Table of Contents
- 1 BCom 3rd Year Depreciation and Reserves Notes Study Material
- 1.1 BCom 3rd Year Depreciation and Reserves Notes Study Material
- 22.214.171.124 DEPRECIATION
- 126.96.36.199 Meaning of Depreciation
- 188.8.131.52 Causes of Depreciation
- 184.108.40.206 Necessity of Depreciation
- 220.127.116.11 Bases of Depreciation
- 18.104.22.168 Methods of Providing for Depreciation
- 22.214.171.124 Some Arguments as regards Depreciation
- 126.96.36.199 Answer
- 188.8.131.52 RESERVES
- 184.108.40.206 Methods of Creating Secret Reserve
- 220.127.116.11 Objects of Creating Secret Reserve
- 18.104.22.168 Against the Interests of a Business
- 22.214.171.124 Other Objections to Creating Secret Reserve
- 126.96.36.199 LEGAL DECISIONS
- 188.8.131.52 Newton vs. Birmingham Small Arms Co. Ltd. (1906)
- 184.108.40.206 Royal Mail Steam Packet Ltd. (1931)
- 220.127.116.11 Shamdasani vs. Pochkhanwala (1927)
- 18.104.22.168 Provision
- 1.1 BCom 3rd Year Depreciation and Reserves Notes Study Material
BCom 3rd Year Depreciation and Reserves Notes Study Material
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BCom 3rd Year Depreciation and Reserves Notes Study Material
“Depreciation may be defined as the measure of the exhaustion of the effective life of an asset from any cause during a given period.” -Spicer and Pegler
“Depreciation may be defined as a gradual deterioration in value due to use.” -R. G. Williams
“It is a matter of common knowledge that all fixed assets such as plant, machinery, tools, buildings, leaseholds, furniture, etc., gradually diminish in value as they get older and become worn out by constant use in the business.” -J. R. Batliboi
“Depreciation represents the loss in value of the capital sunk in buildings, plant, machinery and other equipment due to normal inevitable deterioration during the life of these assets.” -Harold J. Wheldon
“In practice, the term ‘depreciation’ is commonly used in a very wide sense, covering diminution in the value of assets caused by outside fluctuations in realizable and replacement value, and also the amortization in the cost of an asset over the period of its use.” -De Paula
“Depreciation is a reasonable allowance for the exhaustion, wear and tear of the property used in the trade or business, including a reasonable allowance for obsolescence.” -U. S. Treasury Department, Bureau of Internal Revenue
Meaning of Depreciation
From the above definitions, it is evident that depreciation is the permanent and continuous decrease in the value of an asset from any cause. It differs from fluctuation which is a temporary increase or decrease in value. When a fixed asset is acquired for use in the business, its working capacity or its earnings is gradually reduced. It is a fall in the value of the fixed asset.
In other words, it is the estimated cost of the expired usefulness of the fixed asset. It is, thus, a capital loss and must be provided for out of profits before they are actually distributed. If this is not done the Profit and Loss Account and the Balance Sheet will reveal misleading and incorrect results. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
Causes of Depreciation
The causes of depreciation may normally be two:
(1) Internal Causes, and
(2) External Causes.
(1) Internal Causes. Those causes which relate to the nature of the asset itself may be placed under this head. They are the following:
(i) Wear and Tear. Some assets, such as buildings, plants, machinery, motor, etc., decrease in value by the constant use to which they are put. Although they are kept in order by providing for their repairs, the time comes when they are total of no value.
(ii) Exhaustion. Assets like plantations, animals, etc., lose their value gradually with the passage of time. They have definitely become useless after the expiry of a certain fixed period. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
(iii) Depletion. There are oil wells, mines, etc., which lose their value if the oil or mineral is extracted out of them. This is termed ‘Depreciation by Depletion’.
(iv) Deterioration. Normally, depreciation by deterioration is in case of those assets. e.g., food articles, etc., which have a temporary or short life. Repairs make up for the loss caused by deterioration.
(2) External Causes. Those factors which arise from causes outside the assets are external causes. They are the following:
(i) Effluxion of Time. A decrease in the value of assets, such as patents, leasehold property, etc. is caused by the effluxion of time. An asset acquired on lease becomes valueless after the expiry of the period of the lease.
(ii) Obsolescence. Obsolescence is the loss in the value of an asset that arises out of new inventions which can produce better goods at a cheaper price. Since old machines become out of date due to the discovery of new machines and changes in fashion, a businessman has to purchase the latest models and sell the old ones and thus, suffer a loss. Hence, obsolescence is totally an external factor that has no definite time of its occurrence.
(iii) Accident. Some assets, such as works, machines, motors, furniture, etc., become valueless due to an accident like fire, Mood, or similar other havoc. These are examples of depreciation by accident. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
(iv) Permanent fall in the Market Value. Assets like investments lose their value by a permanent fall in their market value. Actually, this is an example of a permanent or temporary loss in value due to market fluctuations.
Necessity of Depreciation
(1) Every asset is purchased in a business for use and its constant use causes depreciation or a decrease in its earning capacity. Such a decrease in value is like any other business expense which must be debited to the Profit and Loss Account. If it is not done, correct profits cannot be calculated and, secondly, when the asset will become a mere scrap, it would be a heavy charge on the Profit & Loss Account if the whole of the loss, i.e., the entire cost of the asset is charged to the Profit and Loss Account of that year. This is totally unfair, unjustified, and against business principles. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
(2) If a provision is not made for depreciation for a particular asset, it will appear in the Balance Sheet at an inflated figure, i.e., at a higher value than its real value. Thus, the Balance Sheet will not exhibit the true and fair view of the state of affairs of the business.
(3) The real motive of providing for depreciation on a particular asset is to keep the capital intact and show the correct value of the asset in the Balance Sheet. Hence, the entire loss is distributed over a number of years for which the asset remains in use.
(4) Another purpose behind providing for depreciation for an asset is to make the sum available at a time when that asset becomes totally valueless for its replacement.
(5) If depreciation is not provided for, the asset will be shown at an over-valued figure and profits would be higher than the actual ones. If so, dividends will be paid out of capital and thus, a part of the capital will be returned to the shareholders.
Bases of Depreciation
There are some reasonable, accurate, and widely accepted principles on the basis of which the amount of depreciation should be charged to the Profit and Loss Account every year. They are as given below:
(1) Original Cost of the Asset. The books of accounts can reveal facts about the original cost of the asset. If the business has been purchased from the vendors, the price at which it has been acquired should be enquired into. This is a simple affair to know about its cost.
(2) Estimated Working Life. It is rather a technical question to estimate the working life of an asset. The assets differ in their nature and character and the exhaustion in their value also depends upon their use in business. Some businesses employ experts to assess the probable life for which an asset will remain in use and in proper working order. However, much will depend upon the conditions under which an asset is maintained and preserved. Thus, the working life of an asset is careful to be considered.
(3) Provision for Repairs and Renewals. As already stated, proper provision for repairs will help in maintaining an asset in good order. Given proper attention, an asset can work well for the stipulated period otherwise it will become useless after a few years. This has to be considered before depreciation is provided for. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
(4) Capital Expenditure. This is another vital issue to be considered. Throughout the life of an asset, additions, and extensions are made whenever necessary and thus improvements are affected in a way that the asset maintains its normal earning capacity. Such expenditure is of a capital nature and if it is incurred in large amounts, the working life can be extended, and accordingly, depreciation will have to be provided for additions made.
(5) Loss of Interest on Capital Investment. This is another consideration. The capital involved in purchasing an asset could have been invested elsewhere and interest could be earned on that. Since a part of capital is blocked in a particular asset, the loss of interest on that account must be taken into account.
(6) Residual or Scrap Value. The value that an asset will bring when it is sold as scrap should also be considered before making a provision for depreciation.
(7) Depreciation in Case of Obsolescence. This is yet another factor to be considered. If an asset is likely to be of no value due to some new inventions, more amount of depreciation should be provided for. The possibility of new developments and inventions is a factor that should be given due weight before making provisions for depreciation. New inventions make assets valueless.
(8) Provision for Depreciation in Previous Years. If excessive provision has been made for depreciation in previous years, a business may not provide a huge amount for depreciation during the current year. This is also to be considered.
(9) Legal Provision or any change therein. If there is some legal provision for providing depreciation on assets or there has been some amendment to change the existing law in this regard, the effect of such an arrangement should be fully considered. It should be seen whether the legal provisions have been complied with. The provisions of the Companies Act in regard to depreciation, etc., have been discussed in a separate chapter of this book. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
Methods of Providing for Depreciation
Different methods may be adopted and applied to provide for the depreciation of different types of assets but it is to be remembered that once a method has been finally decided and adopted, it must be followed from year to year. The following are some of the important methods of providing for depreciation:
- Fixed Installment Method.
- Diminishing Balance or Reducing Installment Method.
- Annuity Method.
- Depreciation Fund Method.
- Insurance Policy Method.
- Revaluation Method.
- Compound Interest Method.
- Depletion Unit Method.
- Use of Kilometer (Mileage) Method.
- Efficiency Hour Method.
- Single Charge Method.
- Global Method.
1. Fixed Installment Method. This method is also called the ‘Fixed Percentage Method’, ‘Straight Line Method’, or ‘Original Cost Method’. Under this method, a fixed percentage of the original cost of the asset is written off each year till the asset is ultimately reduced to nil or to its break-up value. Thus, the entire cost less the scrap value is written off during the estimated working life after which the asset becomes valueless.
This method is simple in calculation and also in such a case, the charge to the Profit and Loss Account is uniform every year. But with the passage of time, the charges of repairs increases and hence, the effects on net profits are not steady every year. In case of additions made to the asset, a lot of calculations are involved. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
2. Diminishing Balance Method. This method is also known as the ‘Diminishing Value Method’ or ‘Written-Down Value Method’ ‘Decline Balance Method’. Under this method, a fixed percentage is written off every year on the reduced balance of the asset.
Thus, the percentage of depreciation is not applied to the original cost but only to the balance which remains after charging depreciation at the beginning of a year. The percentage of depreciation remains fixed for all the years of the working life of an asset but the actual amount of depreciation written-off every year goes on decreasing with the reduction in the value of the asset till, after the expiry of the working life, the value of the asset is brought down to its scrap value by and by. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
It is a useful method in the case of assets that have a fairly long life and which require plenty of repairs, e.g., plant and machinery. For assets having short life for which depreciation has to be charged at a uniform rate, it is not of much use.
3. Annuity Method. Under the annuity method of charging depreciation, the asset is treated just like an interest-bearing investment, i.e., the money invested in the asset is retained in the business and is expected to earn interest at a fixed rate.
Thus, an amount equivalent to the estimated loss of interest is written off in the Profit & Loss Account throughout the useful life of the asset, and a certain fixed amount of depreciation as shown by the annuity table is provided for every year. The asset account is debited with interest at a fixed rate and also a fixed sum is written off the asset account so that the value of the asset plus interest comes to nil at the end of its working life. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
The Annuity Method is applied in case of assets that have a definite span of life e.g., lease, etc. It is not of much value for assets to which additions are made every year. This is why this method is not popular.
4. Depreciation Fund Method. This is also known as the ‘Sinking Fund Method’ or ‘Reduction Fund Method’ ‘Amortization Fund Method’. According to this method, a depreciation fund is created every year and credited with the amount charged to the Profit & Account, and simultaneously, an equivalent sun is invested outside the business to bring interest every year while the asset remains at its original cost in the books of accounts.
The installments are fixed in such a way that the whole investment will accumulate at the compound interest and provide a sum equivalent to the replacement cost of the asset at the end of its working life. This is the usual practice followed under this method.
Thus, the asset will be written off entirely after a fixed interval of time and the money would be available to replace it at the end of its useful life. The cash is usually invested in gilt-edged securities. This is a good method of charging depreciation under which no inconvenience is caused to the business and money becomes available from outside to replace the asset after the expiry of its working life.
5. Insurance Policy Method. Under this method, the fund instead of being invested in gilt-edged securities is applied in taking out an Insurance Policy so that after the expiry of the working life of the asset, the insurance company will pay the sum assured by which the asset can be replaced.
The superiority of this method over the Depreciation Fund Method is that under it, there are little chances of loss on realization, but at the same time, it is more expensive and is not applicable to assets the life of which cannot be calculated and determined precisely.
6. Revaluation Method. This is a simple method under which the asset is required to be valued at the end of each year when the Balance Sheet has to be prepared and the fall in its value is charged as depreciation. Occasions are rare in which there are profits on revaluation. Assets are usually revalued by technical experts and their value is determined as the value to the business as a going concern. This method is applicable in the case of assets such as loose tools, horses, patterns, models, designs, bottles, trademarks, etc.
This method may be said to be the most scientific method of calculating depreciation. However, it is costly in the sense that competent men are needed to revalue the assets. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
- Compound Interest Method. This method is usually adopted for charging depreciation on fixed assets of the electric supply undertakings. It is just like the Depreciation Fund Method, the only difference is that investments are not made outside the business and the interest is also calculated on the increasing balance of depreciation each year. The depreciation provided for each year is so adjusted that it becomes equivalent to 90% of the value of the asset accumulated at the rate of 4% per annum compound interest.
This method enables retention of working capital in the business and involves no risk of loss on realization as in the case of the Depreciation Fund Method.
- Depletion Unit Method. This is also known as the ‘Production Unit Method’. This method is used in case of wasting assets such as mines, quarries, etc. To find out the amount of depreciation, the value of the mine is reduced to the extent to which the output is obtained from it. It is, thus, based on factual data and not so much on calculations.
The method provides that the amount of depreciation should be written off to the account according to the amount of output raised.
- Use or Kilometre (Mileage) Method. This method is adopted in case of those assets, the use of which can be measured in terms of kilometres, e.g., cars, buses, motor-cycles, etc. If a car costing Rs.4,00,000 is estimated to run for about 1,60,000 kilometre and on an average, it runs for about 16,000 kilometre each year, it will be valueless after the expiry of 10 years. But if it runs 32,000 kilometre in the first year, 24.000 kilometre in the second year, 28.000 kilometre in the third year and so on, the depreciation charged will be Rs.80,000, Rs.6,000 and Rs.70,000 respectively (calculated at the rate of 2.50 paise per kilometre).
This method is simple in nature but difficult for adoption in practice.
- Efficiency Hour Method. This method is also known as ‘Machine Hour Method’ or ‘Unit of Production Method’ or ‘Hours of Service Method’. It is just like the Kilometre Method with the only difference that the working life of the asset is calculated in terms of hours instead of calculating it in terms of kilometre. This is applied in case of machines, the working life of which can be measured in terms of hours. This is used for costly machines. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
- Single Charge Method. Under this method, a fixed sum of money equivalent to the amount of depreciation and repairs over the working life of the asset is charged to the Profit & Loss Account and credited to a depreciation and Repairs Reserve Account. Repairs affected in the following years are charged to this account. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
- Global Method. Under this method, a flat rate of den on all the assets is taken together. This method is practically not much in use. The use of this method, a flat rate of depreciation is charged every year this method is not permissible under the Companies Act as the fixed assets have to be distinguished from one another for this purpose.
Auditor’s Duty as regards Depreciation
It has already been made clear that the auditor is not a valuer. It is difficult for him to estimate the amount of depreciation in the case of each individual asset. It is actually for competent men and technical experts in the line to ascertain exactly the amount of depreciation for different types of assets. The auditor should, however, see that:
(i) adequate provision has been made for depreciation every year;
(ii) relevant principles of accountancy have been followed in making provision for depreciation;
(iii) the officers of the business have sincerely and honestly made provision for depreciation;
(iv) the principles followed from year to year for providing depreciation are more or less the same;
(v) the capital employed in the assets is being kept intact;
(vi) the business traditions and rules have been fully considered; and
(vii) the provisions of the Companies Act as regards depreciation have been complied with.
But if he finds that :
(i) the depreciation has not been dealt with honestly by the management;
(ii) competent persons have not been employed, and if employed they have not carefully examined the issue:
(iii) the provision for depreciation is not adequate; and
(iv) the principles of accountancy have not been followed by the management in making the charge for depreciation;
the auditor should draw the attention of the owners of the business towards the issue and mention the fact in his report. If there is any change in the method of providing for depreciation, it must be disclosed in the Profit & Loss Account along with its effect on the profit or loss for the year. This is all that he can do in this matter. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
The Income-tax Act and the rules laid down under it have specified the rate of depreciation on different types of assets in a company before arriving at its assessable income. Thus, an auditor has been relieved of his burdensome responsibility regarding the provision for depreciation. The Electricity (Supply) Act, of 1948, has laid down the provisions for working out the working life of the different classes of assets and rates for charging depreciation, Sections 123 and 198 of the Companies Act, 2013 are quite important in this regard.
Some Arguments as regards Depreciation
The Directors of a company have made no provision for depreciation and for this, they have advanced the following arguments:
(1) The market value of the fixed asset has improved and is much in excess of its present book value.
(2) The repairs and renewals have fully maintained the asset and hence, it is as good as new.
(3) The current year’s profits are not sufficient to provide for further depreciation.
(4) The amount of depreciation already written off during previous years has been quite excessive. Hence, there is no necessity of providing for depreciation.
(1) A fixed asset is not acquired for resale but for the purpose of earning profits. Its depreciation is a necessary business charge against the profits, not an appropriation of profits. Hence, the market price should not be taken into account in calculating depreciation and the loss in value sustained by its use must be brought into account. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
(2) This argument is again invalid. It is to be remembered that no amount of repairs and renewals can protect a fixed asset from being depreciated, though, of course, it can maintain it for a longer time in proper working order. Depreciation represents loss in the value of the asset caused by its constant use. Hence, depreciation must be provided for
(3) It is also wrong to think that since current year’s profits are not sufficient, depreciation should not be provided on the assets. Depreciation is a charge against Profit & Loss Account and not an appropriation of profits. Hence, profits may be sufficient or insufficient, or dividends may be paid or not, or the shareholders may be satisfied or not, but depreciation must be provided for. Even in a year of loss, depreciation has to be charged against the Profit & Loss Account. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
(4) The excessive depreciation provided for in the past years is not a sound argument to contend that no provision should be made. Depreciation being an actual loss arising out of the use of a fixed asset during the current year must be provided for before the calculation of net profits. Only then, the Balance Sheet can reveal the true and correct view of the financial affairs of a business.
If excessive depreciation is provided for in the previous years, it may be transferred to Reserve Account. The provision for depreciation should be made out of the profits of a year in which the assets have been used and hence, it must be so provided at all costs.
Reserve is an appropriation of profits and it denotes that amount that is kept aside for emergencies likely to arise in the future. Any contingency, known or unknown, can be met out of reserve so created. A reserve is, thus, a part of the profits set aside for some general contingencies or for some specific purposes and is the undistributed portion of the profits. Classification of Reserves
Reserves are of the following types:
- General Reserve,
- Specific Reserve,
- Capital Reserve,
- Reserve Fund,
- Sinking Fund,
- Secret Reserve.
1. General Reserve
The purpose of creating a general reserve is to provide additional working capital or to strengthen the financial position of a business. Such a reserve is available to meet any unknown contingency or for expansion of business, etc. The purpose behind its creation is usually general.
Aims. (1) A general reserve is often created to strengthen the liquid resources of a business. It is an appropriation of profits. It increases the reputation of a business in the market. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
(2) It is also aimed at making additional working capital available. Borrowing money from outside for providing working capital is not a healthy practice and hence, a general reserve is created to provide additional working capital.
(3) It is also designed to meet any known liability, contingency, or similar other commitments. In the absence of general reserve, the business has to face a lot of difficulties. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
(4) In the absence of adequate profits during a particular year, the general reserve can also be utilised for equalizing the rates of dividends.
(5) It is also thought useful to create a general reserve in circumstances to conceal the actual profits which are excessive in a particular year.
Progressive institutions usually adopt this practice.
Auditor’s Duty. The question of creating a general reserve depends absolutely upon the management and the policy of a business concern. The auditor can neither make recommendations in this connection nor can place any restrictions on this account. He should merely see that a general reserve is created in the interests of the business and shown properly on the Balance Sheet. He should keep the following points in view:
(1) He should examine carefully the rules of the business. e.g., Articles of Association in the case of a company.
(2) If some definite rate of creating a general reserve is prescribed, he should see that it is created on the basis of this rate of percentage.
(3) He should also scrutinize the provisions made for granting depreciation, providing for doubtful debts, etc. Ordinarily, a general reserve is equivalent to net assets (i.e., Assets – Liabilities). (BCom 3rd Year Depreciation and Reserves Notes Study Material)
If the auditor finds something objectionable in the accounts in this regard, he may mention the fact in his report. However, he can advise his client on the issue of adequacy or otherwise of the general reserve, if he is asked to do so. He should not insist upon its creation if the profits are not adequate. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
- Specific Reserve
A specific reserve is created for some specific purpose and is meant to meet certain but unestimated liabilities. It is a charge on profits and not an appropriation of profits. Some examples of such reserves are:
(1) To meet out some future expected loss, such as depreciation, repairs, renewals, etc.
(2) To meet an outstanding liability for expenses, e.g., salary, wages, income tax, rent, etc.
(3) To provide for an expected contingency, e.g., doubtful debt, discount on debtors. a disputed claim, equalization of dividends, etc.
Hence, it is evident that a specific reserve has to be made irrespective of the fact that there is profit or not. It is not a surplus but purely a charge against profits. It is a prior provision to meet some future liability.
Auditor’s Duty. The auditor should be alert as to the adequacy of the specific reserves. He has no doubt a great responsibility in regard to the creation of a specific reserve. How much specific reserve is adequate will depend upon the nature and the objectives of a business.
- Capital Reserve
The capital reserve is created out of capital profits or gains of a capital nature. They arise out of:
(1) Premium on issue of shares or debentures:
(2) Sale of fixed assets at a profit;
(3) Amount in the credit of the Forfeited Shares Account;
(4) Profit prior to incorporation;
(5) Profit (i.e., as a result of appreciation) on revaluation of assets or liabilities;
(6) Profit on taking over a business from the vendor;
(7) Profit on redemption of debentures.
Capital is, as a general rule, not distributable among the shareholders, though, of course, it can be so distributed under certain specific conditions. It can, however, be utilized for meeting capital losses or writing-off abnormal losses.
Auditor’s Duty. 1. The auditor should see that a capital reserve is created out of capital gains.
2. He should ensure that capital reserve is utilized for meeting losses of a capital nature.
3. If the capital reserve is utilized for distribution among the shareholders by way of dividends, he should study the rules in this regard, i.e., the provisions of the Articles and the Law. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
4. Capital reserve has to be shown separately and distinctly in the Balance Sheet and must be distinguished from the revenue or general reserve.
4. Reserve Fund
Reserve Fund and general reserve have more or less the same object. The term Reserve Fund is often used by some accountants when the money so reserved is invested outside the business in Securities which are readily and easily realizable.
Hence, Reserve Fund is not a new concept. It is only a means of setting aside a sum of money so as to strengthen the financial position of a business. To invest such a Reserve Fund outside the business, a Reserve Fund Investment Account is opened and when a Reserve Fund is invested, it is debited and such account is credited. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
Auditor’s Duty. The auditor should see that the Reserve Fund has been distinctly shown in the Balance Sheet. It is also to be mentioned that the fund is a red special provision for a specific purpose.
- Sinking Fund
Sinking Fund is a type of specific reserve created with one of the following objects in view:
(i) Replacement of liability, e.g., loans, debentures, etc., or
(ii) Redemption of a Wasting Asset, e.g., a mine, etc., or
(iii) Replacement of an asset of depreciable nature, or
(iv) Renewal of a lease.
Thus, a Sinking Fund is created by means of a sum set aside periodically out of the profits every year with the purpose of investing it outside the business so that by a specific date, a certain sum may be accumulated to meet a liability or to replace a wasting asset.
The procedure is simple. The Sinking Fund is created by setting aside a portion of profits. But there is a difference between Sinking Fund and Reserve Fund. A Sinking Fund is always for a specific purpose while a Reserve Fund is usually created for general contingencies. A Sinking Fund is invested outside the business as a matter of rule while a Reserve Fund may or may not be so invested. Two things are still more important:
(1) In the case of a Sinking Fund created for the replacement of an asset, it is a charge against profits and the object is to provide against a loss that is likely to fall on revenue. Depreciation on Sinking Fund is a good example of this type of Sinking Fund and to create it, the Profit & Loss Account is debited every year with a certain sum of money
(2) The creation of a Sinking Fund for redemption or reduction of liability is usually an appropriation of profits and in such a case, the Profit & Loss Appropriation Account is debited with a certain sum of money every year. Debenture Redemption Fund is an example of this type.
Whatever the purpose behind the creation of a Sinking Fund, a certain sum of money is invested outside the business in such a way that a fixed amount accumulated with compound interest may be made available at a future date to meet our liability or loss or to replace an asset.
There is another point of difference. In the case of a Sinking Fund, created to repay a liability, the accumulated profits remain unused at the end of the period and the liability is paid out of the cash raised from the sale of investments. The Sinking Fund Account is closed by transferring the balance to General Reserve Account. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
In the case of a Sinking Fund for the replacement of an asset, the old asset is closed by transferring to the Sinking Fund Account, and a new asset is purchased out of the sale of investments. If any loss is incurred in the process, it is transferred to the debit of the Profit and Loss Account.
Auditor’s Duty. (1) The auditor should see that a Sinking Fund is created according to the provisions of the Articles of Association, the Debenture Trust Deed, etc. It is to be ensured that the provisions have been duly complied with.
(2) He should also see that the provisions made in this regard every year are adequate. This is a necessary part of his duty.
(3) Proper records are being maintained in regard to the creation of a Sinking Fund and investing it outside the business. He should vouch for such records and see that the investments made in this respect are distinctly earmarked on the Balance Sheet.
- Secret Reserve
This is often called ‘Hidden Reserve’ or ‘Internal Reserve’ or ‘Inner Reserve’. A secret reserve is not disclosed on the face of the Balance Sheet. However, if close and intelligent scrutiny is made into the accounts of a business, the existence of a secret reserve may be established. It is, of course, true that if a secret reserve exists, the Balance Sheet of a business cannot reveal the correct picture of the financial affairs of the business.
Methods of Creating Secret Reserve
There are a variety of ways of creating a secret reserve as given below:
(1) Undervaluing investments, stock-in-trade, plant, and machinery, etc., and showing them much below their cost or market value.
(2) Not recording the permanent appreciation or rise in the value of a fixed asset.
(3) Providing excessive depreciation on fixed assets.
(4) Overprovision for bad and doubtful debts.
(5) Under-estimating Goodwill.
(6) Omitting some of the assets totally from the Balance Sheet.
(7) Charging capital expenditure to revenue or creating revenue receipts to an asset.
(8) Overvaluing a liability.
(9) Inclusion of fictitious liabilities.
(10) Showing contingent liabilities as real liabilities.
(11) Grouping items of dissimilar nature on the liabilities side of the balance sheet.
Objects of Creating Secret Reserve
There are various objects for creating a secret reserve. They may or may not be always in the interest of the business. Some of such objects are the following:
In the Interest of a Business
(1) The reserve may be utilized to meet out an unforeseen loss without making the fact known to the owners or outsiders.
(2) The existence of a secret reserve can help in avoiding undue competition by concealing the high amount of profits from the rivals.
(3) A secret reserve enables the company to regulate a normal rate of Dividend, i.e., by creating a reserve when there are abnormal profits and distributing the same in a lean year. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
(4) A secret reserve increases the working capital and, thus, strengthens the financial position of a business.
(5) The management may have an opportunity to hide a portion of the profits by creating a secret reserve that it does not want to distribute to the advantage of the business as a whole.
Against the Interests of a Business
(1) By creating a secret reserve, the Balance Sheet gives a false and inaccurate picture of the affairs of a business. Thus, the true position is concealed and the value of the shares goes down in the market as the position of the concern is not shown better than what it actually is.
(2) The directors favour the creation of a secret reserve in case, they get an opportunity of misappropriating the funds of the business.
(3) The actual profits are not made known to the owners of the business and hence, by creating a secret reserve, the directors indulge in malpractices and speculations in the shares of the company which goes against the interests of the concern.
Other Objections to Creating Secret Reserve
(1) The Balance Sheet does not present a true picture of the financial affairs of a concern.
(2) The owners or the shareholders of a company do not get their due share in the profits of the business and as such, they are deprived of their legitimate right to the share of profits. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
(3) Value of shares goes down in the market.
(4) The concern loses its reputation in the market.
(5) Secret reserve may be a measure of concealing the inefficiency and other defects. Losses arising out of careless and negligent management are concealed by the management against a secret reserve.
(6) If fixed assets are undervalued to create a secret reserve, claims may be made with the insurance company in case of a break of fire on the basis of the valuation shown in the Balance Sheet. It goes against the interests of the business.
(7) Directors find an opportunity to misuse funds out of a secret reserve.
(8) If an asset is altogether omitted from the Balance Sheet to create the auditor may omit to verify the existence of an asset that can be misappropriated easily. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
(9) According to the Companies Act, 2013, the creation of secret reserves is prohibited except in the case of companies governed by special Acts such as Banking, Insurance, and Electric Supply Companies. The following are the reasons:
(i) It requires full disclosure in the actual accounts of the transactions relating to reserves and provisions.
(ii) It is also required under the Act that the Profit and Loss Account and the Balance Sheet must show a true and fair view of its profit or loss and of financial position. For this, the accounts must not be misleading, i.e., there should neither be an overstatement of the assets nor an understatement of the liabilities. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
Thus, the building up and utilization of undisclosed reserves is now prohibited under the provisions of the Companies Act except in the case of Banking, Insurance, and Electricity Supply Companies.
Auditor’s Duty. It is now clear that no secret reserve can be created by public companies other than Banking, Insurance, and Electricity Supply Companies and the position of the auditor is quite a state. If he finds that something contrary to this has been done, he may disclose the fact in his report. He should never certify as correct the Profit and Loss Account and the Balance Sheet under such circumstances:
(1) He should, first of all, enquire into the necessity of creating a secret reserve.
(2) He should study thoroughly the Articles of Association and examine the legality or otherwise of creating a secret reserve. He should ensure that the intentions of Directors in this regard are quite honest.
(3) He should try to collect every minute of information about the creation of a secret reserve. He should satisfy himself with the method and the procedure of creating such a reserve. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
(4) If a secret reserve is created by overvaluing liabilities or undervaluing assets, he should discuss the issue with the management and go deep into the policy and practices behind it. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
(5) He should ensure that unless it is felt absolutely necessary to create a secret reserve, he should not accept the creation of secret reserves as valid and ask the management to prepare the revised annual accounts.
But if the management is not prepared to accept his arguments, he should mention the fact in his report. Hence, if the creation of a secret reserve is absolutely necessary, proper and within rules, he should not object to such a creation, otherwise, he should disclose the fact in his report.
Newton vs. Birmingham Small Arms Co. Ltd. (1906)
Brief Facts of the case. The Articles of Association of the Company were altered by special resolution to give Directors the powers to build up a secret reserve without showing it on the face of the Balance Sheet. The special resolution also gave powers to the auditors to verify the transactions relating to the creation of a secret reserve and to see that this reserve was properly utilized. The special resolution also provided that the matter of secret reserve would not be brought to the notice of the shareholders by the auditors through their report.
Decision. A special resolution to insert an article that deprives the auditor of statutory power is ultra vires, i.e., against the accepted Canons of Law.
Royal Mail Steam Packet Ltd. (1931)
Brief Facts of the case. For several years, this company had been running at a loss but their accounts showed considerable profits available for being distributed as dividends. This manipulation in the accounts was made possible through the utilization of special credits in connection with the excess profits, duty recoveries, and taxation reserves created in excess out of the past profits while on the face of the final accounts, there was no indication of any secret reserve and the shareholders were totally in the dark about the real trading position.
Decision. The keeping of secret reserves by a company is a very disputed point. The auditors should not as a rule be liberal in the matter of allowing undisclosed reserves to be utilized for inflating the profits with the resultant dividend payment. The auditor should without any hesitation mention in his report the presence of a secret reserve. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
Shamdasani vs. Pochkhanwala (1927)
It was held in this case that if any part of the secret reserve is availed of to meet bad and doubtful book debts, it must be revealed in the Balance Sheet and not concealed. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
When some loss is anticipated but its exact amount cannot be ascertained, a provision is made. Such provisions may be made either (i) to provide for losses that may arise on the realization of certain assets, or (ii) on accruing liabilities. The exact amount cannot readily be made known for the present in such cases, e.g., provision for bad debts, provision for discount, provision for taxation, etc.
Auditor’s Duty. The auditor should thoroughly check the sums allocated as provisions against specific loss or liability. He should examine all facts and figures and go through all the relevant documents to ensure that all known losses, liabilities, and contingencies have been duly provided for. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
For this, he should examine the Articles of Association and the Directors’ Minute Book to ensure whether there is any resolution in respect of provisions contained therein. He should ensure that provisions have been adequately made and he can point out the valid arguments in favor of making provisions if he is so asked by his client. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
If he feels that the losses are considerable and due provisions have not been made, he should refer to the issue in his report. This is all that he can do in this regard. (BCom 3rd Year Depreciation and Reserves Notes Study Material)
BCom 3rd Year Depreciation and Reserves Notes Study Material