Classification of Reserves

Classification of Reserves

1. GENERAL RESERVE

A reserve which is created out of the profits or surplus of a business for meeting any unknown liability is called as ‘General Reserve’ or ‘Free Reserve’ or ‘Revenue Reserve.’ It is an appropriation of profit. According to Companies Act, creation of general reserve is not compulsory; it is to be created only when the company has sufficient profit. However, if the Articles of Association of the company state that a specific amount is to be set aside out of profit before distribution of dividend, then the amount should be transferred to General Reserve account.

Objects of creating General Reserve

It is created with an object to:

·           Provide additional working capital,

·           Strengthen the liquid resources of the business,

·           Meet any unknown contingency or liability,

·           Equalize dividend in the years in which profits are inadequate, and

·           Expand business etc.

AUDITOR'S DUTY

1. Examine Articles of Association: The auditor should examine the Articles of Association to see whether provision regarding creation of general reserve has been complied with.

2. Verify Mode of Creation: It is the duty of the auditor to ensure that reserve is created only out of profits of the company.

3. Verify Purpose of Creation: Auditor should ensure that general reserve is created for the best interest of the company.

4. Disclosure in Balance Sheet: He should examine that reserve amount is properly shown in the Balance Sheet. When reserve amount is invested in securities, he should verify that investments are shown on the assets side of the Balance Sheet.

5. Examine Minutes of Board of Directors: Auditor should examine Minutes of Board of Directors meeting to verify directors approval for utilizing the reserve amount.

2. SPECIFIC RESERVE

A reserve which is created for the purpose of providing for losses and contingencies which are known or expected to occur at a future date is called as a Specific Reserve. In simple words, it is a reserve created out of profit or loss of a company for a specific purpose. For example, Dividend Equalization Reserve, Investment Fluctuation Reserve, Reserve for redemption of Debentures, Plant Replacement Reserve etc.

Specific Reserve is not represented by any asset and therefore it is not available for distribution amongst the shareholders. The reserve must be created irrespective of profit or loss involved in the business.

Objects of creating Specific Reserve The reserve is created with a definite object to:

·           Meet a known loss, such as depreciation, heavy repairs and renewals etc.

·           Meet an expected contingency, such as, doubtful debts, discount on debtors, liability for a disputed claim, contingency under Workmen’s Compensation Act, etc.

·     Meet an outstanding liability for expenses already incurred, such as, salaries and wages, commission, income tax and other accrued expenses.

AUDITOR'S DUTY

1.        Verify Articles of Association: It is the duty of the auditor to verify the Articles of Association to check whether the amount appropriated from profit to specific reserve is duly complied.

2. Verifying Minute Book of Board meeting: The auditor should ensure that profits are appropriated according to the board of directors decision by verifying the Minutes book of the Board meeting.

3. Verify Adequacy of Provision: Auditor should ensure that adequate provision has been created. In case if the amount created is not adequate, he should insist the management to increase the provision. Otherwise, he should disclose the same in the audit report.

4. Disclosure in Balance Sheet: The auditor should see whether provisions are properly shown on the liabilities side of the Balance Sheet.

5. Utilization of Reserve: Lastly, the auditor has to ensure that reserve is utilized for the special purpose for which they are created.

3. CAPITAL RESERVE

A reserve which is created out of capital profits of a company is called as a Capital Reserve. It is defined in Part III of Schedule VI of the Companies Act as, “any reserve which cannot legally be distributed amongst the shareholders”. Capital profit refers to the following:

·           Profits on sale of fixed assets

·           Profits on revaluation of fixed assets and liabilities

·           Profits earned prior to incorporation of a company

·           Profits made in purchasing a business

·           Profits on redemption of debentures at a discount

·           Premium received on issue of shares or debentures

·           Profits earned from forfeited shares and re-issue of forfeited shares

·           Exceptional profits not earned during regular course of business.

Capital profits should not be utilized in distributing dividend to the shareholders but should be kept aside to strengthen the financial position of the company and to meet capital or abnormal revenue losses.

Objects of creating Capital Reserve Capital Reserve are utilised for the following purpose:

·     To issue bonus shares to the shareholders subject to the Articles of Association of the company.

·     To write off intangible assets of the company, like goodwill, preliminary expenses etc.

·     To provide for premium payable on the redemption of debentures or redeemable preference shares.

·     To write off discount allowed, commission paid or expenses incurred on the issue of shares and debentures of the company.

AUDITOR'S DUTY

1. Creation of Reserve: The auditor should ensure that the reserve is created only out of the capital profits of the company.

2. Utilisation of Reserve: He should verify that the reserve is utilized according to the provisions of the Companies Act and the Articles of Association of the company.

3. Disclosure in Balance Sheet: Auditor should examine whether capital reserve has been shown separately from the revenue reserve in the Balance Sheet.

Any addition or deduction from the previous year balance sheet should be clearly shown.

4. Investment in Securities: The auditor should check whether capital reserve is invested in easily realizable securities or may be invested in the business itself.

4. SECRET RESERVE

It is a reserve, the existence of which is not apparent on the face of the Balance Sheet. It is also called as “Hidden Reserve” or “Internal Reserve” or “Inner Reserve”. The reserve represents the surplus of assets over liabilities and capital. Secret Reserves are usually created by banking companies, insurance companies and electricity supply companies. When secret reserve exist, the financial position of the company is better than what it would appear from the balance sheet. However, the existence of such a reserve is found only by a close and intelligent scrutiny of the account of the company.

Objects of creating Secret Reserve Secret Reserve is created for the following purpose:

·     To meet any extraordinary loss without disclosing the fact to the shareholders or outsiders.

·     To increase the working capital and to strengthen the financial position of the company.

·     To withhold information of the progress of the company from trade competitors.

·     To equalize the payment of dividend during the period of loss.

·     To meet unexpected financial losses in future.

Methods of Creating Secret Reserve

·     Undervaluing the assets below cost or market value.

·     Not recording the appreciated value of an asset.

·     Providing excess reserve for bad and doubtful debts or discount on debtors.

·     Providing excess depreciation on fixed assets.

·     Writing down goodwill to a nominal value

·     Omitting some of the assets in the Balance Sheet.

·     Undervaluing the assets by charging capital expenditure to revenue account.

·     Overvaluing the liabilities.

·     Inclusion of fictitious liabilities

·     Showing contingent liabilities as real liabilities.

·     Grouping dissimilar items on the liabilities side of the Balance Sheet.

AUDITOR'S DUTIES

1. Verify Articles of Association: The auditor should study the Articles of Association of the company to ascertain the legal implications of creating the reserve.

2. Examine Object and Method of Creation: Auditor should examine carefully the object and method of creating a secret reserve if he is fully satisfied, he should disclose the facts in his report.

3. Disclosure to Shareholders: It is the duty of the auditor to disclose the fact to the shareholders that secret reserve has been created. If he fails to do so, he will certify a false statement which will not exhibit a true and fair view of the state of affairs of the company.

4. Examine Company’s Policy: When secret reserve is created by undervaluing the assets or overvaluing the liabilities, the auditor should make a detailed enquiry with the directors and examine the company’s policy.

5. RESERVE FUND

It is a reserve created out of the surplus of the company and is invested in outside securities. It is similar to general reserve, which is created out of surplus but is retained in the business. In other words, reserve fund is appropriations of profits which is invested in safe securities and are easily realizable.

AUDITOR'S DUTY

1. Examine Directors meeting Minutes Book: Auditor should examine the Minutes of Board of Directors meeting to verify that all investments are made with the consent of the Board.

2. Verify Investment Register: The auditor should physically verify the securities with the Investment Register.

3. Investment in Securities: The auditor should ensure that the reserve fund is invested in easily realizable securities.

4. Disclosure in Balance Sheet: He should verify that the reserve fund is shown distinctly on the liabilities side of the Balance Sheet.

6. SINKING FUND

The fund which is created to have a certain sum of money accumulated for a future date by setting aside a certain sum of money every year is called as Sinking Fund. It is defined as, “a form of specific reserve set aside for redemption of a long debt or replacement of a wasting or a depreciable asset”.

Objects of Creating Sinking Fund

The objects of creating Sinking Fund are as follows:

·           To reduce a liability, for example, redemption of debentures or repayment of a loan.

·           To replace a wasting asset.

·           To replace a depreciating asset.

·           To renew a lease.

AUDITOR'S DUTY

1. Verify Articles of Association: Auditor should verify Articles of Association and examine the creation and utilisation of the fund.

2. Verify Minutes of Directors: He should verify the Minutes of the Board of Directors to ensure the correctness of the amount transferred to Sinking Fund.

3. Verify amount Invested: He should ensure that the amount set aside is invested in guilt-edged securities known as Sinking Fund Investment which earns a reasonable rate of return.

4. Disclosure in Balance Sheet: The auditor should verify that sinking fund and Sinking Fund Investment is separately and properly disclosed in the Balance Sheet.