EPFO APFC 2023 General Studies · Question 44 of 120

Correct — D, (d) ‘Provision’ is a charge against profit. A provision is an amount set aside for depreciation, for a diminution in the value of an asset, or for a liability that is known to exist but whose amount cannot be determined with substantial accuracy. Because the loss or the obligation already exists, the amount must be brought into the accounts before the profit for the year is arrived at — it is deducted in the profit and loss account, not out of the profit once found. That is what the phrase charge against profit means, and the sharpest test of it is what happens in a bad year. Depreciation on the machinery, the provision for doubtful debts, the provision for taxation and the provision for repairs are all created whether the business earned anything or not; a provision made in a year of loss simply enlarges the loss. An appropriation of profit — a transfer to the general reserve, a dividend, a transfer to a sinking fund out of profits — can only be made if a profit exists to appropriate, and it is shown below the line, in the profit and loss appropriation account. Everything else follows from that single distinction. A provision is not part of the shareholders' funds and cannot be distributed as dividend; a free reserve can. A provision for a diminution in the value of an asset is presented as a deduction from that asset, and a provision for a liability as a liability; a reserve sits under reserves and surplus. An excess provision is written back to the profit and loss account when the need for it disappears. And a provision must be made even when it hurts, because prudence requires that all known liabilities and losses be provided for while profits are not anticipated. AS-29, Provisions, Contingent Liabilities and Contingent Assets, states the accounting definition in the same spirit: a provision is a liability which can be measured only by using a substantial degree of estimation. The estimation is what distinguishes it from an ordinary creditor; the certainty that the obligation exists is what distinguishes it from a contingent liability, which is disclosed but not provided for.

• (a)Capital reserves are normally created out of free or distributable profits. — This reverses the definition. A capital reserve is created out of capital profits — gains that do not arise from the ordinary trading operations of the business. The standard sources are the premium on the issue of shares or debentures, the profit made prior to incorporation, the profit on the reissue of forfeited shares, the profit on the redemption of debentures, the surplus on a revaluation of assets, and the profit on the sale of a fixed asset. Free or distributable profits — the profits earned by trading — are the source of revenue reserves, of which the general reserve is the leading example. The consequence of the distinction is practical rather than academic: a capital reserve is not normally available for distribution as dividend, and the Companies Act, 2013 defines free reserves in section 2(43) as those reserves which, as per the latest audited balance sheet, are available for distribution as dividend, expressly excluding unrealised and notional gains and any surplus arising from a revaluation of assets.
• (b)Dividend equalization reserve is an example of general reserve. — A dividend equalisation reserve is the standard textbook example of a specific reserve, not of a general one. It is built up in good years for a single named purpose — to allow the company to maintain a steady rate of dividend in a year when profits fall — and the whole point of naming the purpose is that the amount is earmarked for it. A general reserve is defined by the absence of any such earmarking. Both are revenue reserves, both are created by appropriating profit already earned, and both appear under reserves and surplus, which is what makes the option tempting; the difference is that one has a destination attached and the other does not. Other specific reserves in the same family are the debenture redemption reserve and a reserve for the replacement of an asset.
• (c)General reserve can be used only for some specific purposes. — This states the position of a specific reserve and attaches it to the general reserve, which is the opposite of what the term means. A general reserve is a free reserve created by setting aside a part of the profit without earmarking it for anything: it strengthens the financial position of the business, provides for contingencies that cannot be foreseen and named, and is available for any purpose the directors may lawfully apply it to, including the payment of a dividend in a lean year. Because it is not tied to any purpose it is also called a contingency reserve or, in older texts, a free reserve. The word only in this option is what makes it false; a general reserve may of course be used for a specific purpose, but it is not confined to one.

The distinction between a provision and a reserve runs through the whole of final accounts, and it is a distinction about timing and about whose money it is. A provision is a charge against profit: the loss or the obligation already exists — an asset has worn out, a debtor is doubtful, a tax liability has arisen — so the amount must be brought into the profit and loss account before the profit is arrived at, and it must be brought in whether or not there is a profit to bring it into. A reserve is an appropriation of profit: the profit has already been arrived at, and a part of it is retained in the business instead of being distributed, which can only happen if the profit exists. The consequences of that one difference are systematic. A provision cannot be distributed as dividend and is not part of shareholders' funds; a free reserve can be, and is. A provision for the diminution of an asset is shown as a deduction from that asset in the balance sheet, while a reserve appears on the equity and liabilities side under reserves and surplus. An excess provision is written back to the profit and loss account, whereas a reserve no longer needed is simply retained or transferred. Reserves themselves divide twice over: by source, into capital reserves created out of capital profits and revenue reserves created out of trading profits; and, within revenue reserves, by purpose, into general reserves that are free of any earmark and specific reserves such as a dividend equalisation reserve or a debenture redemption reserve. The recurring examiner's trick is to swap the attributes of two of these categories, which is what three of the four options in this item do.

EPFO's accountancy block prefers items in which each of the four options is a complete sentence and the candidate must find the one true statement. That format punishes half-knowledge more sharply than a definition question does, because a candidate who knows the terms but not their attributes will find at least two options plausible. It also rewards a habit worth building: read each option as an assertion with a subject and a predicate, and ask whether the predicate belongs to that subject or to its neighbour. Here the predicates have been shuffled between capital reserve and revenue reserve, between general reserve and specific reserve, and between reserve and provision, so the same knowledge answers all four. The paper carries related items elsewhere in this block — a computation involving a provision for doubtful debts, and a question on the convention that justifies a provision against a fall in the value of investments — so the reserve-and-provision family is worth learning as a whole rather than as isolated definitions. Note the printed form: option (d) prints the word Provision inside curly single quotation marks, and each option is a full sentence closing with a full stop, as printed.

• A provision is a charge against profit — debited in the profit and loss account before the profit is arrived at, and created whether the year shows a profit or a loss; a reserve is an appropriation of profit and can be made only out of profit.
• A provision covers depreciation, a diminution in the value of an asset, or a known liability whose amount cannot be determined with substantial accuracy; AS-29 defines it as a liability that can be measured only by using a substantial degree of estimation.
• A provision is not distributable as dividend and is shown either as a deduction from the asset concerned or as a liability; an excess provision is written back to the profit and loss account.
• Capital reserves arise from capital profits — securities premium, profit prior to incorporation, profit on reissue of forfeited shares, profit on redemption of debentures, surplus on revaluation — and are not normally available for dividend.
• Revenue reserves are created out of trading profits and divide into general reserves, which carry no earmark, and specific reserves such as a dividend equalisation reserve or a debenture redemption reserve.
• Section 2(43) of the Companies Act, 2013 defines free reserves as reserves available, per the latest audited balance sheet, for distribution as dividend, and excludes unrealised gains, notional gains and any revaluation surplus.

• Treating a provision as an appropriation because both reduce the amount finally left in the business; the test is whether it is made before the profit is arrived at, and whether it is made even in a loss year
• Assuming a capital reserve is simply a large reserve; it is defined by its source, which must be a capital profit, not by its size
• Reading dividend equalisation reserve as a general reserve because it is available for dividends; it is earmarked for one purpose, which makes it specific
• Missing the word only, which is what makes the statement about the general reserve false
• Forgetting that an excess provision is written back to the profit and loss account, so a provision can increase a later year's reported profit

The Commission sets this family either as a which-statement-is-correct item, as here, or as a straight definitional one asking whether a named fund is a charge or an appropriation. Expect the attributes of neighbouring categories to be swapped rather than invented, and expect at least one option that is true of a related term. The efficient preparation is a two-column table — provision against reserve, capital reserve against revenue reserve, general against specific — learnt by the attributes rather than by the examples.

No directly related past PYQ was found.

• 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 — the loss is already probable, so the amount is debited to the profit and loss account before the profit for the year is arrived at, and it is made whether or not the year is profitable. The other three are appropriations of a profit already computed and can be made only if a profit exists.

• practice — not a real PYQ

  The premium received on the issue of shares at a price above their face value is credited to an account that is in the nature of

  • (a)a general reserve
  • (b)a capital reserve
  • (c)a provision
  • (d)a revenue receipt of the year

  Answer(b) a capital reserve — securities premium is a capital profit, not a trading profit, so it is not available for distribution as an ordinary dividend and its use is restricted. Reserves created out of trading profits are revenue reserves, of which the general reserve is the unearmarked example.