Provisions and Reserves

When a business sells goods on credit, some customers might not pay. A provision for doubtful debts is money set aside to cover potential losses from customers who won't pay their bills. For example, if a Lagos supermarket gives credit to traders worth ₦500,000 but suspects 5% might default, they'll provision ₦25,000. This protects the business from sudden shocks.

Provision for discounts works similarly—you set aside money expecting customers will claim early payment discounts. Depreciation means recording how fixed assets like vehicles lose value over time. A business buying a delivery van for ₦2,000,000 knows it won't be worth that forever, so depreciation spreads the cost across years when the asset actually works.

These provisions give a true picture of your financial position by showing realistic asset values.

The straight line method is the simplest way to spread a cost evenly across several years. Imagine your school buys a bus for ₦5 million that will last 5 years. Instead of writing off all ₦5 million in year one, you divide it equally: ₦1 million per year for five years. This keeps your annual accounts fair and honest.

Think of a Lagos manufacturing company that purchases machinery for ₦10 million with a 10-year lifespan. Using straight line depreciation, they record ₦1 million depreciation expense yearly. This method works brilliantly because it's straightforward, matches costs with revenue logically, and is widely accepted by auditors and WAEC examiners.

The formula is simple: (Asset Cost − Salvage Value) ÷ Useful Life = Annual Depreciation.

The reducing balance method is a way of calculating depreciation where the asset loses value faster in early years and slower later. Think of it like a used car—a brand-new Toyota Camry loses significant value in year one, but by year five, the depreciation is much smaller.

In this method, you apply a fixed percentage to the book value (remaining value) each year, not the original cost. For example, if a Nigerian manufacturing company buys machinery for ₦1,000,000 at 20% depreciation rate, year one depreciation is ₦200,000, leaving ₦800,000. Year two's depreciation is 20% of ₦800,000, which is only ₦160,000.

This method matches how assets actually lose value in real life, making financial statements more realistic.

The sum of the years digits is a depreciation method that reduces an asset's value faster in early years and slower later. Think of it like how a brand new car loses value quickly when you drive it off the lot, then the depreciation slows down.

To calculate this, you add up the years of the asset's useful life. For example, if a machine will last 4 years, you add 4+3+2+1 = 10. In year one, you depreciate 4/10 of the cost; year two, 3/10; year three, 2/10; and year four, 1/10.

A Nigerian manufacturing company buying a printing machine for ₦500,000 with a 5-year life would depreciate ₦500,000 × 5/15 in year one, then ₦500,000 × 4/15 in year two, and so on.

Think of provisions and reserves as ways businesses protect themselves and plan for the future. When a company like Nigerian Breweries sets money aside because it knows it will face expenses or losses, that's a provision. For example, if a business expects to pay workers' compensation claims, it creates a provision now rather than waiting.

Depreciation is different—it's spreading the cost of an asset over its useful life. A vehicle costing ₦5 million used for five years costs ₦1 million annually as depreciation expense.

Reserves come in two types. Revenue reserves come from profits and can be distributed to shareholders as dividends. Capital reserves, like those from selling fixed assets above cost, usually cannot be distributed. These protect the business and show financial strength to investors and creditors.