Secret reserves

RESERVES

Reserves are amounts appropriated out of

profits, which are not intended to meet any
liability, contingency commitment or
diminution.
Reserves means accumulated or
undistributed profits.
If the provisions exceeds the amount which
is required to meet the loss or liability, the
excess is to be treated as reserve.

Objectives of Reserves

To strengthen the financial position of

the enterprise.
To provide funds for modernization and
expansion of existing plant or
acquisition of a new plant.
To equalise the dividends during the
periods of inadequate profits.
To meet unforseen abnormal losses.

Types of Reserves

Revenue Reserve : those reserves which

are created out of profits available for
distribution by way of dividend.
General Reserve : Reserves which is not
created for any specific purpose. E.g.
General Reserve, Contingency Reserve.
Specific Reserve : Reserves which is
created for specific purpose. E.g. Dividend
Equalisation Reserve, Debenture
Redemption Reserve.

Capital Reserve: Those reserves

created out of profits of capital nature
and not out of operating profits. E.g.
Profits prior to incorporation, Premium
on issue of Shares and Debentures,
Premium on reissue of forfeited shares.
Revenue reserves are free for
distribution by way of dividend
whereas amount of capital reserve are
not free for distribution by way of
dividend.

SECRET RESERVES

It may be defined as, any reserve

which is not apparent on the face of
balance sheet. It is also called as
hidden reserve or inner reserve.
Secret reserve is created by under
statement of assets or over statement
of liabilities. It is not disclosed in the
books of accounts.

Ways of creating Secret

Reserves

Under estimation of assets.

By not writing up any asset whose
price has permanently gone up.
By creating more reserve for bad debts
and discounts than what is necessary.
By providing excessive depreciation.
By omitting some of assets from
Balance Sheet.

Objectives of creating Secret Reserves

To meet extra ordinary loss without

disclosing it to share holders and
outsiders.
To with hold information of the progress
of the company from trade competition.
To utilise funds in lean years.
To increase working capital.
To increase financial soundness.
To equalise the payment of dividend.

Objections in creating secret

reserves

The true financial position is not available

from Balance Sheet.
Sharehoders do not get due share of profit.
Value of asset goes down in the market.
Indulgence of directors in speculation.
Concealment of the weakness of the
management.

According to companies act, creation of secret reserve is

prohibited except in the case of banking, insurance or finance
companies.

Case Study
(Royal Mail Steam Packet CO.)

Fact of the caseA huge amount of secret reserve was created

by the company under the head taxation
reserve in the boom years.
Later when the company suffered heavy
losses, this secret reserve was used to conceal
the loss.
The share-holders were given to understand
through annual report that the company was
running profitably and they were being paid
dividend out of current years profit.

Legal view:
The auditor was criminally prosecuted
along with the chairman of the
company for deceiving the
shareholders.
While defending himself the auditor
argue that the purpose of secret
reserve was to augment profit in lean
years and had he disclosed the fact, its
purpose would have been defeated.
But the auditor was held liable for
comitting breach of duty.

Decision:
It was held by Justice Wright, J that
a protected utilisation of secret
reserve, in order to keep the company
going is a serious matter, which ought
to be disclosed by the company.