Secret Reserves: Advantages and Disadvantages

 Q. What are Secret Reserves? Give their advantages and disadvantages. 

Ans. MEANING OF SECRET RESERVES: A Secret reserve is one which is not disclosed by the Balance Sheet. These reserves are created by showing profit at figure much lower than actual and by showing the assets at a lower figure and liabilities at a higher figure. When secret reserves exist, the actual position of the firm is much better than what is disclosed by the Balance Sheet.

Secret reserves may be created in the following ways:

(i) Writing off excessive depreciation;

(ii) Charging Capital expenditure (such as addition to assets) to Profit & Loss Account.

(iii) Treating a revenue receipt as a capital receipt (such as rent received credited to building account)

(iv) Undervaluation of assets (such as undervaluation of closing stock)

(v) Showing an actual asset as a contingent asset;

(vi) Showing a contingent liability as an actual liability;

(vii) Suppressing the sales;

(viii) Creating excessive or unnecessary provision for doubtful debts and other contingencies.

ADVANTAGES OF SECRET RESERVES: 

(i) Financial Stability: Creation of secret reserves strengthens the financial position of the enterprise without disclosing this fact to the shareholders or the public.

(ii) Helpful in Absorbing Unforeseen Losses: The presence of secret reserves enable such concerns to absorb any unexpected losses with any public discomfiture.

(iii) Regularity of dividends: Such reserves help the enterprise in maintaining the rate of dividend during the adverse trading conditions without disclosing this fact to shareholders or the public.

(iv) Avoidance of Competition: Because of concealment of actual profitability of the enterprise, the entry of the competing firms in the particular line of business is avoided.

DISADVANTAGES OF SECRET RESERVES:

(i) Unfair Presentation of Financial Statements: Statement of Profit & Loss fails to disclose true profit and the Balance Sheet fails to disclose a true and fair view of the financial position of the enterprise.

(ii) Loss to Shareholders: Shareholders who wish to sell their shares may not get actual price of their shares because of understatement of profits and financial position of the enterprise.

(iii) Misuse by Management: Fraudulent management may take undue advantage by creating secret reserves. Profits may be suppressed to enable them to buy the shares of the company at a lower price and then the profits may be enhanced by eliminating the secret reserves to enable them to sell the shares at a higher price.

(iv) Cover for Misdeeds of Management: Secret reserves may be utilised by management to cover their mistakes or misleads. 

The creation of secret reserves is not allowed under the Companies Act, 1956 as it requires a full disclosure of all material facts and significant accounting policies followed in preparing financial statements.

secret reserves: advantages and disadvantages

meaning, characteristics and uses of accounting

 Q. Define Accounting. Explain the characteristics and uses of accounting.

Ans. MEANING OF ACCOUNTING: Accounting is the art of recording, classifying, summarising and communicating financial information to users for correct decision making. It gives information on:
(i) resources available
(ii) how the available resources have been employed
(iii) the results achieved by their use.
Since accounting is a medium of communication, it is called The language of business. 

DEFINITION OF ACCOUNTING: According to American Institute of Certified Public Accountants (A.I.C.P.A.), “Accounting is the art of recording, classifying and summarising in a significant manner and in terms of money, transactions and events which are, in part atleast, of a financial character, and interpreting the results thereof.”

CHARACTERISTICS OF ACCOUNTING: Following are the characteristics of accounting:
i) Accounting is an art as well as science: Art is the technique of attaining some pre-determined objectives. Accounting is an art of recording, classifying and summarising business transactions with a view to ascertain the net profit and financial position of the business enterprise.
        Any organised body of knowledge which is based on certain specified principles is called science. In this respect accounting is also a science since it is also an organised body of knowledge based on certain specified principles and accounting standards.

ii) Recording of Transaction of financial character: Only those transactions and events are recorded which are of a financial character and which can be expressed in terms of money. Hence, accounting involves the identifying of transactions and events that are considered of financial character and relate to the enterprise.

iii) Recording in terms of money: Each transaction is recorded in the books in terms of money only. For example, if business possesses ₹50,000 in Cash; Land measuring 2,000 metres; 5 trucks; 5 machines; 10 ton of raw materials; and so on. These cannot be added up and hence cannot give any useful information. But if they are expressed in terms of money, they will provide useful information such as, Cash ₹50,000; Land ₹2 crore; Trucks ₹50,00,000; Machines ₹20,00,000.

iv) Classifying: After recording the transactions in the books of accounts, the transactions are classified. Classification is the process of grouping the transactions of one nature at one place in a separate account. The book in which various accounts are opened is called ledger.

v) Summarising: Summarising is the art of presenting the classified data in a manner which is understandable and useful to management and other users of such data. This involves the balancing the ledgers and the preparation of trial balance and financial statements.

vi) Interpreting the results: Interpreting refers to explaining the results of business in such a manner that interested parties can make a meaningful Judgement (can have a full information) about profitability and financial position of the business.

vii) Communicating: It refers to transmission of summarised and interpreted information to the users who have an interest in the business enterprise to enable them to make reasoned decisions.

USES OF ACCOUNTING: Accounting is useful in following ways:
i) Useful in Management of Business: Management needs a lot of
information for the efficient running of the business. All such information is provided
by the accounting which helps the management in planning, decision making and controlling. For example management would like to know whether the sales are
increasing or decreasing and also the speed of increase in the cost of production. All such information is provided by the accounting, which helps the management in estimating the future sales and expenses. 

ii) Provides Complete and Systematic Record : Business transactions have grown in size and complexity and it is not possible to remember each and every transaction. Accounting keeps a prompt and systematic record of all the transactions and summarizes them in order to provide a true picture of the activities of the business entity.

iii) Information Regarding Profit or Loss : Accounting reports the net result of business activities of an accounting period. The Profit & Loss Account prepared at
the end of each accounting period discloses the net profit earned or loss suffered during that period. The information regarding profit is of great use to the owners and various other interested parties.

iv) Information Regarding Financial Position: Accounting reports the
financial position of the business by preparing a Balance Sheet at the end of each accounting period.

v) Evidence in Legal matters: Properly maintained accounts, supported by authenticated documents are accepted by the courts as a firm evidence.

vi) Facilitates Comparative Study: By keeping a systematic record, accounting helps the owners to compare one year's costs, expenses, sales and profit etc. with those of other years. Such a comparison provides the useful informations on the basis of which important decisions can be taken more judiciously.

vii) Facilitates in Assessment of Tax Liability: Properly maintained records will be of great help when the firm is assessed to income tax or sales tax. Such records
when audited are trusted by the taxation authorities.

viii) Facilitates Sale of Business: If a business entity is being sold, the
accounting information can be utilised to determine the proper purchase price.

ix) Helpful in Raising Loans: Accounting information is of great help while
raising loans from banks or other financial institutions. Such institutions before
sanctioning loan screen various financial statements of the firm such as final accounts, fund flow statement, cash flow statement etc.

x) Helpful in Prevention and Detection of Errors and Frauds.