Nature of Reserves

                            Nature of Reserves

Reserve is an appropriation of profit and thus, belongs to the proprietors just as capital does, it being appropriation of profit. Reserves reduce divisible profits and can be invested in outside securities. Reserves are shown on the liabilities side of the Balance Sheet.

Reserve Fund: If Reserves are invested in outside securities and such securities are earmarked for a particular purpose denoted by the reserve, the reserve is known as Reserve Fund. A business will invest the funds outside only if:
(a) ready cash is necessary on a certain date, or
(b) The funds cannot be profitably invested in the business itself

It should be remembered that a reserve fund and debit balance in profit and Loss Account or Statement of Profit and Loss (in case of companies) cannot exist together.

In case it shows a debit balance, at any subsequent date, it is adjusted against the Reserve Fund. The reason being that it would be a contradiction to state on one side of the Balance Sheet, an item showing a deficiency in Profit and Loss Account or Statement of Profit and Loss (in case of companies) and on the other side, an item representing the surplus set aside out of profits. Thus, the debit balance in the Profit and Loss Account or Statement of Profit and Loss (in case of companies) (if any) should be shown as a deduction from the Reserve Fund or General Reserve under the head 'Reserves and Surplus' on the liabilities side of the Balance Sheet or vice versa.

SECRET RESERVE:
Secret reserve is a reserve the existence and/or the amount of which is not disclosed in the Balance Sheet. It is also called Hidden Reserve. It can be said that there is a surplus of assets over liabilities and that the surplus is not disclosed or shown by the Balance Sheet. Such reserves are created by showing the assets at a lower amount and liabilities at a higher amount.

Creation of a Secret Reserve:-- Some of the ways in which Secret Reserve can come into existence are: 1. by charging excessive depreciation,
2. by undervaluing stock-in-trade and goodwill,
3. by creating excessive provision for bad debts and other contingencies,
4. by charging capital expenditure to Profit and Loss Account,
5. by showing a contingent liability as a real liability, and 6. by grouping free reserves as creditors.

Advantages of a Secret Reserve:--
1. It increases the working capital of the concern and also strengthens its financial position.
2. It enables the directors to tide over unfavourable time. As and when profit reduces, the directors can maintain the rate of dividend by utilising it.
3. Heavy losses of an exceptional nature can be met without disclosing the fact in the published statements and without disturbing the normal business profit.

Disadvantages of a Secret Reserve:

1. The Balance Sheet will not disclose true and fair position of the affairs of the business.
2. Value of shares goes down in the market.
3. The shareholders do not get their due share of profit from the business.

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