Advanced Accounting Assignment

Hidden Reserves

Prepared by Ali Ahsan

Submitted to: University of California

Contents

Contents numbers

Page

Introduction

Literature Review

Summary & Conclusion

References

10

Introduction
Reserves are funds set aside in business either for special purpose or general purpose. But some organizations create hidden reserves for fraudulent

objectives Companies operating in turbulent market conditions are inclined to conserve peak period profits and leverage them in the lean periods. This practice is not new. It seems wise to offset peaks against troughs in a time series of profit of a company or corporation. Reserves prove prudent way of managing ups and downs of profit and loss. Appropriation of profit is done via creating profit reserves whether hidden reserves or open reserves. Open reserves do not pose a danger of accounting scam however, hidden reserves do. The ABC corporations chief thinks that his company is making phenomenal profits which can be utilized by them in times of recession. They should devise some smart accounting strategy to hide these profits from being openly disclosed in their annual financial statements. In case these profits are shown up in the balance sheets, they will be subjected to heavy taxation and a larger proportion of their profits will be taken away by the states corporate commercial taxation autjorities and ABC corporation will be able to utilize only a limited poroportion of their own hard earned profits. So he is intending to hide a certain percentage of their corporations profits from now on. He called upon his comnpanys CFO and asked hiom to explain him how many types of reserves existed in accounting practice and what was the difference between them. What was the difference between reserve and provisions? What different methods and techniques could be adopted if they wanted to hide a certain percentage of their profits. What were the regulation about such a practice.

Literature Review
In response to the queries raised by the Corporations chief, CFO explained that there are 2 major types of reserves in accounting practice which are as follows: First type is Capital Reserves which are created out of capital profits which do not arise from regular trading profits. They are profits on rare transactions such as Profit on sale of fixed' assets, profit prior to incorporation, profit on redemption of debentures, profit on premium on issue of shares or debentures, profit on forfeiture of shares, profit on acquisition of business, profit which have not been earned in the regular course of business etc.. He further explained that capital reserves are generally not available for distribution as dividend. They are set aside to strengthen the financial position of the business or to meet capital losses arising from the sale of an asset. Capital reserves can be utilized in the issue of bonus shares, writing off goodwill, writing off preliminary expenses, writing off shares/debentures issue expenses, writing off losses prior to incorporation etc.. Second type is revenue reserves which are created out of revenue profits. They are available for distribution as dividend. Revenue reserves are of two types-those immediately so available for distribution and those not immediately so available. Then there are General Reserves which are essentially retained profits. It is a good business policy to create reserves as they strengthen' the' financial position of the business. Reserves are created for several purposes such as for expansion of business; for redemption of debentures or loans. Else, reserves may be created out of capital profits or out of revenue profits. The reserves created out of capital profits are called capital reserves, whereas, others are called revenue reserves. CFO further explained that: General reserve is created by setting aside revenue profits. The object could be to strengthen the general financial position of the business and this reserve is not for a specific purpose. It is a free reserve and it acts as a safety margin against contingencies in the future. It is immediately available for distribution as dividend profit.

Special reserve is created by setting aside revenue profits too. But it is created for a specific purpose. This is not immediately available for distribution. For example, a reserve created for the redemption of debentures becomes a general reserve on the redemption of debentures. Similarly, a other special purpose reserves may also be created such as a reserve for equalization of dividend etc. The Corporation chief further asked CFO would it be appropriate to create a reserve or a provision and what was the difference between the two. What could be the examples of provisions? CFO explained that provisions are a pre-profit matters. Reserves are post-profit matters. We cannot create reserves, without first finding out profits. So the difference between reserves and provisions is that of profits. Reserves are created from profits and provisions can be created before profit is calculated. He further explained that there are 4 types of provisions (Specific Reserves)

(i) (ii) (iii) (iv)

Provision for doubtful debts Reserve for discount on debtors; Reserve for discount on creditors; Reserve for repairs and renewals.

Source: http://www.evancarmichael.com/Accounting/3626/Nature-of-ReservesFunds-or-Provisions.html

The ABC Corporations chief further asked the CFO to explain him what was meant by the Hidden reserves and how could they create one? What is the hidden reserve anyways? How are they created? For what purpose can they serve and how do they remain hidden in the financial statements? CFO explained to the corporations chief that hidden reserves is a type of reserves which is not shown in final accounts of the company. It is neither shown in profit and loss appropriation account nor in balance sheet. These reserves in principle are easy to create by showing less value of assets and more value of liabilities in balance sheet. He further explained that these reserves can be created by showing heavy depreciation of assets, by

showing the less value of goodwill and closing stock of business, by showing heavy liabilities which is not of company, showing capital expenses as revenue expenses by grouping of free reserves with creditors by current asset not shown in balance sheet.

Therefore hidden reserves refer to a rather conservative accounting practice aimed at reducing current profits and storing them for less profitable future accounting periods. As regards how we can create hidden reserves, CFO explained that companies creat hidden reserves in many possible manners. Some of these are as follows: Firstly, companies create excessive provisions or provisions for non-existing obligations in order to hide profits for a particular year or a time series of years. For example, if we want to create hidden reserve, we may declare that we are going to invest PKR 10 million in a future year to realize our factorys expansion plan. Therefore, the reserve is required to be created to fund that expansion plan and then we start appoirtioning a certain percentage of our profit towrads this fake goal. Secondly, another popular source of creating hidden reserve is practiced by practicing excessive asset write-downs and /or impairments. Companies report higher depreciationof their assets than is actual for their assets, thus hiding their profits as hidden reserves. As an example after the 5 years use of the machine, we assume that the market value is still 80,000 US-$. However the value in the balance sheet is 0 US-$ (the machine was depreciated over a period of 5 years). Meaning we have a hidden reserve of 80,000 US- $. When the company now sells the machine for its market value it will receive cash in return. The amount of cash received will be reported in the balance sheet and the hidden reserve therefore unraveled. Source: http://EzineArticles.com/3186302, http://ezinearticles.com/?

expert=Wolfram_Nogge Thirdly, companies also create hidden reserve by way of adjustments of accrued or deferred expenses or revenues thus hiding their profits as hidden reserves. Fourthly, there are also several structural methods which help create hidden reserves. These include, rapid depreciation and amortisation of assets which means we charge higher

depreciations for our assets and show them in the accounting books that our assest are depleted earlier than they actually did. Fifthly, we can opt for low capitalization of costs method which will help us hide a percentage of our profits Sixthly, there are inventory valuation methods for example LIFO (Last in first out) in an environment of rising prices can production Seventhly we can adopt historical cost principle to over costing g of our cost of production thus hiding our profits. Eighthly, we create a combination of all of the above mentioned methods to show higher costs or lower profits thus contribute towards a hidden reserve. ABC Corporations chief further asked CFO to explain him what did commercial law and regulation say about the hidden reserves. CFO explained him that in every country hidden reserves are not encouraged very much because of their inherent potential for accounting frauds or scams. The company laws in our country are not in favor of hidden reserves because; it increases accounting scams and can give the management a tool to cheat the stakeholders, the taxation authority and the shareholders as well. help us hide our profits by showing higher cost of

The management can easily cheat and steal the earned profits and wealth of the shareholders, if they start to building heavy hidden reserves. This is the reason why in most countries including ours, the company law does not encourage companies to build hidden reserves because it can be an erosion of the earned profits.

Summary & Conclusion:

The foregoing discussion can be summarized as follows Summary: Companies are inclined to conserve profits by creating profit reserves whether hidden reserves or open reserves. Open reserves do not pose a danger of accounting scam however, hidden reserves do. Capital Reserves do not arise from regular trading profits and are generally not available for distribution as dividend. Revenue reserves arise from revenue profits. They are available for distribution as dividend. Special reserve is created by setting aside revenue profits too. But it is created for a specific purpose.

Hidden reserve is a type of reserves which is not shown in final accounts of the company. It is neither shown in profit and loss appropriation account nor in balance sheet. These reserves in principle are easy to create by showing less value of assets and more value of liabilities in balance sheet. He further explained that these reserves can be created by showing heavy depreciation of assets, by showing the less value of goodwill and closing stock of business, by showing heavy liabilities which is not of company, showing capital expenses as revenue expenses by grouping of free reserves with creditors by current asset not shown in balance sheet. The hidden reserves are not encouraged by the company law in our country because; it increases accounting scams and can give the management a tool to cheat the stakeholders, the taxation authority and the shareholders as well.

The management can easily cheat and steal the earned profits and wealth of the shareholders, if they start to building heavy hidden reserves.

In conclusion, it can be said that the practice of creating hidden reserves can be used to strengthen the companys financial position, it is equally liable to be used for fraudulent goals. It can steer path for the management to cheat the shareholder and infiltrate their due share of profits. Since creating reserves is usually accomplished in an in direct manner

through structural means, it is the job of the auditors to spot on this potentially lethal way of stealing shareholders wealth. This is the job of the auditors to unravel the hidden reserves through technical analysis of the financial data and statements. There are regulatory restrictions on the practice creating hidden reserves, it must still however not be forgotten that accounting experts shape accounting principles and practice at their sole discretion that can deliver their desired results which can easily elude such regulatory restrictions. This is precisely why In the case of ABC Corporation, the Corporations chief is consulting the CFO. He is trying to find ways and means to win his opinion on hidden reserves so that they may hide a part of the corporations profit this year and then adopt it as an ongoing practice for the years to come.

References:
1. 2.
Article Source: http://EzineArticles.com/3186302 Nature Provisions.html of ReservesFunds or Provisions

http://www.evancarmichael.com/Accounting/3626/Nature-of-ReservesFunds-or-

3. 4. 5. 6.

http://en.wikipedia.org/wiki/Reserve_(accounting)

http://www.list4everything.com/list-of-types-of-reserves.html http://www.svtuition.org/2009/02/types-of-reserves.html http://www.list4everything.com/list-of-types-of-reserves.html