Chapter 8. Reserves and Provisions – Auditing: Principles and Techniques

Chapter 8

Reserves and Provisions

CHAPTER OUTLINE
8.1 CONCEPT OF RESERVES

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.

According to American Institute of Accountants, “the use of the term reserve is limited to indicate that an undivided portion of the asset is being held or retained for general or specific purposes”.

8.2 CONCEPT OF PROVISIONS

Provisions are amounts charged against revenue to provide for the following:

  1. Depreciation, renewals or diminution in the value of assets
  2. A known liability, the amount whereof cannot be determined with substantial accuracy
  3. A claim, which is disputed

According to the Penguin Dictionary of Commerce, “a provision is the amount written off or retained by way of providing depreciation, renewals or diminution in the value of assets, or retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy”.

8.3 DIFFERENCE BETWEEN RESERVES AND PROVISIONS

Reserves represent that portion of the business profits, which is meant for a use in future, in situation of emergency or contingency—general or specific. On the other hand, provisions are charges against earnings and must be shown in the profit and loss account. In the balance sheet, reserves are shown under the heading ‘reserves and surplus’ irrespective of the nature of reserves, capital or revenue. But, in case of provisions, that part of the provisions which represents liabilities will be shown under the heading ‘current liabilities and provisions’ and that part of the provisions which represents the diminution in the value of assets, e.g. provisions for depreciation, provisions for bad and doubtful debts are generally deducted from the balance of the concerned assets in the asset side of the balance sheet.

The difference between reserves and provisions is illustrated in Table 8.1.

8.4 CLASSIFICATION OF RESERVES

The net worth of the company consists of capital contribution by the shareholders as well as total undistributed profits held either to the credit of the profit and loss account or to a reserve. The reserves can again be segregated as revenue reserves and capital reserves.

As per Part I of Schedule VI, the following items are shown under the heading “reserves and surplus” in the liabilities side of the balance sheet:

  • Capital reserves
  • Capital redemption reserves
  • Other reserves specifying the nature of each reserve and the amount in respect thereof less debit balance in profit and loss account (if any)
  • Securities premium account
  • Surplus, i.e. balance in profit and loss account after providing for proposed allocations, namely—dividend, bonus or reserves
  • Proposed additions to reserves
  • Sinking fund

TABLE 8.1 Distinction between reserves and provisions

Reserves Provisions

1. It is an appropriation of profit. Hence it is created by debiting profit & loss appropriation account.

1. It is a charge against profit. Hence it is debited to profit and loss account.

2. A reserve is created for an unknown liability.

2. A provision is made for a known liability.

3. Creation of reserves depends upon the financial policy of the firm.

3. Creation of provisions is a must as these are meant for meeting known liabilities.

4. The reserve is shown in the balance sheet of a company under the head “Reserves & Surplus”.

4. The provisions are usually deducted from the concerned assets in the asset side of the balance sheet.

5. Past reserves can be utilised for distribution of dividend.

5. Provision can never be utilised for dividend payment. Only excess provision written back can be used for dividend distribution.

6. It is possible to create revenue only if the company earns profit. If there is a loss, no reserve cannot be created as it is an appropriation of profit.

6. Provisions are possible to be made even if there is loss as it is a charge against profit.

7. Creation of reserves is discretionary and the auditor need not devote much time for the verification of reserves.

7. Creation of provision is a must and the auditor should qualify his report if adequate provisions are not made.

8. A reserve is always reserve till it is fully utilised. Even if it is more than the requirement, it will not change its nature.

8. As per Schedule VI of the Companies Act, provision in excess of requirement can be treated as reserve.

8.4.1 Revenue Reserve

It represents profits that are available for distribution to shareholders held for the time being for any one or more purposes, e.g. supplement divisible profits in lean years, to finance an extension of business or to generally strengthen the financial position of the company.

Since the creation of this reserve is not a must, the auditor has no duty to report on the creation, adequacy or inadequacy of such a reserve. He may advise the management on the desirability of creation and maintenance of such reserve in the interest of the business.

8.4.2 Capital Reserve

It represents reserves which are created out of capital profit. Capital profits are those profits, which do not arise in the normal course of business. So, capital reserve is created out of the profits of following nature:

  1. Profit earned on sale of fixed assets at a price in excess of cost
  2. Profit on revaluation of all assets
  3. Profit earned prior to incorporation of the company
  4. Profit on re-issue of forfeited shares.

According to the definition of capital reserve, as contained in Part-III of Schedule VI to the Companies Act, it is reserve, which does not include any amount regarded as free for distribution through the profit and loss account. In the narrowest sense, therefore the description would include only Securities premium, Capital redemption reserve, Development rebate reserve and Profit on re-issue of forfeited shares.

A capital reserve can be generally utilised for the following purposes:

  • It can be utilised for issuing bonus shares, if the Articles of Association so provide.
  • It can also be utilised for writing off various types of intangible and fictitious assets.

But the amount of securities premium or capital redemption reserves account can be utilised only for the purposes specified in Section 78 and Section 80 of the Companies Act.

The question whether capital reserve can be made available for the distribution of dividend or not has not been dealt specifically with by the Companies Act. However, from the decisions of the two leading cases, i.e. (1) Lubbock vs The British Bank of South America (1892) and (2) Foster vs. The New Trinidad Lake Asphalte Co. Ltd. (1901) it is learnt that the following conditions must be fulfilled before distribution of dividend out of capital reserve:

  1. The Articles of Association must authorise such distribution.
  2. The capital reserve created out of profit on sale of fixed assets should be realised in cash.
  3. The capital profit must exist after revaluation of all the assets and liabilities of the company.

So, capital reserve created out of the following incomes is not available for dividend payment:

  1. Securities premium, the distribution of which as dividend is specifically prohibited by Section 78 of the Companies Act
  2. Capital redemption reserve
  3. Profit on re-issue of forfeited shares
  4. Profit prior to incorporation
  5. Profit on redeeming debentures at a discount
  6. Profit on purchase of business.

The auditor should examine that the capital reserve is created out of capital profits only. If the capital reserves are to be utilised for distribution of dividend, he should ensure that the same is permitted by the articles of the company.

8.4.3 Capitalisation of Reserve

The term ‘capital reserve’ should not be confused with the term ‘capitalisation of reserve’. Capitalisation of reserve is the process by which the reserve, whether capital in nature or revenue nature is permanently retained by the company by way of issuing bonus shares. It is one of the methods of financing the growth and expansion of the business and is popularly known as the ‘ploughing back of profit’.

So, capital reserve and capitalisation of reserve are two different terms having the following differences between them as depicted in Table 8.2.

 

TABLE 8.2 Distinction between capital reserve and capitalisation of reserves

Capital reserve Capitalisation of reserves

1. Capital reserve is created out of capital profit only.

1. Capitalisation of reserve is done either out of capital reserve or revenue reserve.

2. Capital reserve does not increase the capital of the company.

2. Capitalisation of reserve increases the amount of capital of the company.

3. There is no specific provision in the Companies Act regarding creation and utilisation of capital reserve.

3. SEBI has introduced detailed guidelines for the capitalisation of reserves.

4. Capital reserve is created by any type of capital profit when they arise.

4. Capitalisation of reserve is possible only out of some specific reserves.

5. Creation of capital reserve is accompanied by an increase in asset of the company.

5. Capitalisation of reserve does not increase the assets of the business. Only there is some reorganisation of capital structure of the company.

Advantages of capitalisation of reserve

Capitalisation of reserve is the process by which reserve is permanently retained by the company by way of issuing bonus shares. The shareholders as well as the company itself are benefited from the issue of bonus shares.

Advantages from the point of view of shareholders

  1. The shareholders get back their undistributed profit in the shape of shares.
  2. Accumulated profit can be distributed without disturbing the liquidity position of the company.
  3. It will increase the number of shares in the hands of the existing shareholders without any extra payment. Thus it will increase the marketability of shares.
  4. They receive profit of the company, though in kind, but in case of necessity, shares can be converted into cash by selling them in the market.

Advantages from the point of view of the company

  1. The company can keep its shareholders happy without impairing the financial position and liquidity of the company.
  2. Creditors can feel more protected due to increase in share capital.
  3. Growth of the company is ensured by permanently keeping the reserve in the business.
  4. By way of capitalisation of reserves, disparity between effective capital and book capital can be eliminated and the balance sheet can be presented in a more meaningful way.

Auditor’s duty in respect of capitalisation of reserves

The auditor will ensure that the following SEBI guidelines have been duly adhered to by the company at the time of capitalising its reserves.

  1. Bonus shares can be issued out of free reserves created out of genuine profits or securities premium only.
  2. Reserves created out of revaluation of assets have not been utilised for the purpose of capitalisation.
  3. The company has not defaulted in payment of interest and principal in respect of debentures and public deposits.
  4. There has been provision in the Articles of Association authorising the company to issue bonus shares.
  5. The extended capital after the issue of bonus shares has been within the limit of the authorised capital of the company.
  6. In addition to the above guidelines, the auditor will also check the accounting entries to ensure himself that they have been passed properly in the books of accounts.

8.4.4 Reserve Fund

Reserves can either be retained in the business as a part of working capital or invested outside the business in marketable securities.

The term ‘reserve fund’ is used to describe a reserve only when the amount of reserve is invested outside the business and it is represented by the readily realisable assets.

Again, according to Part-I of Schedule VI to the Companies Act, the word ‘fund’ in relation to any ‘reserve’ should be used only where such reserve is specifically represented by earmarked investments. So, the term ‘reserve fund’ should not be used loosely to represent any other fund.

The auditor should see that the reserve fund has been distinctly shown in the balance sheet and the fund is represented by readily realisable and earmarked funds.

8.4.5 Sinking Fund

A sinking fund is a specific type of fund, which is created for the redemption of a long-term debt or for the replacement of an asset. This fund is created by the regular investment of an amount, which will accumulate along with the compound interest earned thereon to make available a certain amount of money at the end of a stated period.

Creation of sinking fund

Sinking fund is created by adopting any of the following two methods:

  1. Sinking fund investment method   Under this method, a pre-determined amount is debited to the profit and loss account every year crediting sinking fund account and an equivalent amount should be taken out of business and invested in readily saleable securities. When the period of the fund expires, the investments are sold and the amount so realised is utilised for the concerned purpose.

     

  2. Sinking fund policy method   Under this method, a policy for the period is taken up and the premium on the policy is debited to the profit and loss account. At the end of the policy period, the amount received is utilised for the concerned purpose. This method is adopted usually in those situations, where a certain amount is required to be received at the end of the period.

Auditor’s duty regarding sinking fund

  1. The auditor should ensure that the reserve fund created has been separately shown in the balance sheet.
  2. He has to ensure that the purpose for which the fund is created has been clearly indicated.
  3. He should also see that the creation of sinking fund for any specific purpose is authorised by the Articles of Association of the company.
  4. He should also ensure that proper entries have been passed in the books of accounts to record the creation and utilisation of the fund.

8.4.6 Secret Reserve

The reserves, which is not disclosed in the balance sheet, is known as secret reserve or hidden reserve. It is called ‘hidden reserve’ as this reserve is not apparent on the face of the balance sheet. Obviously, if secret reserves are created, the balance sheet does not reveal the true and fair picture of the financial affairs of the company. The actual financial position of the company, in reality, is better than what is revealed on the face of the balance sheet.

Creation of secret reserve

Secret reserves can be created by adopting the measures given below.

  • Charging capital expenditure as revenue expenditure
  • Providing for more depreciation on fixed assets
  • Making excessive provision for bad and doubtful debts
  • Writing down goodwill to a nominal value
  • Under-valuation of stock-in-trade
  • Omitting some assets from the balance sheet
  • Showing contingent liabilities as real liabilities
  • Showing imaginary liabilities or overvaluing the liabilities
  • Making an excessive provision for contingencies or by continuing to carry forward provisions when they are not required
  • Ignoring the permanent appreciation in the value of assets
  • Suppression of sales
  • Inflating purchases.

Objects of creation of secret reserves

Secret reserves are usually created to serve the following purposes.

  • Meet any extraordinary loss in future without disclosing the fact to the shareholders.
  • Strengthen the financial position of the company
  • Mislead the competitors about the financial position of the organisation
  • Evade income tax and wealth tax
  • Manipulate share price for some ulterior motives
  • Regulate steady payment of dividend

Legal provisions

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 reserve.

But after the introduction of the Companies Act, 1956 it is no more possible for a company to create secret reserves. However, a banking company may continue to have secret reserves.

It is not possible to maintain secret reserves at present in a company form of organisation because of the following reasons:

  1. Section 227 of the Companies Act requires the auditor of a company to state in his opinion whether the balance sheet gives a ‘true and fair’ view of the state of affairs of the company as at the end of its financial year. But, if secret reserves are created, it will either overstate liabilities or understate assets and as a result financial statement will not reflect a true and fair view.
  2. Part I of Schedule VI to the Companies Act requires that the balance sheet will make full disclosure for reserves and provisions.
  3. Part III of Schedule VI to the Companies Act also requires that a provision for depreciation, renewal or diminution in the value 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 reserve account. As a result, it is not possible any more for a company to create secret reserves.

Auditor’s duty regarding secret reserves

The auditor is required to report on whether the balance sheet reflects a true and fair view of the state of affairs of the company. If secret reserve is created, the balance sheet will not reflect a true and fair view of the state of affairs of the company. So the auditor cannot ignore the existence of secret reserve in the balance sheet. If there is secret reserve, he must find it out. His position in this respect will not change even if it is created for some good purposes, e.g. for strengthening the financial position of the business or for meeting any future contingency. The auditor should, therefore, exercise reasonable skill and care in detecting all cases of secret reserves. He will advise his client to rectify the accounts to do away with secret reserve if it exists. If his advice is ignored, he will qualify his report.

There is also some relaxation in case of banking, insurance, electricity and finance companies, which may continue to have secret reserve. But even the auditor of such companies must not remain indifferent to the secret reserve. He must ascertain the magnitude of secret reserve existing in the books and enquire into its necessity. He will allow it to continue if he is satisfied that it has been created in the best interest of the company and the amount is reasonable.

In the context of the auditors duty while he detects the existence of secret reserve, the decision in the Royal Mail Steam Packet Company case (1931) is noteworthy.

[The fact of the case was that a huge amount of secret reserve was created under the head ‘Taxation Reserve’ in boom years. Later, when the company suffered heavy losses, this secret reserve was used to conceal the loss. The shareholders were given to understand through annual report that the company was running profitably and they were being paid dividend out of current year’s profits. The auditor was criminally prosecuted along with the chairman of the company for deceiving the shareholders. While defending himself, the auditor argued that the purpose of secret reserve was to augment profit in lean years and had he disclosed the fact of secret reserve, its purpose would have been defeated. But the auditor was held liable for committing breach of duty. It was held that ‘a protected utilisation of secret reserve, in order to keep the company going, is a serious matter which ought to be disclosed to the shareholders of the company.]

Even a provision in the articles of association forbidding the auditor from disclosing the fact of secret reserve is ultra-vires and invalid as was held in the case of Newton vs Birmingham Small Arms Co. Ltd. In these judicial pronouncements, it is noted that although creation of secret reserve was permitted, its disclosure was made obligatory.

Before the Companies Act 1956 came into force, there were no restrictions on the creation of secret reserves except that whenever it was utilised, it was necessary to disclose the amount adjusted out of such reserves.

The Companies Act now prohibits the creation of secret reserves. Only the banking, insurance and electricity companies etc. are allowed to create such reserves. Therefore, the auditor should state in his report, if he finds that such a reserve has been created. In case of companies, where creation of secret reserve is permitted, he should carefully enquire into the necessity of creating such a reserve. He need not qualify his report, if he is satisfied with the purpose of creation of such a reserve and the amount involved.

Legal views as regards secret reserves

The legal views as discussed in different cases so far taken to courts of law are summarised below.

Case Study

  1. Case: Royal Mail Steam Packet Company (1931)

    Fact of the case: A huge amount of secret reserve was created by the company under the head “taxation reserve” in boom years. Later, when the company suffered heavy losses, this secret reserve was used to conceal the loss. The shareholders were given to understand through annual report that the company was running profitably and they were being paid dividend out of current year’s profit.

    Legal view: The auditor was criminally prosecuted along with the chairman of the company for deceiving the shareholders. While defending himself, the auditor argued 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 committing breach of duty.

    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”.

  2. Case: Newton vs Birmingham Small Arms Co. Ltd. (1906)

    Fact of the case: In this case, the Articles of Association of the company provided that

    1. The Directors should have powers to form an internal reserve fund, which was not to be disclosed in the balance sheet and which should be utilised in whatever way the directors thought fit.
    2. The auditor should have access to the accounts relating to such reserves, but they should not disclose any information with regard thereto to the shareholders or otherwise.

    Legal view: It was held that these provisions were ultra-vires since they limit the statutory duty of the auditors.

    Justice Buckley opined that, “any regulations which precluded the auditors from availing themselves of all the information to which under the Act they are entitled, as material for the report which under the act they are to make as to true and correct state of the companies affairs, are, I think, inconsistent with the Act”.

8.4.7 Specific Reserve

A specific reserve is created for some definite purpose, out of the profits of the company. The purpose may be anything connected with the business, which the articles of association or the directors want to be provided for, such as dividend equalisation, replacement of fixed assets, expansion of the organisation, income tax liability for the future etc.

Though the concerned amount is carried under earmarked head, this reserve is available for distribution as dividend on the recommendation of the directors, but subject to the approval of the shareholders, since this is created by appropriation of profits.

Normally, specific reserves are created to comply with the terms of the Articles of Association or in accordance with a decision of the board of directors to meet a particular situation, which may arise in future.

Also some of the specific reserves may be required to be created under contractual obligations or legal compulsion. An example of the former would be the fund for redemption of debentures that of the latter would be the development rebate reserve, which is compulsory to be created, if the advantages of the development rebate are to be enjoyed from income tax liability. Such specific reserves take on the character of capital reserve.

Purposes of creation of specific reserve

The purposes of creation of specific reserve can be anything connected with the business, which the Articles of Association or the Board of Directors want to be provided for.

Some of the important purposes for which it is created are as follows:

  1. Debenture redemption reserve   In order to redeem debentures after a certain period of time, sometime debenture trust deed provides for the creation of sinking fund or debenture redemption fund. This fund is created by transferring an equal amount of profit every year to the said fund upto the specified period from profit and loss account.

     

  2. Capital redemption reserve   When preference shares are redeemed out of profit, i.e. without corresponding fresh issue of shares, an amount equal to the nominal value of shares redeemed is transferred to capital redemption reserve account from revenue profit of the company according to the provision of Section 80 of the Companies Act.

     

  3. Dividend equalisation reserve   In order to equalise the rate of dividend between lean years and boom years sometimes a reserve is created, which is known as dividend equalisation reserve. This reserve enables the company to pay dividend at a stable rate in different years irrespective of the amount of profit earned.

     

  4. Foreign project reserve   For availing deductions u/s 80HHB, a foreign project reserve account is to be created, which is equivalent to a certain percentage of profit from foreign projects earned during any financial year. The amount credited to this reserve account has to be utilised within a period of five years for the purpose of the business itself, and not for distribution of dividend.

     

  5. Staff welfare reserve fund   This reserve is created for conducting different welfare activities of the workers and employees of the organisation. The intention of this reserve is to create good image of the company amongst its employees and workers by undertaking various activities for their benefit.

Auditor’s duty as regards specific reserve

Specific reserve is created out of revenue profit of the company. So, creation of this type of reserve in no way distorts the true and fair view of the financial position of the company. However, this does not mean that the auditor has no duty in respect of specific reserves, particularly for those specific reserves, which are to be created to fulfil any legal requirement. The auditor must verify its adequacy and ensure that it is not used for any purpose other than that for which it is created. If he fails to do so, he will be held guilty of negligence as was held by the Chennai High Court in the case of M.S. Krishnaswami (1952).

So, the auditor has to take the following steps in order to justify the existence of specific reserves in the balance sheet of a company.

  1. Examination of the articles of association   The auditor should study the Articles of Associations to examine whether there is any provision for creation of specific reserve.

     

  2. Examination of the directors’ meeting minute books   He will go through the minute books of Directors’ meeting to see whether the management has taken any decision for the creation of any specific reserve and if so, whether the reserve has been created according to the decision taken.

     

  3. Examination of the balance sheet   The auditor will satisfy himself that the specific reserve created has been shown in the balance sheet according to the requirement of Part I of Schedule VI of the Companies Act.

     

  4. Examination of legal documents   He will also examine the related documents, e.g. the debenture trust deed, the tax audit file etc. to ensure that adequate provision has been created according to the legal requirements and the amount credited, if utilised, has been utilised according to the legal provisions.
POINTS TO PONDER
  • 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.
  • Provisions are amounts charged against revenue to provide for depreciation, renewals 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.
  • The reserves can be of either capital reserve or revenue reserve. Revenue reserve represents profits that are available for distribution to the shareholders held for the time being. Capital reserve represents reserves, which are created out of capital profit.
  • Capitalisation of reserve is the process by which the reserve is permanently retained by the company by way of issuing bonus shares. It is also known as ploughing back of profit.
  • Reserve can be retained in the business as a part of working capital or invested outside the business. Reserve fund is that part of reserve which is invested outside the business.
  • A sinking fund is a specific type of fund, which is created for the redemption of a longterm debt or for the replacement of an asset. It is created either by sinking fund investment method or by sinking fund policy method.
  • Reserves which are not disclosed in the balance sheet are known as secret reserves. At present, it is not possible for a company to create secret reserves, except banking, insurance and electricity companies.
  • A specific reserve is created for some definite purpose, out of the profits of the company. The purpose may be anything connected with the business, which the Articles of Association or the directors want to be provided for. Examples of specific reserve include debenture redemption reserve, capital redemption reserve, dividend equalisation reserve etc.
REVIEW QUESTIONS

Short-answer Questions

  1. What do you mean by ‘capitalisation of reserve’?
  2. How do you distinguish between reserve and provision?
  3. What is sinking fund? How and why it is created?
  4. How is secret reserve created and utilised?
  5. What is the difference between ‘capital reserve’ and ‘revenue reserve’?

Essay-type Questions

  1. What do you mean by ‘capital reserve’? How does the capital reserve differ from capitalisation of reserve? Can capital reserve or capitalised reserve be available for distribution of dividend? Discuss with reference to Indian Companies Act.
  2. What is meant by ‘capitalisation of reserves’? State the advantages of such capitalisation to the business and to the shareholders. What is the duty of an auditor in respect of capitalisation?
  3. What is secret reserve? Why it is created? Discuss the duties of an auditor in regard to secret reserve with reference to provision of Indian Companies Act.
  4. What is meant by ‘special reserve’? What are the purposes of creation of such reserves? What are the duties of the auditor regarding special reserve?