Reserves & Provisions: Accounting Treatments & Auditing Procedures
Reserves & Provisions: Accounting Treatments & Auditing Procedures
Reserves & Provisions: Accounting Treatments & Auditing Procedures
PROVISIONS
Accounting treatments & Auditing
procedures
Reserves &
Provisions
(1/19)
Contents
A.
Definition of reserves.................................................................................... 3
B.
Definition of provisions..................................................................................3
C.
Measurement of provisions...........................................................................4
D.
Use of provisions............................................................................................ 5
E.
Disclosure of provisions................................................................................ 5
F.
G.
H.
Classification of reserves.............................................................................. 9
I.
J.
K.
L.
Capitalization of reserves...........................................................................11
M.
N.
O.
P.
Reserve fund................................................................................................. 14
Q.
Sinkingfund................................................................................................... 14
R.
S.
T.
U.
V.
Specific reserves.......................................................................................... 18
W.
X.
References.................................................................................................... 20
(2/19)
(3/19)
A.
Definition of reserves
Reserves are amounts appropriated out of profits, which are not intended to
meet any liability, contingency, commitment or diminution in the value of
assets known to exist at the date of the balance sheet or retained by way of
providing for any known liability.
(Clause 1(x) of Part 1 of the 5thSchedule to CO, 1984.)
Another definition given by the AICPA is, the use of the term reserve is
limited to indicate that an undivided portion of the asset is being held or
retained for general or specific purpose.
Reserves refer to retained profits or surpluses. In a not-for-profit entity,
these are described as accumulated funds. Reserves may be distributable
(revenue reserves) or non-distributable (capital reserves).
(Cima Official Terminology)
Amounts set aside from profits in company accounts for an unspecified
purpose. Reserves are part of retained earnings i.e. undistributed profits and
belong to the ordinary shareholders of the company.
(International Dictionary of Finance by Graham Bannock & William Manser)
B.
Definition of provisions
Provisions refer to liabilities of uncertain timing or amount. A provision should
be recognized when and only when:
an enterprise has present obligation (legal or constructive) as a result of
past event;
it is probable (i.e. more likely than not) that an outflow of resources
embodying economic benefits will be required to settle the obligation; and
a reliable estimate can be made of the amount of the obligation.
(Source: IAS 37para 10 and 14)
Provisions are amounts charged against revenue to provide for the following:
Depreciation, renewals or diminution in the value of assets
A known liability, the amount whereof cannot be determined with
substantial accuracy
A claim, which is disputed
A possible obligation (a contingent liability) is disclosed but not accrued.
However, disclosure is not required if payment is remote. [IAS 37.86]
(4/19)
In rare cases, for example in a lawsuit, it may not be clear whether an entity
has a present obligation. In those cases, a past event is deemed to give rise
to a present obligation if, taking account of all available evidence, it ismore
likely than not that a present obligation exists at the balance sheet date. A
provision should be recognized for that present obligation if the other
recognition criteria described above are met. If it is more likely than not that
no present obligation exists, the entity should disclose a contingent liability,
unless the possibility of an outflow of resources is remote. [IAS 37.15]
C.
Measurement of provisions
The amount recognized as a provision should be the best estimate of the expenditure
required to settle the present obligation at the balance sheet date, that is, the amount
that an entity would rationally pay to settle the obligation at the balance sheet date or to
transfer it to a third party. [IAS 37.36]
This means:
Provisions for one-off events
discounted present value using a pre-tax discount rate that reflects the current
market assessments of the time value of money and the risks specific to the
liability. [IAS 37.45 and 37.47]
In reaching its best estimate, the entity should take into account the risks and
uncertainties that surround the underlying events. [IAS 37.42]
If some or all of the expenditure required to settle a provision is expected to be
reimbursed by another party, the reimbursement should be recognized as a separate
(5/19)
asset, and not as a reduction of the required provision, when, and only when, it is
virtually certain that reimbursement will be received if the entity settles the obligation.
The amount recognized should not exceed the amount of the provision. [IAS 37.53]
(6/19)
D.
Use of provisions
Provisions should only be used for the purpose for which they were originally
recognized. They should be reviewed at each statement of financial position date and
adjusted to reflect the current best estimate. If it is no longer probable that an outflow of
resources will be required to settle the obligation, the provision should be reversed. [IAS
37.61]
E.
Disclosure of provisions
Reconciliation for each class of provision: [IAS 37.84]
Opening balance
Additions
Used (amounts charged against the provision)
Unused amounts reversed
Unwinding of the discount, or changes in discount rate
Closing balance
F.
This area of work therefore requires the close attention of the manager and audit
partner.
The method used to verify each provision made in the accounts varies considerably,
depending on the nature of the provision. Both understatement and overstatement must
be considered. For each provision or group of provisions, an auditor should carry out
the following steps:
1. Prepare or obtain a schedule showing opening and closing balances
2.
3.
Review, with supporting evidence, the adequacy of the closing provision and
consider whether it is, in fact, necessary
4.
5.
6.
Assess the competence of the personnel responsible for calculating the closing
balance of all provisions under audit.
7.
8.
9.
Audit files
Client correspondence
Reviews of minutes of meetings
Discussions with management
G.
Provisions
(9/19)
H.
Classification of reserves
1. Revenue reserves
2. Capital reserves
Definition of revenue reserve
Revenue reserve means a reserve that is normally regarded as available for distribution
through the profit and loss account, including general reserves and other specific
reserves created out of profit and un-appropriated profit i.e. credit balance of
statement of comprehensive income after appropriation for the period to the date of
statement of financial position.
(Clause 2(v) of Part 1 of 4th Schedule to the CO, 1984.)
It represents profits that are available for distribution to shareholders held for the time
being for any one or more purposes for example supplement divisible profits in lean
years, to finance an extension of business, or to generally strengthen the financial
position of the company.
A revenue reserve shall include:
General reserve
Dividend equalization reserve
Other reserves created out of profit
Un-appropriated profits/ retained earnings
I.
(10/19)
J.
(11/19)
K.
L.
Capitalization of reserves
Capitalization of reserves must not be confused with capital reserves. It is a different
concept.
Capitalization of reserves is the process of retaining any capital or revenue reserve
permanently by issuing bonus shares.
It is one of the methods of internal financing for the growth and expansion of the
business and is popularly known as the ploughing back of the profits.
(12/19)
M.
Capital reserves
Capitalization of reserves
2. Capitalization of reserve
increases the amount of
companys capital.
3. Capitalization of reserve is
possible only out of some
specific reserves.
(13/19)
N.
O.
Reserve fund
If amounts equal to a reserve are invested in outside securities, the reserve will be
named as reserve fund. If there are no specific investments, it cannot be called a
reserve fund but merely a reserve.
Reserves can be retained in the business as a part of working capital or invested
outside the company in marketable securities.
Fund in relation to any reserve, shall be used only where such a reserve is represented
by specifically earmarked investments or other assets realizable at not less than the
amount of the reserve.
(Clause 1(v) of Part 1 of 5th Schedule to CO, 1984.)
The term reserve fund is used to describe a reserve only when the amount of reserve is
invested outside the business of the company and it is represented by readily realizable
assets. It means that it has a separate legal existence. Board of trustees takes care of
such funds. Their income is separately reported in the separate accounts which are
audited separately and reported to the said board.
The auditor should see that the reserve fund has been distinctly shown in the statement
of financial position and the fund is represented by readily realizable assets.
Q.
Sinking fund
A sinking fund is a specific type of fund which is created for the redemption of a longterm debt or for the replacement of an asset in future. This fund is created by the
regular investment of an amount, which will accumulate along with the compound
interest earned thereon to make available a certain amount of money at the end ofa
stated period.
(15/19)
R.
S.
T.
liabilities are overstated. When the secret reserves exist, the financial position of the
company is better than what appears.
They are the reserves which are not shown on the face of statement of financial
position. Obviously, if secret reserves are created then a statement of financial
position cannot reveal the true and fair view of the companys statement of financial
position. And, therefore, can be subject of audit objection, if noted. The actual financial
position of the company can be better than what is revealed on the face of statement of
financial position.
Following are the few ways by which secret reserves are created:
1. Charging capital expenditure as revenue expenditure.
2. Providing for excessive/more depreciation on fixed assets.
3. Making excessive provision for bad and doubtful debts.
4. Writing down the goodwill to a nominal value.
5. Under-valuation of stock-in-trade.
6. Omitting some assets from the face of the statement of financial
position.
7. Showing contingent liabilities as real/actual liabilities.
8. Showing fictitious liabilities or over-valuation of the liabilities.
9. Making an excessive provision for contingencies or by continuing to carry forward
provisions when they are not required.
10. Ignoring the permanent appreciation in the value of assets.
11. Suppression of sales.
12. Inflating purchases.
13. Using the last-in, first-out inventory method in periods of rising price levels.
14. Showing an asset as a contingent asset.
15. Crediting revenue receipts to an asset e.g. Rent received credited to
Building Account.
(17/19)
(18/19)
U.
(19/19)
V.
Specific reserves
These are the reserves created for some definite purpose to be served in future out of
profits of the company. The purpose of creating reserves can be pre-defined in Articles
or by the decision of the Board. Also some of the specific reserves may be required to
be created under contractual obligations or legal compulsion. An example of the former
would be the fund for redemption of debentures and the example of the latter would be
the development rebate reserve, which is compulsory to be created, if the advantages
of the development rebate are to be enjoyed from income tax liability. Such reserves
take on the character of capital reserves.
Following are some of the purposes of creating such reserves:
1. Debenture redemption reserve:
2. Capital redemption reserve:
for redemption of preference shares
3. Dividend equalization reserve:
to enable the company to pay dividend at a stable rate in different years
irrespective of the amount of profit earned
4. Foreign project reserve
5. Staff welfare reserve fund: Workers Profit Participation Fund (WPPF)
W.
(20/19)
(21/19)
X.
References
1.
2.
3.
4.
5.
The End.
(22/19)