry of time or Lapse of time:
•Accident:
•Disuse:
•Depletion:
Needs for Depreciation
(i)Ascertainment of net profit or loss:
(ii) Presentation of true financial position:
(iii) Replacement of assets:
(iv) Restriction on distribution of dividend out of
capital:
(v) Reduction in income tax:
(vi)Ascertainment of true cost of production:
Basic factors affecting Depreciation
(i)Cost of the Asset:
(ii)Estimated life of the Asset:
(iii)Scrap value of an Asset:
(iv)Chance of obsolescence:
(v)Capital expenditure:
Methods of Providing Depreciation
1. Straight line Method or Original Cost Method
2. Diminishing balance Method or Written down value
Method
3. Annuity Method
4. Depreciation Fund or Sinking Fund Method
5. Insurance Policy Method
6. Machine Hour Rate Method
7. Depletion or Output Method
8. Revaluation Method
1. Straight Line Method: Under this method, amount of
depreciation is fixed and equal every year and is deducted
from the original cost of the asset as well as written off
from the Profit and Loss A/c. The amount of depreciation
is either ascertained at a fixed rate or is ascertained by
dividing the original cost less scrap value of the asset by
the estimated life(in years).In this method amount of
depreciation remain the same every year.
2. Diminishing Balance method: Under this method the rate
of depreciation is given in percentage and the
depreciation is charged on the opening balance of the
asset i.e. on its book value every year. Depreciation is
charged at a specific rate every year. This process goes on
till the end of life period of an asset.
3. Annuity Method: Under this method the amount of depreciation
this includes the cost of the asset and also the interest, is written off by
equal annual instalments over the life-time of the asset. At the end of
the life of the asset, its book value is reduced to zero or to its residual
value. The amount of depreciation can be ascertained by reference to
the annuity table. This method is best suited to those assets which
require considerable investment.
4. Sinking Fund method: This method besides providing
depreciation also accumulates sufficient amount for replacement of
the asset on the expiry of its useful life. These methods ensure that
when the replacement of the asset is due, ready funds are available.
Thus, under this method, the amount of depreciation is set aside and
invested outside the business along with the investments. Investment
are realized when the asset is to be replaced. The amount of
depreciation to be provided every year is calculated by making
reference to readily available Sinking Fund Table.
5. Insurance Policy Method: Under this method, an
insurance policy is taken for investing the amount of
depreciation. This policy will provide the required
amount for the replacement of an old asset at the
end of its life. The method and accounting entries
are similar to depreciation fund (Sinking Fund)
method except that no interest is received from
investment.
6. Machine Hour Rate method: In this method
depreciation is charged at an hourly rate for the
number of hours the machine worked/used during
the year. The method is used by those companies
which are highly mechanized and where the actual
working hours of the machine are noted and
observed.
7. Depletion Method: In the case of wasting assets
such as mines, quarries and oil wells etc.,
depreciation is charged on the basis of quantity of
output extracted. It means, depreciation represents
the cost of expired capital outlay in respect of
quantity of output extracted from the mines, etc.
8. Revaluation method: Under this method, the
asset is revalued at the at the end of each financial
year. The difference between the opening and
closing values of asset is treated as depreciation and
charged to the profit and loss account. This method
is suitable in case of losses tools livestock, packages,
crockery, sacks, etc
RESERVE
Reserve is the fund meant for meeting unknown
liability and losses in the future. Reserve mean the
amount set aside out of profit and other surpluses,
which are not earmarked in any way to meet any
particular liability, known to exist on the date of
Balance Sheet. The main objective to make the
reserve is to increase the working capital of business
and strengthen the financial position of the business.
If the reserves are invested outside the business,
then they are called as “Reserve Fund”.
Features of Reserve
• It is created out of net profit or divisible profit. Therefore,
reserves are also termed as Retained Earning or
Undistributed profits.
• Creation of reserves is not a legal necessity, it is created
voluntarily.
• Reserve is created for strengthening the financial position of
the business and for meeting an unanticipated situation in
the future.
• Reserve is created for unknown liabilities.
• When amount of Reserve is invested outside the business
it’s called as Reserve fund.
• Reserves belong to the proprietors, just as capital. So it’s
shown on the liabilities side of the Balance Sheet.
Importance of Reserve
1. Strengthening the financial position of the
business:
2. Helpful in meeting the unforeseen
liabilities or losses in future:
3. Equalization of dividends over the year
4. Reserve for specific purpose:
Types of Reserve
1. Revenue Reserves:These reserves are created out of profit which
has been earned by normal course of business operation. Therefore, the
revenue reserves represent undistributed profit and as such are available for
distribution of dividend. Revenue Reserves may be of the following two types:
(i)General Reserve: Usually the businessmen do not withdraw the entire
profits from business but retain a part of it in the business to meet the
unforeseen future uncertainties. Such reserves are also called as
“Contingency Reserves” or “Free Reserves” because these are not created for
any specific purpose and can be freely used for any purpose.
(ii)Specific Reserves: Such reserves are created for a specific purpose and
can be utilized only for that purpose. For example, Debenture Redemption
Reserve, Staff welfare Reserve, Asset Replacement Reserve etc.
2. Capital Reserves: In business there are various sources to
receive the capital profit. Capital reserves are that types of reserves which
are created out of capital profit. This amount is not available for
distribution of dividend to the shareholders. Sources of capital profit are
as follows:
• Profit on sale of fixed assets.
• Profit on revaluation of assets and liabilities.
• Profit on purchase of running business.
• Premium on issue of shares and debenture.
• Profit on reissue of forfeited of shares.
PROVISION
A provision is an amount set aside to meet a
future expense or loss whose occurrence or
exact amount is uncertain. A Provision means
‘any amount written off or retained by way of
providing for depreciation, renewal or
diminution in value of assets or retained by way
of providing for any known liability of which the
amount cannot be determined with substantial
accuracy’.
Features of Provision
•Provision is created to meet the known liability.
•The liability is known but the amount of such
liability cannot be determined with reasonable
accuracy. For example, it is almost certain that some
debts will prove irrecoverable but the exact amount
of bad debts cannot be predicted with certainty.
•Provision is a charge against profit and as such
reduces the profit of the year in which it is created.
The loss when actually occurs will be written off
against such provision and thus the profit of the
year in which such loss occurs will not be affected.
Importance of Provision
•To provide for known losses in the
future:
•For the equitable distribution of
expenses and losses:
•To ascertain the true net profit of the
business:
•To ascertain the true financial position
of the business:
Reserve vs provision
Reserves Provisions
1. It is created to meet an unknown
liability.
2. Creation of reserve is discretionary.
It can be created only it adequate profit
have been earned.
3. The object of reserve is to
strengthen the financial position of the
business.
4. It is created through Profit and Loss
Appropriation A/c. Therefore, it
reduces the divisible profit.
1. It is created to meet a Known liability.
2. Creation of provision is a legal
necessity. Provisions have to be provided
even if there are losses.
3. The object is to provide for
depreciation, doubtful debts and other
specific liabilities.
4. It is created through Profit and Loss
A/c; hence it reduces the net profit.
Reserve vs provision
Reserves Provisions
5. Reserve can be invested outside the
business
6. It is shown in the liabilities side.
Under the head “Reserves and Surplus.
7. It can be utilized for distribution of
dividend among share holders.
8. It is not created to provide for a
specific loss and hence can be used for
any purpose.
5. Provision never been invested outside
the business
6. It is either shown on the assets side by
way of deduction from the assets for
which it is created or as a distinct item
on the liabilities side.
7. It cannot be utilized for distribution of
dividend among share holders.
8. It is created to provide for a specific
loss and can only be used for meeting
that loss.

More Related Content

Similar to Depreciation, Reserve & Provisions - Dr.J.Mexon

caiib_fmmodbacs_nov08 module finance.ppt
caiib_fmmodbacs_nov08 module finance.pptcaiib_fmmodbacs_nov08 module finance.ppt
caiib_fmmodbacs_nov08 module finance.ppt
MajedAlshawafi1
 
Overview of Corporate Finance in India a presentation
Overview of Corporate Finance in India a presentationOverview of Corporate Finance in India a presentation
Overview of Corporate Finance in India a presentation
footydigarse
 
Management of working capital
Management of working capitalManagement of working capital
Management of working capital
Harsimran Kaur
 
IDBI Basic of MF & SBI Product
IDBI Basic of  MF &  SBI ProductIDBI Basic of  MF &  SBI Product
IDBI Basic of MF & SBI Product
Ranjeet Dwivedi
 
IDBI Basic of MF & SBI Product
IDBI Basic of  MF &  SBI ProductIDBI Basic of  MF &  SBI Product
IDBI Basic of MF & SBI Product
Aradhana Rai
 

Similar to Depreciation, Reserve & Provisions - Dr.J.Mexon (20)

Case study Accounting.docx
Case study Accounting.docxCase study Accounting.docx
Case study Accounting.docx
 
Financial management
Financial managementFinancial management
Financial management
 
Depreciation
DepreciationDepreciation
Depreciation
 
Financial management
Financial managementFinancial management
Financial management
 
Depreciation accounting
Depreciation accounting Depreciation accounting
Depreciation accounting
 
PPT2.pptx
PPT2.pptxPPT2.pptx
PPT2.pptx
 
caiib_fmmodbacs_nov08 module finance.ppt
caiib_fmmodbacs_nov08 module finance.pptcaiib_fmmodbacs_nov08 module finance.ppt
caiib_fmmodbacs_nov08 module finance.ppt
 
1 Financial in Operations Management.pptx
1 Financial in  Operations Management.pptx1 Financial in  Operations Management.pptx
1 Financial in Operations Management.pptx
 
Overview of Corporate Finance in India a presentation
Overview of Corporate Finance in India a presentationOverview of Corporate Finance in India a presentation
Overview of Corporate Finance in India a presentation
 
Management of working capital
Management of working capitalManagement of working capital
Management of working capital
 
IDBI Basic of MF & SBI Product
IDBI Basic of  MF &  SBI ProductIDBI Basic of  MF &  SBI Product
IDBI Basic of MF & SBI Product
 
IDBI Basic of MF & SBI Product
IDBI Basic of  MF &  SBI ProductIDBI Basic of  MF &  SBI Product
IDBI Basic of MF & SBI Product
 
working capital management
working capital managementworking capital management
working capital management
 
Investment decisions
Investment decisionsInvestment decisions
Investment decisions
 
Accounting chapter-10
Accounting chapter-10Accounting chapter-10
Accounting chapter-10
 
Project engg ppt
Project engg pptProject engg ppt
Project engg ppt
 
Zuvari cements working capital management
Zuvari  cements  working capital managementZuvari  cements  working capital management
Zuvari cements working capital management
 
Fm
FmFm
Fm
 
Financial management
Financial managementFinancial management
Financial management
 
Financial Appraisal
Financial AppraisalFinancial Appraisal
Financial Appraisal
 

More from Dr. J.Mexon Fernando

More from Dr. J.Mexon Fernando (19)

Ratio Analysis- Dr.J.Mexon
Ratio Analysis- Dr.J.MexonRatio Analysis- Dr.J.Mexon
Ratio Analysis- Dr.J.Mexon
 
Introduction to International Finance - Dr. J. Mexon
Introduction to International Finance - Dr. J. MexonIntroduction to International Finance - Dr. J. Mexon
Introduction to International Finance - Dr. J. Mexon
 
Introduction to Management Accounting- Dr. J.Mexon
Introduction to Management Accounting- Dr. J.MexonIntroduction to Management Accounting- Dr. J.Mexon
Introduction to Management Accounting- Dr. J.Mexon
 
Performance Appraisal - Dr. J.Mexon
Performance Appraisal -  Dr. J.MexonPerformance Appraisal -  Dr. J.Mexon
Performance Appraisal - Dr. J.Mexon
 
Training and Development - J.Mexon
Training and Development - J.MexonTraining and Development - J.Mexon
Training and Development - J.Mexon
 
Recruitment and Selection - Dr.J.Mexon
Recruitment and Selection - Dr.J.MexonRecruitment and Selection - Dr.J.Mexon
Recruitment and Selection - Dr.J.Mexon
 
Human Resurce Planning - Dr.J.Mexon
Human Resurce Planning - Dr.J.MexonHuman Resurce Planning - Dr.J.Mexon
Human Resurce Planning - Dr.J.Mexon
 
Introduction to HRM - Dr.J.Mexon
Introduction to HRM - Dr.J.MexonIntroduction to HRM - Dr.J.Mexon
Introduction to HRM - Dr.J.Mexon
 
Final Accounts
Final AccountsFinal Accounts
Final Accounts
 
Subsidiary Book
Subsidiary BookSubsidiary Book
Subsidiary Book
 
General Insurance
General InsuranceGeneral Insurance
General Insurance
 
Book Keeping
Book KeepingBook Keeping
Book Keeping
 
Claim Management
Claim ManagementClaim Management
Claim Management
 
Life Insurance
Life InsuranceLife Insurance
Life Insurance
 
Introduction to Accounting - Dr. J. Mexon
Introduction to Accounting - Dr. J. MexonIntroduction to Accounting - Dr. J. Mexon
Introduction to Accounting - Dr. J. Mexon
 
Introduction to Cost Accounting - Dr.J.Mexon
Introduction to Cost Accounting - Dr.J.MexonIntroduction to Cost Accounting - Dr.J.Mexon
Introduction to Cost Accounting - Dr.J.Mexon
 
Material Cost and Labour Cost PPT - Dr.J.Mexon
Material Cost and Labour Cost PPT - Dr.J.MexonMaterial Cost and Labour Cost PPT - Dr.J.Mexon
Material Cost and Labour Cost PPT - Dr.J.Mexon
 
Insurance Industry PPT - Dr.J.Mexon
Insurance Industry PPT - Dr.J.MexonInsurance Industry PPT - Dr.J.Mexon
Insurance Industry PPT - Dr.J.Mexon
 
Risk Management - Dr.J.Mexon
Risk Management - Dr.J.MexonRisk Management - Dr.J.Mexon
Risk Management - Dr.J.Mexon
 

Recently uploaded

Recently uploaded (20)

TỔNG HỢP HƠN 100 ĐỀ THI THỬ TỐT NGHIỆP THPT VẬT LÝ 2024 - TỪ CÁC TRƯỜNG, TRƯ...
TỔNG HỢP HƠN 100 ĐỀ THI THỬ TỐT NGHIỆP THPT VẬT LÝ 2024 - TỪ CÁC TRƯỜNG, TRƯ...TỔNG HỢP HƠN 100 ĐỀ THI THỬ TỐT NGHIỆP THPT VẬT LÝ 2024 - TỪ CÁC TRƯỜNG, TRƯ...
TỔNG HỢP HƠN 100 ĐỀ THI THỬ TỐT NGHIỆP THPT VẬT LÝ 2024 - TỪ CÁC TRƯỜNG, TRƯ...
 
How to Manage Closest Location in Odoo 17 Inventory
How to Manage Closest Location in Odoo 17 InventoryHow to Manage Closest Location in Odoo 17 Inventory
How to Manage Closest Location in Odoo 17 Inventory
 
MichaelStarkes_UncutGemsProjectSummary.pdf
MichaelStarkes_UncutGemsProjectSummary.pdfMichaelStarkes_UncutGemsProjectSummary.pdf
MichaelStarkes_UncutGemsProjectSummary.pdf
 
Word Stress rules esl .pptx
Word Stress rules esl               .pptxWord Stress rules esl               .pptx
Word Stress rules esl .pptx
 
Capitol Tech Univ Doctoral Presentation -May 2024
Capitol Tech Univ Doctoral Presentation -May 2024Capitol Tech Univ Doctoral Presentation -May 2024
Capitol Tech Univ Doctoral Presentation -May 2024
 
Discover the Dark Web .pdf InfosecTrain
Discover the Dark Web .pdf  InfosecTrainDiscover the Dark Web .pdf  InfosecTrain
Discover the Dark Web .pdf InfosecTrain
 
Dementia (Alzheimer & vasular dementia).
Dementia (Alzheimer & vasular dementia).Dementia (Alzheimer & vasular dementia).
Dementia (Alzheimer & vasular dementia).
 
Removal Strategy _ FEFO _ Working with Perishable Products in Odoo 17
Removal Strategy _ FEFO _ Working with Perishable Products in Odoo 17Removal Strategy _ FEFO _ Working with Perishable Products in Odoo 17
Removal Strategy _ FEFO _ Working with Perishable Products in Odoo 17
 
Exploring Gemini AI and Integration with MuleSoft | MuleSoft Mysore Meetup #45
Exploring Gemini AI and Integration with MuleSoft | MuleSoft Mysore Meetup #45Exploring Gemini AI and Integration with MuleSoft | MuleSoft Mysore Meetup #45
Exploring Gemini AI and Integration with MuleSoft | MuleSoft Mysore Meetup #45
 
2024_Student Session 2_ Set Plan Preparation.pptx
2024_Student Session 2_ Set Plan Preparation.pptx2024_Student Session 2_ Set Plan Preparation.pptx
2024_Student Session 2_ Set Plan Preparation.pptx
 
philosophy and it's principles based on the life
philosophy and it's principles based on the lifephilosophy and it's principles based on the life
philosophy and it's principles based on the life
 
The Ball Poem- John Berryman_20240518_001617_0000.pptx
The Ball Poem- John Berryman_20240518_001617_0000.pptxThe Ball Poem- John Berryman_20240518_001617_0000.pptx
The Ball Poem- John Berryman_20240518_001617_0000.pptx
 
Essential Safety precautions during monsoon season
Essential Safety precautions during monsoon seasonEssential Safety precautions during monsoon season
Essential Safety precautions during monsoon season
 
How to Analyse Profit of a Sales Order in Odoo 17
How to Analyse Profit of a Sales Order in Odoo 17How to Analyse Profit of a Sales Order in Odoo 17
How to Analyse Profit of a Sales Order in Odoo 17
 
slides CapTechTalks Webinar May 2024 Alexander Perry.pptx
slides CapTechTalks Webinar May 2024 Alexander Perry.pptxslides CapTechTalks Webinar May 2024 Alexander Perry.pptx
slides CapTechTalks Webinar May 2024 Alexander Perry.pptx
 
Open Educational Resources Primer PowerPoint
Open Educational Resources Primer PowerPointOpen Educational Resources Primer PowerPoint
Open Educational Resources Primer PowerPoint
 
Basic Civil Engineering notes on Transportation Engineering, Modes of Transpo...
Basic Civil Engineering notes on Transportation Engineering, Modes of Transpo...Basic Civil Engineering notes on Transportation Engineering, Modes of Transpo...
Basic Civil Engineering notes on Transportation Engineering, Modes of Transpo...
 
An Overview of the Odoo 17 Discuss App.pptx
An Overview of the Odoo 17 Discuss App.pptxAn Overview of the Odoo 17 Discuss App.pptx
An Overview of the Odoo 17 Discuss App.pptx
 
Navigating the Misinformation Minefield: The Role of Higher Education in the ...
Navigating the Misinformation Minefield: The Role of Higher Education in the ...Navigating the Misinformation Minefield: The Role of Higher Education in the ...
Navigating the Misinformation Minefield: The Role of Higher Education in the ...
 
Incoming and Outgoing Shipments in 2 STEPS Using Odoo 17
Incoming and Outgoing Shipments in 2 STEPS Using Odoo 17Incoming and Outgoing Shipments in 2 STEPS Using Odoo 17
Incoming and Outgoing Shipments in 2 STEPS Using Odoo 17
 

Depreciation, Reserve & Provisions - Dr.J.Mexon

  • 1. FINANCIAL ACCOUNTING 551/552 AC 46 Unit 1 Dr. J. Mexon P. Rayan
  • 2. Depreciation Depreciation is the process of spreading the cost of fixed assets over the different periods which derive the benefit from their use. Depreciation is a permanent decline in the value of an asset. The gradual decrease, both in the value and usefulness, of an asset due to its nature and usage is termed as depreciation. It is common experience that whenever an asset is used it reduce in value. The net result of depreciation is that sooner or later, the asset becomes useless. So, it can be stated that depreciation is that portion of the cost of an asset which is reduced from revenues for the services of the asset in the operation of a business.
  • 3. Definitions •According to spicer and pegler “Depreciation is the measure of the exhaustion of the effective life of an asset from any cause during a given period”. •According to International Accounting Standards Committee “Depreciation is the allocation of the depreciable amount of an asset over its estimated useful life. Depreciation for the accounting period is charged to income either directly or indirectly”.
  • 4. Causes of Depreciation •Constant use: •Obsolescence: • Expiry of time or Lapse of time: •Accident: •Disuse: •Depletion:
  • 5. Needs for Depreciation (i)Ascertainment of net profit or loss: (ii) Presentation of true financial position: (iii) Replacement of assets: (iv) Restriction on distribution of dividend out of capital: (v) Reduction in income tax: (vi)Ascertainment of true cost of production:
  • 6. Basic factors affecting Depreciation (i)Cost of the Asset: (ii)Estimated life of the Asset: (iii)Scrap value of an Asset: (iv)Chance of obsolescence: (v)Capital expenditure:
  • 7. Methods of Providing Depreciation 1. Straight line Method or Original Cost Method 2. Diminishing balance Method or Written down value Method 3. Annuity Method 4. Depreciation Fund or Sinking Fund Method 5. Insurance Policy Method 6. Machine Hour Rate Method 7. Depletion or Output Method 8. Revaluation Method
  • 8. 1. Straight Line Method: Under this method, amount of depreciation is fixed and equal every year and is deducted from the original cost of the asset as well as written off from the Profit and Loss A/c. The amount of depreciation is either ascertained at a fixed rate or is ascertained by dividing the original cost less scrap value of the asset by the estimated life(in years).In this method amount of depreciation remain the same every year. 2. Diminishing Balance method: Under this method the rate of depreciation is given in percentage and the depreciation is charged on the opening balance of the asset i.e. on its book value every year. Depreciation is charged at a specific rate every year. This process goes on till the end of life period of an asset.
  • 9. 3. Annuity Method: Under this method the amount of depreciation this includes the cost of the asset and also the interest, is written off by equal annual instalments over the life-time of the asset. At the end of the life of the asset, its book value is reduced to zero or to its residual value. The amount of depreciation can be ascertained by reference to the annuity table. This method is best suited to those assets which require considerable investment. 4. Sinking Fund method: This method besides providing depreciation also accumulates sufficient amount for replacement of the asset on the expiry of its useful life. These methods ensure that when the replacement of the asset is due, ready funds are available. Thus, under this method, the amount of depreciation is set aside and invested outside the business along with the investments. Investment are realized when the asset is to be replaced. The amount of depreciation to be provided every year is calculated by making reference to readily available Sinking Fund Table.
  • 10. 5. Insurance Policy Method: Under this method, an insurance policy is taken for investing the amount of depreciation. This policy will provide the required amount for the replacement of an old asset at the end of its life. The method and accounting entries are similar to depreciation fund (Sinking Fund) method except that no interest is received from investment. 6. Machine Hour Rate method: In this method depreciation is charged at an hourly rate for the number of hours the machine worked/used during the year. The method is used by those companies which are highly mechanized and where the actual working hours of the machine are noted and observed.
  • 11. 7. Depletion Method: In the case of wasting assets such as mines, quarries and oil wells etc., depreciation is charged on the basis of quantity of output extracted. It means, depreciation represents the cost of expired capital outlay in respect of quantity of output extracted from the mines, etc. 8. Revaluation method: Under this method, the asset is revalued at the at the end of each financial year. The difference between the opening and closing values of asset is treated as depreciation and charged to the profit and loss account. This method is suitable in case of losses tools livestock, packages, crockery, sacks, etc
  • 12. RESERVE Reserve is the fund meant for meeting unknown liability and losses in the future. Reserve mean the amount set aside out of profit and other surpluses, which are not earmarked in any way to meet any particular liability, known to exist on the date of Balance Sheet. The main objective to make the reserve is to increase the working capital of business and strengthen the financial position of the business. If the reserves are invested outside the business, then they are called as “Reserve Fund”.
  • 13. Features of Reserve • It is created out of net profit or divisible profit. Therefore, reserves are also termed as Retained Earning or Undistributed profits. • Creation of reserves is not a legal necessity, it is created voluntarily. • Reserve is created for strengthening the financial position of the business and for meeting an unanticipated situation in the future. • Reserve is created for unknown liabilities. • When amount of Reserve is invested outside the business it’s called as Reserve fund. • Reserves belong to the proprietors, just as capital. So it’s shown on the liabilities side of the Balance Sheet.
  • 14. Importance of Reserve 1. Strengthening the financial position of the business: 2. Helpful in meeting the unforeseen liabilities or losses in future: 3. Equalization of dividends over the year 4. Reserve for specific purpose:
  • 15. Types of Reserve 1. Revenue Reserves:These reserves are created out of profit which has been earned by normal course of business operation. Therefore, the revenue reserves represent undistributed profit and as such are available for distribution of dividend. Revenue Reserves may be of the following two types: (i)General Reserve: Usually the businessmen do not withdraw the entire profits from business but retain a part of it in the business to meet the unforeseen future uncertainties. Such reserves are also called as “Contingency Reserves” or “Free Reserves” because these are not created for any specific purpose and can be freely used for any purpose. (ii)Specific Reserves: Such reserves are created for a specific purpose and can be utilized only for that purpose. For example, Debenture Redemption Reserve, Staff welfare Reserve, Asset Replacement Reserve etc.
  • 16. 2. Capital Reserves: In business there are various sources to receive the capital profit. Capital reserves are that types of reserves which are created out of capital profit. This amount is not available for distribution of dividend to the shareholders. Sources of capital profit are as follows: • Profit on sale of fixed assets. • Profit on revaluation of assets and liabilities. • Profit on purchase of running business. • Premium on issue of shares and debenture. • Profit on reissue of forfeited of shares.
  • 17. PROVISION A provision is an amount set aside to meet a future expense or loss whose occurrence or exact amount is uncertain. A Provision means ‘any amount written off or retained by way of providing for depreciation, renewal or diminution in value of assets or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy’.
  • 18. Features of Provision •Provision is created to meet the known liability. •The liability is known but the amount of such liability cannot be determined with reasonable accuracy. For example, it is almost certain that some debts will prove irrecoverable but the exact amount of bad debts cannot be predicted with certainty. •Provision is a charge against profit and as such reduces the profit of the year in which it is created. The loss when actually occurs will be written off against such provision and thus the profit of the year in which such loss occurs will not be affected.
  • 19. Importance of Provision •To provide for known losses in the future: •For the equitable distribution of expenses and losses: •To ascertain the true net profit of the business: •To ascertain the true financial position of the business:
  • 20. Reserve vs provision Reserves Provisions 1. It is created to meet an unknown liability. 2. Creation of reserve is discretionary. It can be created only it adequate profit have been earned. 3. The object of reserve is to strengthen the financial position of the business. 4. It is created through Profit and Loss Appropriation A/c. Therefore, it reduces the divisible profit. 1. It is created to meet a Known liability. 2. Creation of provision is a legal necessity. Provisions have to be provided even if there are losses. 3. The object is to provide for depreciation, doubtful debts and other specific liabilities. 4. It is created through Profit and Loss A/c; hence it reduces the net profit.
  • 21. Reserve vs provision Reserves Provisions 5. Reserve can be invested outside the business 6. It is shown in the liabilities side. Under the head “Reserves and Surplus. 7. It can be utilized for distribution of dividend among share holders. 8. It is not created to provide for a specific loss and hence can be used for any purpose. 5. Provision never been invested outside the business 6. It is either shown on the assets side by way of deduction from the assets for which it is created or as a distinct item on the liabilities side. 7. It cannot be utilized for distribution of dividend among share holders. 8. It is created to provide for a specific loss and can only be used for meeting that loss.