RESERVES AND PROVISIONS

The lack of uniformity and looseness in the past in the employment of the term 'reserve' have tended not only to create confusion in the mind of the student but to difficulties in the proper understanding of the financial position of businesses as shown in their Balance Sheets. The matter has now been considerably clarified by the Companies Acts 1948 to 1976, and although the requirements of the Acts (which will be stated in detail in a later chapter) apply only to limited companies, it is proposed in this chapter to deal with reserves and provisions on the lines of the definitions laid down in the Acts. The reader should, however, bear in mind that at this stage the matter is being considered more in broad principle than in regard to the specific requirements of the Acts which apply to the published accounts of limited companies.

As a preliminary to closer study, reserves and provisions may be defined as follows:

1. Reserves are amounts set aside out of profits and other surpluses which are not designed to meet any liability, contingency, commitment or diminution in value of assets known to exist at the date of the Balance Sheet.

2. Provisions are amounts set aside out of profits and other surpluses to provide for:

(a) depreciation, asset renewals, or reduction in asset value, or (b) any known liability with an undeterminable amount

with substantial accuracy.

It follows therefore that:

1. Any funds allocated for the purposes outlined in (2) (a) and (b)

ACCOUNTANCY

Any amount exceeding the estimated requirements should be considered a reserve.

2. Sums set aside to meet known liabilities of which the amount can be determined with substantial accuracy do not fall within the definition of a provision and Reserves are essentially a portion of the undistributed profits of the business and, therefore, part of the proprietorship. In contrast, provisions and accruals reduce the proprietorship, form of a liability or diminution of an asset. The former are broadly appropriations of, the latter charges against, profits.

Reserves

By the Companies Act 1967, there is now no legal requirement as there was by the Companies Act 1948, to distinguish between capital and revenue reserves in the published accounts of limited companies. This change affects only what must be disclosed; it does not affect whether a reserve is legally distributable or what reserves Directors determine should not be distributed. Consequently it might still be considered appropriate in the published accounts of certain limited companies to distinguish the two kinds of reserves.

1. Capital Reserves. In limited company accounting, these reserves are typically not considered available for dividend distribution. Such reserves may arise from:

(a) The sale of fixed assets at a profit.

(b) Profit accrued by the company before incorporation or purchase.

(d) Profit on redemption of debentures.

(e) Profit on forfeiture of shares.

(f) Surplus on revaluation of assets and liabilities.

(g) Capital Redemption Reserve Fund.

The matters are dealt with in more detail in Chapter 23, but it may be stated broadly that in certain circumstances some of these profits may be considered as revenue but the better practice is to regard them as capital: others are subject to special restrictions and treatment in accordance with the provisions of the Companies Acts 1948 to 1976.2

2. Revenue Reserves. These items are typically considered distributable through the Profit and Loss Account, categorized into two groups: those readily available and those not immediately accessible.

(i) General Reserve. This reserve is created by setting aside profits in order to strengthen the general financial position of the business. Such

Typically, any surplus above the book value is often allocated to the Capital Reserve, even though strictly speaking, capital profit only refers to the amount exceeding the sale proceeds over the original cost..

Comprising the Companies Acts 1948, 1967 and 1976.

DEPRECIATION, RESERVES, AND PROVISIONS

profits, however, remain available for distribution, and for this reason it is often described as a 'free' reserve. In this group should be included any undistributed balance of the Profit and Loss Account (by deduction, if a debit balance).

(ii) Specific Reserve. Under this category are amounts allocated from profits for a specific purpose or obligation, which, while still considered revenue, are not immediately distributable. A common example occurs in the accounts of limited companies when a portion of profits is earmarked until the repayment of debentures, which function akin to loans. Throughout the loan's term, this reserved amount remains part of undistributed profits. Upon repayment, it can be transferred back to the Profit and Loss Account or General Reserve.

Share Premium Account and Specific Reserves should be separately stated in the Balance Sheet. In respect of all reserves sufficient detail should be given to show how increases and decreases have arisen and how the reserves have been utilized.

So far, consideration has been confined to reserves which are shown as such in the Balance Sheet. There may, however, be reserves which are not disclosed therein:

1.Hidden reserves refer to profits, including revenue or capital reserves, that are deliberately described in a way that implies a liability, such as being included under Sundry Creditors.

2. Inner Reserves are provisions set aside to cover exceptional and abnormal losses, which are not openly disclosed.. general contingencies reserve (in the case of a bank) included in creditors, usually under the heading of 'Deposit. Current and other accounts."

3. Secret Reserves, where the net asset position is stronger than that disclosed by the Balance Sheet by reason of:

(a) Excessive depreciation of an asset (particularly Goodwill), or exces- sive valuation of a liability, or excessive provisions.

(b) Complete elimination of an asset; undervaluation or understate-

ment of an asset.

(c) Charging capital expenditure to revenue or crediting revenue receipts to an asset (e.g. dividends received and earned credited to the investment).

(d) Permanent appreciation in a fixed asset, or permanent diminution or extinction of liability not recorded.

(e) Showing a contingent liability as an actual liability or as a provision therefor; or an actual asset as a contingent asset.

(f) The classification of 'free' reserves alongside creditors.

(g) Crediting exceptional or non-recurring profit to a Contingencies Reserve without proper disclosure.

(h) in the hands of a subsidiary com pany.

An example of the creation of a secret reserve can be observed when a bank

ACCOUNTANCY

provides for depreciation of investments, but does not re-credit a subse- quent appreciation of investments.

From this it will be seen that secret reserves may

(i) arise, as in (d),

(ii) be created, as in the remainder of the examples given,

(iii) be maintained by allowing (i) to remain or by continuing the practice of (ii).

It may here be noted that the Companies Acts 1948 to 1976, contain provisions which aim at preventing the creation of secret reserves; this is dealt with more fully in Chapter 23.

Reserve Fund. The word 'fund' is now frequently employed in substitu- tion for the word 'account,' whether it is represented by specifically earmarked investments or not. It is recommended that the term 'Reserve. Fund' should only be used where a reserve is in fact specifically rep- resented by readily realizable and earmarked assets.

Provisions

Provision will be required in the final accounts for (1) Depreciation and diminution in value of assets, and (2) Estimated and anticipated liabilities which exist at the date of the Balance Sheet, e.g. claims for delay in delivery of goods, accident and employer's liability claims, estimated bad and doubtful debts (these may be regarded as coming under the heading in (1) of diminution in value of assets), etc.

These provisions will be normally either deducted from assets in the Balance Sheet (as in the case of depreciation and bad and doubtful debts) or grouped with liabilities under appropriate sub-headings, unless in the published accounts it would be detrimental to the company's interests for a provision to be openly disclosed, e.g. a provision against a disputed claim.

Where any provision is used for a purpose other than that for which it was created, this fact should be shown, and when any provision becomes redundant it should be credited back to the Profit and Loss Appropriation Account.

Contingencies

Amounts set aside in respect of contingencies may be in the nature of a reserve, or a provision, or what is termed a contingent liability.

1. Contingency Reserve. Amounts are sometimes set aside out of profits under this heading although there are no actual, probable or really possible contingencies at the date of the Balance Sheet. There is thus little or no difference between such a reserve and a General Reserve as already described, and the two may well be shown together.

2. Contingency Provision. As already stated provision should be made for all known contingencies, even if the amount can only be estimated. existing at the date of the Balance Sheet, e.g. under employer's liability, to cover possible claims against accidents which have already occurred.

3. Contingent Liabilities. Where there is a possibility that upon the

DEPRECIATION, RESERVES, AND PROVISIONS

happening of a contingency an actual liability will arise, it is not usual to make any relevant provision in the accounts, but by way of a footnote in the Balance Sheet. Examples of contingent liabilities are bills under discount and calls on shares in limited companies.

If the contingency does arise it will involve a loss. The liability incurred may be reflected in an asset, e.g. the call on the share may arise because the company is in difficulties, in which case the liability incurred will probably be considered a loss; but if the calls are made in the ordinary course of events, the liability incurred will be reflected in an increase in the value of the assets.

As already stated any amount set aside in excess of a necessary provision is a reserve and should appear so in the Balance Sheet. For example, in regard to Stock, the amount required to cover the excess of cost over say, net realizable value is a provision; any further amount, e.g. in respect of a possible future fall in values, is a reserve.

In recent cases dealing with the ascertainment of Capital Transfer Tax valuation of shares the Court has taken the narrow view of the meaning of contingent liabilities--that a liability which already actually exists in law at a relevant date, though it might be payable in certain events only, is quite different from a potential liability, which from the business angle is almost a certainty but which does not become a liability in law until the happening of a future event, such as liability for future balancing charge which might arise on a sale of assets where Capital Allowances have in the past been given in excess assessments for Taxation.

Thus a contingent liability may be regarded from either of the following angles: (a) a 'negative' to a 'positive,' i.e. a possible to an actual liability (e.g. as in a guarantee), or (b) a 'positive' to a 'negative,' i.e. an actual to a possible or probable liability (e.g. as in future tax liability).

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