Unit 4

Provisions and reserves

1. Understanding Provisions and Reserves:

- Provisions: These are amounts set aside from a company’s
profits to cover anticipated future liabilities or losses.
Provisions are recognized when:
1. The company has a present obligation (legal or
constructive) as a result of a past event.
2. It is probable that an outflow of resources embodying
economic benefits will be required to settle the obligation.
3. A reliable estimate can be made of the amount of the
obligation.
- Reserves: These are portions of profits set aside to
strengthen the financial position of the company. Unlike
provisions, reserves are not meant to cover specific liabilities
or losses. They are created to meet future uncertainties or
expansion purposes.
2. Types of Provisions:
- Provision for Doubtful Debts: Amount set aside to cover
debts that might not be recovered.
- Provision for Depreciation: Amount set aside to account
for the reduction in the value of fixed assets due to wear and
tear.
- Provision for Taxation: Amount set aside for future tax
liabilities.

3. Types of Reserves:
- General Reserves: These are not earmarked for any
specific purpose and can be used for any general future
contingency.
- Specific Reserves: These are earmarked for specific
purposes, such as:
- Capital Reserves: Created out of capital profits and used
for purposes such as issuing bonus shares.
- Revenue Reserves: Created out of revenue profits and
used to meet future business expenses.
4. Key Differences Between Provisions and Reserves:
- Purpose:
● - Provisions are for covering known liabilities or losses.
● Reserves are for strengthening the financial position
and meeting future uncertainties.
● Compulsory/Optional:
● Provisions are usually compulsory as per accounting
standards.
● Reserves are generally optional and depend on the
management's discretion.
● Impact on Profit:
● Provisions reduce the net profit.
● Reserves do not directly affect net profit; they are
appropriations of profit.
● Presentation in Financial Statements:
● Provisions are shown as liabilities.
● Reserves are shown under shareholders' equity.
5. Accounting Treatment:
- Provisions:
- Recognized as an expense in the income statement.
- Recorded as a liability on the balance sheet.
- Reserves:
- Created by appropriating profits after tax.
- Shown under reserves and surplus in the shareholders'
equity section of the balance sheet.

6. Practical Example:

- Provision Example:
- A company estimates that it might not recover $10,000
from its debtors. It creates a provision for doubtful debts by
debiting the profit and loss account and crediting the
provision for doubtful debts account.
- Entry:
Profit and Loss A/C Dr. $10,000
To Provision for Doubtful Debts A/C $10,000
 - Reserve Example:
- A company decides to create a general reserve of
$50,000 from its profits.
- Entry:
Profit and Loss Appropriation A/C Dr. $50,000
To General Reserve A/C $50,000

7. Importance in Financial Management:

- Provisions: Ensure that the company is prepared for
future liabilities, thus maintaining financial stability.
- Reserves: Provide a cushion against future uncertainties
and help in funding expansion or other long-term projects.
 Financial Statements of a Sole Proprietorship Firm

1. Introduction:
- A sole proprietorship is a business owned and operated by
one individual. The financial statements of a sole
proprietorship are essential for evaluating its financial
performance and position. They include the Trading Account,
Profit and Loss Account, and Balance Sheet.

2. Financial Statements:

a. Trading Account:
- Purpose: To determine the gross profit or gross loss during
an accounting period.
- Components:
- Opening Stock: Inventory at the beginning of the period.
- Purchases: Total goods bought for resale, adjusted for
returns.
 - Direct Expenses: Costs directly associated with
production or purchasing goods, like wages, carriage inwards,
and freight.
- Sales: Revenue from goods sold, adjusted for returns.
- Closing Stock: Inventory at the end of the period.
- Formula:

Gross Profit/Loss = (Sales - Returns) + Closing Stock -

(Opening Stock + Purchases - Returns + Direct Expenses)
b. Profit and Loss Account:
- Purpose: To ascertain the net profit or net loss after
accounting for all indirect expenses and incomes.
- Components:
- Gross Profit/Loss: Carried down from the Trading
Account.
- Operating Expenses: Indirect expenses like
administrative, selling, and distribution expenses.
- Non-Operating Expenses: Financial expenses such as
interest on loans and bank charges.
- Non-Operating Incomes: Other incomes such as
commission received, rent received, and discounts received.
- Depreciation: A systematic allocation of the cost of
tangible assets over their useful life.
- Formula:
Net Profit/Loss = Gross Profit + Other Incomes -
(Operating Expenses + Non-Operating Expenses +
Depreciation)
c. Balance Sheet:
- Purpose: To present the financial position of the business
at a specific point in time, showing its assets, liabilities, and
owner's equity.
- Components:
- Assets: Resources owned by the business.
- Fixed Assets: Long-term assets like land, buildings,
machinery, and equipment.
- Current Assets: Short-term assets like cash, bank
balances, debtors, inventory, and prepaid expenses.
 - Liabilities: Obligations of the business.
- Long-term Liabilities: Debts payable over a period
longer than a year, like loans.
- Current Liabilities: Debts payable within a year, like
creditors, bills payable, and bank overdrafts.
- Owner’s Equity: The owner's claim on the business,
including capital introduced and retained earnings.
- Formula:
Assets = Liabilities + Owner's Equity
3. Key Accounting Concepts and Principles:

a. Business Entity Concept:

- The business is treated as a separate entity from the
owner. This distinction ensures that the business’s financial
statements reflect only its activities, separate from the
personal financial affairs of the owner.

b. Going Concern Concept:

- Assumes that the business will continue to operate
indefinitely. This principle supports the use of historical cost in
valuing assets and liabilities.

c. Consistency Concept:
- Ensures that the same accounting principles and methods
are applied consistently from one accounting period to
another, facilitating comparability.
d. Accrual Basis of Accounting:
- Revenues and expenses are recognized when they are
earned or incurred, not necessarily when cash is received or
paid. This principle ensures that financial statements reflect
the true financial performance and position of the business.

e. Prudence (Conservatism) Concept:

- Encourages caution in financial reporting, ensuring that
expenses and liabilities are recorded as soon as possible, but
revenues only when they are certain. This principle prevents
the overstatement of financial health.

4. Preparation and Presentation:

a. Preparation:
- Journal Entries: Record daily transactions in chronological
order.
- Ledger Accounts: Post journal entries to respective ledger
accounts to summarize transactions.
 - Trial Balance: List all ledger account balances to ensure
that total debits equal total credits.
- Adjusting Entries: Make necessary adjustments for
accrued expenses, prepaid expenses, depreciation, etc.
- Adjusted Trial Balance: Prepare a trial balance after
adjustments to ensure accuracy.

b. Presentation:
- Trading Account: Prepared first to determine the gross
profit or loss.
- Profit and Loss Account: Prepared next to ascertain the
net profit or loss.
- Balance Sheet: Prepared last to present the financial
position on a specific date.

5. Importance:

a. Decision Making:
 - Financial statements provide valuable information for the
owner to make informed business decisions regarding
expansion, cost control, and investment.

b. Financial Health:
- They help assess the financi al health of the business,
including liquidity, profitability, and solvency.

c. Compliance:
- Ensures compliance with legal and regulatory requirements,
maintaining transparency and accountability.

d. Stakeholder Communication:
- Provides essential information to external stakeholders,
such as creditors, investors, and tax authorities, regarding
the business’s financial performance and position.

e. Performance Evaluation:
- Enables the owner to evaluate the business’s performance
over time, identifying trends and areas for improvement.
 Financial Statements of a Not-for-Profit Organization

1. Introduction:
- Not-for-Profit Organizations (NPOs) are entities that
operate for purposes other than profit generation, such as
charities, educational institutions, and cultural organizations.
The primary goal of these organizations is to provide services
for the public benefit. Their financial statements reflect their
focus on accountability and stewardship of resources.

2. Primary Financial Statements:

a. Receipts and Payments Account:

- Purpose: This account provides a summary of all cash and
bank transactions during a specific period, showing the total
receipts and payments without distinguishing between capital
and revenue items.
- Components:
- Receipts: All cash inflows including donations,
subscriptions, grants, fees, and any other income.
 - Payments: All cash outflows such as rent, salaries,
utilities, office expenses, and other expenditures.
- Format:

b. Income and Expenditure Account:

- Purpose: This account is similar to the Profit and Loss
account of profit-oriented businesses. It is prepared on an
accrual basis to ascertain the surplus or deficit for a specific
period.
- Components:
 - Income: All earnings and receivables for the period
including subscriptions, donations, grants, and other incomes.
- Expenditure: All expenses and payables for the period
such as salaries, rent, utilities, and other operational costs.
- Format:
c. Balance Sheet:
- Purpose: The balance sheet provides a snapshot of the
organization's financial position at a specific point in time,
listing its assets, liabilities, and capital fund.
- Components:
- Assets: Resources owned by the organization such as
cash, bank balances, receivables, fixed assets, and
investments.
- Liabilities: Obligations of the organization including
creditors, loans, and other payables.
- Capital Fund: Represents the net assets of the
organization. It includes accumulated surpluses or deficits,
specific funds, and any capital introduced.
- Format:
3. Key Concepts and Principles

a. Accrual Basis of Accounting:

- Revenues and expenses are recognized when they are
earned or incurred, not necessarily when cash is received or
paid. This ensures that the financial statements reflect the
true financial performance and position of the organization.

b. Matching Principle:
- Expenses are matched with the revenues of the same
period to determine the net surplus or deficit.

c. Prudence (Conservatism) Principle:

- Caution is exercised in financial reporting, ensuring that
liabilities and expenses are not understated, and revenues and
assets are not overstated.
d. Fund Accounting:
- NPOs often use fund accounting to ensure that resources
are used according to donor restrictions. Specific funds (e.g.,
building fund, scholarship fund) are tracked separately.

e. Full Disclosure Principle:

- All significant information is disclosed in the financial
statements to provide a clear and complete picture of the
organization’s financial position and performance.

4. Preparation and Presentation

a. Preparation:
- Journal Entries: Record daily transactions in chronological
order.
- Ledger Accounts: Post journal entries to respective ledger
accounts to summarize transactions.
- Trial Balance: List all ledger account balances to ensure
that total debits equal total credits.
 - Adjusting Entries: Make necessary adjustments for
accrued expenses, prepaid expenses, depreciation, etc.
- Adjusted Trial Balance: Prepare a trial balance after
adjustments to ensure accuracy.

b. Presentation:
- Receipts and Payments Account: Provides a summary of
cash and bank transactions.
- Income and Expenditure Account: Prepared on an accrual
basis to determine the surplus or deficit.
- Balance Sheet: Shows the financial position on a specific
date.

5. Importance

a. Accountability and Transparency:

- Financial statements ensure that NPOs are accountable
to their stakeholders, including donors, members, and
regulatory bodies. Transparency in financial reporting builds
trust and credibility.
b. Decision Making:
- Provides essential information for the management to
make informed decisions regarding resource allocation,
fundraising, and program implementation.

c. Financial Health:
- Helps assess the financial health of the organization,
including its liquidity, solvency, and sustainability.

d. Compliance:
- Ensures compliance with legal and regulatory requirements,
maintaining transparency and accountability.

e. Performance Evaluation:
- Enables the evaluation of the organization’s performance
over time, identifying trends and areas for improvement.