A reserve is an amount set aside out of the profit of the business for a specific or general purpose, such as strengthening the financial position, meeting future losses or expansion. It is not meant for distribution to the owner at present. Examples are general reserve and capital reserve.

Provision for Bad Debt Account

Working notes: debtors after writing off the additional bad debt $= 52{,}000 - 2{,}000 = \text{Rs } 50{,}000$. New provision $= 5\% \times 50{,}000 = \text{Rs } 2{,}500$. The old provision is Rs 7,000, so the excess of $7{,}000 - 2{,}500 = \text{Rs } 4{,}500$ is transferred to the profit and loss account.

The total bad debt of $1{,}000 + 2{,}000 = \text{Rs } 3{,}000$ is charged to the profit and loss account, so the net effect on profit is an addition of $4{,}500 - 3{,}000 = \text{Rs } 1{,}500$.

A secret reserve is a reserve that is not disclosed in the balance sheet. It is created by understating assets or overstating liabilities, or by charging excessive depreciation or expenses, so that the true profit and financial strength of the business is hidden. It can be used to meet unexpected losses in bad years, and is mostly used by banks and insurance companies.

Provision required at year end: $5\% \times Rs\ 1{,}50{,}000 = Rs\ 7{,}500$.

Opening provision is Rs 5,000, so the extra charge to the Profit and Loss Account is $7{,}500 - 5{,}000 = Rs\ 2{,}500$.

Provision for Doubtful Debts Account

The bad debts (Rs 7,000 + Rs 2,000 = Rs 9,000) are written off to the Profit and Loss Account separately, so the total charge to profit for the year is $9{,}000 + 2{,}500 = Rs\ 11{,}500$. The closing debtors of Rs 1,50,000 are taken as already net of these bad debts.

One objective of creating a secret reserve is to strengthen the financial position of the business by hiding part of the profit, so that the business can meet unforeseen losses or difficulties in bad times without disclosing them. It is created by undervaluing assets or overvaluing liabilities.

Provision for Bad Debts

Working notes: the debtors of Rs 80,000 are taken as before writing off the further bad debts. Debtors after further bad debts $= 80{,}000 - 5{,}000 = \text{Rs } 75{,}000$. New provision $= 75{,}000 \times \frac{5}{100} = \text{Rs } 3{,}750$. Existing provision is Rs 3,000, so the additional provision to be charged is $3{,}750 - 3{,}000 = \text{Rs } 750$.

Provision for Bad Debts A/c

Amount charged to Profit and Loss A/c

The amount charged to the profit and loss account is Rs 5,750. In the balance sheet, debtors are shown as $75{,}000 - 3{,}750 = \text{Rs } 71{,}250$.

Provision for Doubtful Debts Account

Working notes:

• Required closing provision: $10\% \times 30{,}000 = \text{Rs } 3{,}000$.
• Existing provision is Rs 2,500, so the additional provision is $3{,}000 - 2{,}500 = \text{Rs } 500$, charged to Profit and Loss A/c.
• Bad debts of Rs 2,000 are written off directly to Profit and Loss A/c and do not pass through this account.

Provision for Bad and Doubtful Debts Account

Working notes:

• Required closing provision: $5\% \times 65{,}000 = \text{Rs } 3{,}250$.
• Existing provision is Rs 3,000, so the additional provision is $3{,}250 - 3{,}000 = \text{Rs } 250$, charged to Profit and Loss A/c.
• Bad debts of Rs 4,000 are written off directly to Profit and Loss A/c and do not pass through this account.

Provision for Bad Debts Account (year ended 31 Chaitra 2080)

Working notes:

• Required closing provision: $10\% \times 60{,}000 = \text{Rs } 6{,}000$.
• The opening provision is also Rs 6,000, so no additional provision is needed and nothing is charged or credited to Profit and Loss A/c for the provision.
• Bad debts of Rs 2,000 are written off directly to Profit and Loss A/c and do not pass through this account.

(c) It is a charge against profit.

A provision is created to meet a known liability or expected loss whose amount cannot be determined exactly, so it is debited to the profit and loss account as a charge against profit — it must be made whether or not there is a profit.

Differences between Reserve and Provision

(Any five differences are sufficient for full marks.)

Working

• Debtors after writing off the additional bad debts = Rs 2,00,000 − Rs 3,000 = Rs 1,97,000
• Required provision at 5% = Rs 1,97,000 × 5/100 = Rs 9,850
• Existing provision = Rs 8,000, so additional provision to be created = Rs 9,850 − Rs 8,000 = Rs 1,850
• Total bad debts for the year = Rs 5,000 + Rs 3,000 = Rs 8,000

Provision for Doubtful Debts Account

Profit and Loss Account (extract) for the year ended Ashadh 31, 2081

Balance Sheet (extract) as on Ashadh 31, 2081

Journal Entries

Profit and Loss Account (Relevant Extracts) For the year ended Chaitra 31, 2081

Profit and Loss Appropriation Account (Relevant Extract)

Balance Sheet (Relevant Extracts) As on Chaitra 31, 2081

Working Notes:

1. Opening written down value of machinery
   $= Rs. 5,00,000 - Rs. 1,20,000 = Rs. 3,80,000$ Depreciation @ 10% = Rs. 38,000.

2. Sundry Debtors after bad debts
   $= Rs. 3,00,000 - Rs. 10,000 = Rs. 2,90,000$ Required provision @ 5% = Rs. 14,500.

3. Additional provision required
   $= Rs. 14,500 - Rs. 12,000 = Rs. 2,500$

4. Total amount debited to Profit and Loss A/c for bad debts and provision
   $= Rs. 10,000 + Rs. 2,500 = Rs. 12,500$