Reserves are amounts appropriated out of profits which are not intended to meet any liability, contingency, commitment or diminution in the value of assets known to exist at the date of the Balance Sheet. In contradistinction, provisions are amounts charged against revenue to provide for:
- depreciation, renewal or diminution in the value of assets; or
- a known liability, the amount whereof cannot be determined with substantial accuracy; or
- a claim which is disputed.
Amounts contributed or transferred from profits to make good the diminution in assets values due to the fact that some of them have been lost or destroyed, as a result of some natural calamity or debts have proved to be irrecoverable are also described as provisions. Provisions are normally charged to the Profit and Loss Account before arriving at the amount of profit. Reserves are appropriations out of profits. The difference between the two is that provisions are amounts set apart to meet specific liabilities of diminution in assets value. These must be provided for regardless of the fact whether or not any profit has been earned the concern. If a provision is in excess of the amount considered necessary, the same must be written back or credited to a Reserve Account. On this consideration, in Part III of Schedule VI to the Companies Act, 1956,it is provided that a provision in excess of the amount which, in the opinion of the directors, is reasonably necessary for the purpose should be treated as a reserve. Reserves are made up of amounts appropriated out of profits, held for equalising the dividends of the company from one period to another or for financing the expansion of the company or for generally strengthening the company financially.
If we examine the Balance Sheet of a company, at a given time, and deduct the total liabilities to outside creditors from the value of assets shown therein, the difference between the two figures will represent the net worth of the company based on the book values of assets as on that date. It will consist of the capital contributed the shareholders as well as total undistributed profit held either to the credit of the Profit and Loss Account or to reserves; the reserves again will be segregated as revenue or capital reserves. It may be noted that the amount of a reserve is affected the values placed on assets. If these are excessive, the real reserve might not exist at all or be smaller than the figure at which it is shown in the balance sheet. Revenue reserves represent profits that are available for distribution to shareholders held for the time being or any one or more purpose, e.g., to supplement divisible profits in lean years, to finance an extension of business, to augment the working capital of the business or to generally strengthen the company’s financial position.
A capital reserve on the other hand represents surplus or profit earned in respect of certain types of transactions; for example, on sale of fixed assets at a price in excess of cost, realisation of profits on issue of forfeited shares or balances which because of their origin or the purposes for which these are held, are not regarded the directors as free for distribution as a dividend through the Profit and Loss Account. However, students may note that as per AS-5, profit or losses arising out of sale of fixed assets should be routed through profit and loss account though they may be shown separately. According to the definition of capital reserve, contained in Part III of Schedule VI to the Companies Act, 1956 it is a reserve which does not include any amount regarded as free for distribution through the Profit and Loss Account. In its narrowest sense, therefore the description would include only share premium, capital redemption reserve, development rebate reserve and profit on reissue of forfeited shares. Capital profits representing surpluses realised on the sale of assets, profit on redemption of debentures and the like, in certain circumstances, are capable of being distributed as dividends. Thus, strictly, these do not form a part of capital reserves in all cases or at all time since circumstances may change from one year to another. It may further be noted that if a company appropriates revenue profit for being credited to the asset replacement reserve with the objective that these are to be used for a capital purpose, such a reserve also would be a capital reserve.
A capital reserve, generally, can be utilised for writing down fictitious assets or losses or (subject to provisions in the Articles) for issuing bonus shares if it is realised. But the amount of share premium or capital redemption reserve account can be utilised only for the purpose specified in Sections 78 and 80 respectively of the Companies Act, 1956. Students may further note that according to the form prescribed for the Balance Sheet in Schedule VI, the amount of capital and revenue reserves must be shown separately. Also capital redemption reserve and share premium account must be segregated. Further, if there are more than one kind of revenue reserves, their nature and amounts must be disclosed; also the balance of the Profit and Loss Account, if in debit, should be deducted from the revenue reserve.
Clause (viii) of Part II of Schedule VI further provides that the aggregate of amount are set aside or proposed to be set aside to reserves, if material, should be disclosed in the Profit and Loss account. Similarly aggregate of amounts, if material, withdrawn from reserves should be disclosed. Reserves either may be retained in the business as a part of the working capital or invested outside the business in marketable securities. To the extent additional capital can be usefully and profitably employed in the business, undistributed profits should be left in the business. For these when so employed, would earn a higher return than what they would if they were invested outside in the shares or debentures of another company. So much of the profits as cannot be usefully employed in the business as well as the part of the profits earned which necessarily must be invested outside the business, under some legal obligation i.e., for the redemption of debentures, reserves should be invested in such securities which are easily realisable and the prices whereof are not liable to wide fluctuations. The term ‘Reserves Fund’ should be employed to describe a reserve only when the amount of reserve is invested outside the business and it is represented the readily realised assets. Reserves which are not disclosed in the Balance Sheet are known as secret or hidden reserves. Secret reserves can be created in the following ways :
- By writing down fixed asset more than what is necessary.
- By writing off capital expenditure as though it were revenue.
- Under-valuation of stock-in-trade.
- By making an excessive provision for bad debts.
- By making an excessive provision for contingencies or continuing to carry forward provision even when they are not required.
Before the Companies Act, 1956 came into force, there were no restrictions on the creation of secret reserves except that whenever secret reserves were brought back into accounts, it was necessary to disclose the amount adjusted out of such reserves. In the light of the provisions contained in Part III of Schedule VI to the Companies Act, 1956 requiring that a provision for depreciation, renewal or diminution in the values of assets and that in respect of a
known liability which, in the opinion of directors, is in excess of the amount which is reasonably necessary for the purpose, should be credited to a Reserve, it is not any more possible for a company to create a secret reserve.
Note : Students may read the decision in the case Rex vs. Kylsant and Moreland to acquaint themselves with the circumstances which led to the introduction of restrictions on the creation of secret reserves.