In accounting context, which one of the following statements is correct ?

Correct — D, (d) 'Provision' is a charge against profit. This is the one statement of the four that states the position correctly, and the distinction it rests on — charge against profit versus appropriation of profit — is the organising idea of the whole item.

A CHARGE AGAINST PROFIT is an amount that must be deducted in arriving at profit. It is debited to the profit and loss account, it is made whether or not there are profits, and the business has no discretion about it. A PROVISION is exactly that: an amount written off or retained by way of providing for depreciation, renewals or diminution in the value of assets, or retained to provide for a known liability whose amount cannot be determined with substantial accuracy. Provision for depreciation, provision for doubtful debts, provision for taxation, provision for repairs — each is made because the loss or liability already exists, even if its amount is estimated, and each must be made in a loss year as much as in a profitable one.

An APPROPRIATION OF PROFIT is a distribution of profit that has already been arrived at. It is debited to the profit and loss appropriation account, it can only be made out of profits, and it is a matter of management discretion. A RESERVE is that: an amount set aside out of profits and other surpluses to strengthen the financial position or to meet a future need. General reserve, dividend equalisation reserve, debenture redemption reserve and the transfer of a portion of profit to reserves are all appropriations.

The two definitions decide the item. Statement (d) puts a provision on the correct side of the line. Statements (a), (b) and (c) each put a reserve on the wrong side of some line — the charge-appropriation line in (a), the capital-revenue-profit line in (b), and the free-earmarked line in (c). Note the paper's own care with the words: option (a) says 'profits' plural and option (d) 'profit' singular in the same phrase 'a charge against …', exactly as printed.

Why the others are wrong

• (a)Reserve created is a charge against profits. — This reverses the very distinction the correct option turns on. A reserve is an APPROPRIATION of profit, not a charge against it. It is debited to the profit and loss appropriation account after profit has been ascertained, it can be created only when there are profits available, and its creation is discretionary. That is why a reserve is shown under shareholders' funds in the balance sheet — it is retained profit belonging to the owners — while a provision reduces an asset or sits among liabilities. Two practical consequences flow from the distinction: a provision must be made even in a year of loss, whereas a reserve need not and generally cannot; and a provision is created for a known liability or an existing diminution in value, whereas a reserve is created for a contingency or for general strengthening.
• (b)Capital reserves are normally created out of distributable profits. — This misstates the source from which a capital reserve is created. A capital reserve is created out of CAPITAL PROFITS — profit on the sale of a fixed asset, profit on the reissue of forfeited shares, securities premium, profit prior to incorporation, profit on the redemption of debentures, surplus on the revaluation of assets — and not out of distributable or revenue profits. The point of the distinction is what may be done with the money: a capital reserve is not generally available for distribution as dividend, whereas a revenue reserve created out of trading profits is. Saying that capital reserves come out of distributable profits collapses the two categories and would make the label meaningless. Note the neighbouring term a candidate should not confuse with it: capital REDEMPTION reserve, which is a statutory reserve created when a company buys back or redeems shares out of profits.
• (c)General reserve can be used only for some specific purposes. — This describes a SPECIFIC reserve, not a general one. A general reserve is a free reserve: it is created out of trading profits without being earmarked for any particular purpose, and it is available for any purpose the management chooses — meeting an unforeseen loss, strengthening the working-capital position, financing expansion, or equalising dividends in a lean year. A reserve tied to a stated purpose is a specific reserve, and dividend equalisation reserve, debenture redemption reserve and workmen's compensation reserve are the standard examples. So the statement has the two kinds the wrong way round: it is the specific reserve that may be used only for its stated purpose, while the general reserve's defining feature is precisely that it is not so restricted.

Two lines organise everything in this item. The first is the line between a CHARGE against profit and an APPROPRIATION of profit. A charge is compulsory, is debited to the profit and loss account, and is made whether or not there are profits; depreciation, provision for doubtful debts, provision for taxation and interest on loans are charges. An appropriation is discretionary, is debited to the profit and loss appropriation account, and can only be made out of profits; transfers to general reserve, dividends, and transfers to specific reserves are appropriations. The second line runs inside the world of reserves. A REVENUE reserve is created out of trading profits and is available for distribution as dividend; a CAPITAL reserve is created out of capital profits — profit on sale of a fixed asset, securities premium, profit on reissue of forfeited shares, profit prior to incorporation — and is not ordinarily distributable. Within revenue reserves, a GENERAL reserve is free and unearmarked while a SPECIFIC reserve is tied to a named purpose. Sitting apart from both is the SECRET reserve, which does not appear in the balance sheet at all, being created by understating assets or overstating liabilities; it is generally impermissible for companies because it defeats the true and fair view. The vocabulary is worth fixing exactly, because a provision that turns out to exceed the liability it was made for is transferred to the profit and loss account or, in effect, becomes a reserve — the two categories are separated by their purpose and their compulsion, not by the size of the sum.

Key facts

• A provision is an amount written off or retained to provide for depreciation, renewals or diminution in the value of assets, or retained to provide for a known liability whose amount cannot be determined with substantial accuracy.
• A provision is a CHARGE against profit — debited to the profit and loss account, compulsory, and made even in a year of loss.
• A reserve is an APPROPRIATION of profit — debited to the profit and loss appropriation account, discretionary, and possible only where profits exist.
• A capital reserve is created out of capital profits such as profit on sale of a fixed asset, securities premium, profit on reissue of forfeited shares and profit prior to incorporation, and is not ordinarily available for dividend.
• A revenue reserve is created out of trading profits and is available for distribution as dividend.
• A general reserve is a free reserve, not earmarked for any particular purpose; a specific reserve is tied to a named purpose, such as dividend equalisation or debenture redemption.
• Reserves appear under shareholders' funds in the balance sheet; provisions reduce the related asset or appear among liabilities.
• A secret reserve is one not disclosed in the balance sheet, created by understating assets or overstating liabilities, and is generally impermissible because it defeats the true and fair view.

Common traps

• Reversing charge and appropriation. A provision is a charge; a reserve is an appropriation.
• Creating a capital reserve out of trading profits. Capital reserves come from capital profits.
• Reading 'general reserve' as earmarked. It is the free reserve; the earmarked one is a specific reserve.
• Assuming a provision may be skipped in a loss year. It is compulsory whether or not there are profits.

• practice — not a real PYQ

  Which one of the following is a charge against profit rather than an appropriation of profit ?

  • (a)Transfer to general reserve
  • (b)Provision for doubtful debts
  • (c)Proposed dividend
  • (d)Transfer to dividend equalisation reserve

  Answer(b) Provision for doubtful debts

• practice — not a real PYQ

  A capital reserve is created out of :

  • (a)Trading profits of the current year
  • (b)Profits available for distribution as dividend
  • (c)Capital profits such as profit on sale of a fixed asset or securities premium
  • (d)Any reserve on which the directors place no restriction

  Answer(c) Capital profits such as profit on sale of a fixed asset or securities premium