Unit-2

-Accounting for Non Profit Organizations

Usually, every business undertakes economic activities with a motive to earn a profit. But, there
are some organizations which work with a motive to provide service to its members as well as to
the general public. The trustees of these organizations are fully accountable to the members and
the public. Hence, Accounting for Non-Profit Organizations become necessary. Examples of
such organisations are charitable institutions, religious organisations, clubs, educational
institutions, trade unions, etc. As we know that the not-for-profit organisations do not trade in
goods or provide services with a profit motive. But, they also require to keep proper records of
incomes, expenses, assets, and liabilities. Their major source of income is donations,
subscriptions, grants, etc. Therefore, most of their transactions are in cash or through the bank
account. They need to keep proper books firstly because they are accountable to the members and
the contributors and secondly because the law requires them to maintain proper books so that the
government can keep proper control over the grants. Also, proper accounting reduces the risk of
fraud and embezzlement. In addition to the ledgers and cash book, they are also required to
maintain a stock register. Also, in a Stock register, a complete record of all fixed assets and
consumables is maintained.

In accounting for non-profit organizations, instead of maintaining a Capital A/c, these

organizations maintain Capital Fund or General Fund A/c. They credit this account with the
surplus, life membership fees, donations, legacies, etc. The final accounts of these organisations
consist of:

1. Receipts and Payments A/c: It is the summary of the cash and bank transactions. It
helps in the preparation of Income and Expenditure A/c and Balance Sheet. We also
need to submit it to the Registrar of Societies along with Income and Expenditure A/c
and Balance Sheet.

2. Income and Expenditure A/c: It is similar to the Profit and Loss A/c and ascertains
the surplus or deficit if any.

3. Balance Sheet: We prepare it in the same manner as the Balance Sheet of concerns
with a profit motive.
Characteristics of Not-for-Profit Organizations

1. Service Motive: These organisations have a motive to provide service to its members
or a specific group or to the general public. They provide services free of cost or at a
bare minimum price as their aim is not to earn the profit. They do not discriminate
among people on the basis of their caste, creed or colour. Examples of services
provided by them are education, food, health care, recreation, sports facility, clothing,
shelter, etc.

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 2. Members: These organisations are formed as charitable trusts or societies. The
subscribers to these organisations are their members.

3. Management: The managing committee or the executive committee manages these

organisations. The members elect the committee.

4. Source of Income: The major sources of income of not-for-profit organisations are

subscriptions, donations, government grants, legacies, income from investments, etc.

5. Surplus: The surplus generated in the due course is distributed among its members.

6. Reputation: These organisations earn their reputation or goodwill on the basis of the
good work done for the welfare of the public.

7. Users of accounting information: The users of the accounting information of these

organisations are present and potential contributors as well as the statutory bodies .
8.
Difference Between Non-profits and For Profit

Non-profit Organizations are those incorporated not for earning some income from their
activities. Rather their primary motive is to enable activities that are generally for aiding or
advancement of the society at large and are not required to pay taxes. In contrast, For-Profit
Organizations are those entities incorporated with a primary objective of earning economic and
monetary benefits either directly or aiding in that process.
Profit. Non-profits

Purpose To make profits for one‟s To make profits for serving society.
fulfillment.

Types of organizations The organization can be a The organizations that are of non-
company, partnership, or sole profit types are clubs, trusts, society,
proprietorship firm. etc.

People that manage Business owners, sole proprietors, Trustees, governing bodies, or
or partners. committee members.

Revenue source The revenue source of this type of The revenue sources of this type of
organization is selling goods and organization are donations,
services. subscriptions, grants, etc.

Seed capital arranged In the case of this type of In the case of a nonprofit
by organization, seed capital is organization, seed capital is arranged
arranged by the business owners or by sourcing government grants,
founders of the asking for donations, etc.
company/proprietorship firms.

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Financial For-profit organizations, the The receipts & payments account,
statements/accounts income statement, the cash flow income & expenditure account, and
prepared statement, and the balance sheet balance sheet for a non-profit
are prepared. organization are prepared.

-Receipt and Payment Account

A Receipt and Payment Account is a financial statement that provides a summary of cash
transactions conducted by an organisation over a specific period, typically covering a year. It is
commonly used by non-profit organisations, clubs, societies, and similar entities to track their
cash inflows and outflows. The primary purpose of this account is to show the sources of cash
receipts and the uses of cash payments during the accounting period.

Receipt and Payment Account serves as a simple and effective tool for organisations to manage
and report their cash transactions. It offers insights into the liquidity and cash flow position of
the entity over a specific period.

Nature of Receipt and Payment Account

The nature has been stated below.

Cash Transactions Only: The Receipt and Payment Account exclusively deals with cash
transactions. It records all cash receipts and payments made by an organisation during a specific
period.

Current and Liquidity Focus: It provides a snapshot of an organisation's current and liquidity
position by detailing cash inflows and outflows. This focus on cash transactions helps in
assessing the organisation's ability to meet its short-term obligations.

No Accrual Basis: Unlike other financial statements, such as the Income and Expenditure
Account, the Receipt and Payment Account does not follow the accrual basis of accounting. It
records transactions when cash is actually received or paid, regardless of when the income is
earned or expenses incurred.

Limited Financial Analysis: The account is not designed for in-depth financial analysis. It lacks
details on revenues, expenses, profits, and losses. Instead, it serves as a summary to show where
the cash came from and how it was spent.

Prepared at Regular Intervals: It is typically prepared at regular intervals, often annually. This
periodicity allows organisations to summarise their cash activities over a defined timeframe.

Simple Format: The Receipt and Payment Account is presented in a simple format, with two
columns for receipts and payments. This simplicity makes it accessible and easy to understand,
especially for small organisations with limited accounting resources.

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Compliance Requirement: In many jurisdictions, non-profit organisations are required to
prepare a Receipt and Payment Account as part of their financial reporting obligations. This
emphasises its role in regulatory compliance.

Supplement to Other Financial Statements: While it provides valuable information on cash

transactions, the Receipt and Payment Account is often used in conjunction with other financial
statements, such as the Income and Expenditure Account and Balance Sheet, to present a more
comprehensive financial picture.

-INCOME AND EXPENDITURE ACCOUNT

MEANING :
Income and expenditure account is a summary of revenue income and revenue expenses of a
particular period. It is similar to profit and loss account in the sense that it gives the picture of
working results of the concern. ' Not for Profit ' concerns prepare Income and Expenditure
Account. It is a Nominal Account. Hence, all expenses / losses of current year are debited and
income / gains of current year are credited to this account.

INCOMES :
In income and expenditure account only revenue income or gains of the current period are
credited. e.g. Subscription received, Interest on investment received, Sundry receipts, General
donation received, Tuition fees etc.

Items of income of ' Not for Profit ' concern may differ from concern to concern. They depend
upon the activity of the concern. Income received for previous year are not taken into this
account. However, all incomes pertaining to current year, whether received or not received or
received during the previous year, for this year, are taken into account. In other words,
outstanding incomes and Pre-received incomes of current year are considered.
EXPENDITURES :
In income and expenditure account only revenue expenses / losses of current period are debited.
e.g. Rent paid, Salaries to staff, Honorarium paid, Purchase of stationary etc.

Items of expenses of ' Not for Profit ' concern may differ from concern to concern. They depend
upon the activity of the concern. Expenses paid for previous year or for next year are not taken
into account. However, all expenses pertaining to current year. Whether actually paid or not paid
or paid during the previous year, for current year, are taken into account. In other words,
outstanding expenses and prepaid expenses during previous year are considered.

The difference in revenue income and expenditure may be surplus /deficit. Income and
expenditure account shows this surplus / deficit of the concern, in the particular period. If their is
a surplus, it is added in the 'Capital Fund' and if there is deficit it is deducted from the 'Capital
Fund'.
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Items of capital receipts are not recorded in income and expenditure account. e.g. proceeds of
the sale of fixed assets, donations received for specific fund like building fund, prize fund etc.

Items of capital expenditure are not recorded in income and expenditure account. e.g.
construction of building, purchase of books, furniture etc.

Items of capital receipts and capital expenditure are shown in balance sheet.

FEATURES OF INCOME AND EXPENDITURE ACCOUNT:

1. Income and expenditure account is a nominal account.

2. In income and expenditure account consider only revenue expenses and revenue incomes,
pertaining to current year are recorded
3. Income and expenditure account is similar to profit and loss account, in the sense that, it gives
the picture of working results of the concern.
4. ' Not for Profit ' concerns prepare income and expenditure account instead of profit and loss
account.

5. This account is prepare for finding out surplus / deficit to a concern for a particular period.

6. Income and expenditure account is a part of final accounts of ' Not for Profit ' concern.
Therefore, it is always accompanied with balance sheet.

7. It has no opening balance.

8. It's closing balance shows either surplus / deficit, which is transferred to capital fund
9. It record all cash items and non-cash items, which are related to current period.

e. g. Salaries paid, and also outstanding salary, bad debts written off, depreciation etc.

-DEPRECIATION
Depreciation is the allocation of the depreciable amount of an asset over its estimated useful life.
According to AS-6, depreciation is a measure of wearing out, consumption or other of value of a
depreciable asset arising from use, effusion of time or obsolescence through technology and
market changes. Depreciation is allocated so as to charge a fair proportion of the depreciable
amount in each accounting period during the expected useful life of the assets. Depreciation
includes amortization of assets whose useful life is pre determined. The American Institute of
Certified Public Accountants (AICPA) employed the definition as given below:
“Depreciation Accounting is a system of accounting which aims to distribute the cost or other
basic value of tangible capital assets, less salvage value (if any) over the estimated useful life of

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unit (which may be a group of assets) in a systematic and rational manner. It a process of
allocation, not that of valuation. Depreciation for the year is the portion of the total charge under
such a system that is allocated to the year.

Depreciation, Depletion, Obsolescence and Amortization:

The terms depreciation, depletion, obsolescence and amortization are used often
interchangeably. However, these different terms have been developed in accounting usage for
describing this process for different types of assets.
Depreciation: Depreciation is concerned with charging the cost of man made fixed assets to
operation (and not with determination of asset value for the balance sheet). In other words, the
term depreciation is used when expired utility of physical asset (building, machinery, or
equipment) is to be recorded.
Depletion: This term is applied to the process of removing an available but irreplaceable
resource such as extracting coal from a coal miner or oil out of an oil well. Depletion differs
from depreciation in that the former implies removal of a natural resource, while the latter
implies a reduction in the service capacity of an asset.
Amortization: The process of writing off intangible assets is termed as amortization. The
intangible assets like patents, copyrights, leaseholds and goodwill are recorded at cost in the
books of account. Many of these assets have a limited useful life and are, therefore, written off.
Obsolescence: It refers to the decline in the useful life of an asset because of factors like (i)
technological advancements, (ii) changes in the market demand of the product, (iii) legal or other
restrictions, or (iv) improvement in production process.

CAUSES OF DEPRECIATION
The depreciation occurs because of the following:
1. Constant use: The constant use of assets results into their wear and tear, which in turn reduces
their working capacity. Hence, a decrease in the value of assets may be seen due to reduced
capacity. The value of assets like, machinery, furniture, etc., declines with the constant use of
them.
2. Passage of Time: Many fixed assets lose their value with the passage of time. This holds true
in case of intangible fixed assets such as patents, copyrights, lease hold properties etc. The term
amortization is generally used to indicate the reduction in the value of such assets.
3. Depletion: Depletion also causes decline in the value of certain assets. This is true in case of
wasting assets such as mines, oil wells and forest-stands. On account of continuous extraction of
minerals or oils, these assets go on declining in their value and finally they gets completely
exhausted.
4. Obsolescence: There may not be any physical deterioration in the asset itself. Despite of this
there may be reduction in the utility of an asset that results from the development of a better
method, machine or process. For example, an old machine which is still in good working
condition may have to be replaced by a new machine because of the later being more economical

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as well as efficient. In fact, new inventions, developments in production processes, changes in
demand for product or services, etc. make the asset out of date.
5. Accidents: An asset may get reduction in its value if it meets an accident.
6. Permanent fall in the Market Value: Certain assets may get permanent fall in their value and
the decline in their value is treated as depreciation. For example, a permanent decline in the
market value of securities and investment may be assumed as depreciation.

FACTORS AFFECTING DEPRECIATION

In order to assess depreciation amount to be charged in respect of an asset in an accounting
period the following three important factors should be considered:
1. Cost of the asset: The knowledge about the cost of the asset is very essential for determining
the amount of depreciation to be charged to the profit and loss account. The cost of the asset
includes the invoice price of the asset less any trade discount plus all costs essential to make the
asset usable. Cost of transportation and transit insurance are included in acquisition cost.
However, the financial charges such as interest on money borrowed for the purchase for the
purchase of the asset should no be included in the cost of the asset.
2. Estimated life of the asset: Estimated life generally means that for how many years an asset
could be used in business with ordinary repairs for generating revenues. For estimating useful
life of an asset one must begin with the consideration of its physical life and the modifications, if
any, made, factors of obsolescence and experience with similar assets. In fact, the economic life
of an asset is shorter than its physical life. The physical life is based mostly on internal policies
such as intensity of use, repairs, maintenance and replacements. The economic life, on the other
hand, is based mostly on external factors such as obsolescence from technological changes.
3. Scrap Value of the Asset: The salvage value of the asset is that value which is estimated to be
realized on account of the sale of the asset at the end of its useful life. This value should be
calculated after deducting the disposal costs from the sale value of the asset. If the scrap value is
considered as insignificant, it is normally regarded as nil.

METHODS OF CALCULATING DEPRECIATION

There are different concepts about the nature of depreciation. Moreover, the nature of all fixed
assets cannot be the same. As a result, different methods are found to exist for charging
depreciation. A broad classification of the methods may be summarized as follows:

Straight Line Method

This is also known as fixed installment method. Under this method the depreciation is charged
on the uniform basis year after year. When the amount of depreciation charged yearly under this
method is plotted on a graph paper, we shall get a straight line. Thus, the straight-line method
assumes that depreciation is a function, of time rather than use in the sense that each accounting
period received the same benefit from using the asset as every other period. The formula for
calculating depreciation charge for each accounting period is:
This method has shortcomings

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. First, it does not take into consideration the seasonal fluctuations, booms and depression. The
amount of depreciation is the same in that year in which the machine is used day and night and in
the another year in which it is used for some months.

Second, it ignores the interest on the money spent on the acquisition of that asset.

Third, the total charge for use of asset (i.e., depreciation and repairs) goes on increasing from
year to year though the assets might have been in use uniformly from year to year. For example,
repairs cost together with depreciation charged in the beginning years is much less than what it is
in the later years. Thus, each subsequent year is burdened with greater charge for the use of asset
on account of increasing cost on repairs.

Diminishing Balance Method

This is also known as Written down value method [WDV]. Under the diminishing balance
method depreciation is charged at fixed rate on the reducing balance (i.e., cost less depreciation)
every year. Thus, the amount of depreciation goes on decreasing every year. Under this method
also the amount of depreciation is transferred to profit and loss account in each of the year and in
the balance sheet the asset is shown at book value after reducing depreciation from it. For
example, if an asset is purchased for Rs. 10,000 and depreciation is to be charged at 20% p.a. on
reducing balance system then the depreciation for the first year will be Rs. 2000. In the second
year, it will Rs. 1600 (i.e. 20% of 8000), in the third year Rs. 1280 (i.e. 20% of 6400) and so on.

-Provision
Provision means setting aside a part of the profits for meeting a liability in future, the amount of
which is not known accurately at the time of finalization of financial statements. In any business,
there may be some expected or unexpected eventualities, which must be met by the businessmen
without delaying them, further. So based on the convention of conservatism, it is necessary for
every business enterprise to conduct the business prudently. For this purpose, necessary
provisions and reserves are to be created at the time of preparation of financial statements.
Provision is to be made in respect of a liability, which is certain to be incurred, but its exact
amount is not known. If the exact amount can be known, it becomes a liability and not provision.
„Provision for Legal Damages‟, „Provision for Depreciation‟, „Provision for Taxation‟,„Provision
for Doubtful Debts‟, and „Provision for Discount on Debtors‟ are few examples of provisions.
Provision is a charge against the profits, which means that irrespective of the fact whether
business enterprise is earning sufficient profit or not, provision has to be made in the financial
statements. Even in the case when the business enterprise is suffering heavy losses, provisions
are to be made. It is worth mentioning that creation of provision does not affect flow of cash
because it is an internal transaction.

According to Part III, Schedule VI of the Companies Act, 1956, „provision‟ means “any amount
written off or retained by way of providing for depreciation, renewals or diminution in value of
assets, or retained by way of providing for any known liability of which the amount cannot be

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determined with substantial accuracy”.
Objectives of Provisions:
1. For Ascertainment of True Net Profit:
For ascertaining true net profit of the business, expenses pertaining to that year, paid or
outstanding must be shown in Profit and Loss Account. In addition a provision should also be
created for those expenses or liabilities for which the exact amount is unknown or cannot be
ascertained accurately. For example provision created for doubtful debts, provision for discount
on debtors etc.
2. For Ascertainment of True Financial Position:
The business must make adequate provisions for all expenses and losses, only then the Balance
sheet will depict the true and fair view of the financial position of business.
3. To Provide for Known Losses in the Future: For meeting a liability in future, the amount for
which is unknown, steps should be taken to set, aside a part of profits. For example, provision
for taxation, provision for repairs, provision for bad debts etc.
4. For Uniform Charge on Income Statements:
For equal distribution of expenses and losses in all the years so that proper analysis can be made,
provisions are required to be created. For example, Rs. 10,000 was to be incurred during the
entire life of the machine, estimated life of which was 10 years

Types of Provision in accounting:

Thus the creation of provision ensures proper matching of revenues and expenses and calculation
of true profit. The following provisions are created at the time of preparing financial statement:
1. Provision for Bad and Doubtful Debts:
Generally, there are some of the debts, which cannot be realized from the debtors/receivable due
to various reasons like death of debtors; insolvency, liquidation or debtors are not traceable etc.
These types of debtors/receivable are treated in the books as a term of bad debts.
2. Provision for Discount to debtors:
To get payment earlier we have to give the discount to our sundry debtors/ Receivables. So, a
provision for discount to debtors/receivable in the current year is to be made.
3. Provision for Discount from Creditors:
The creditors/payable will also give us a discount to get paid earlier. So, a provision for the
discount from Creditors/Payable in the current year is to be made. However, in practicality if,
there is an agreement between the business and the creditors for some provision of discount/cash
back (as in case of digital transactions nowadays), only then, shall one provide for the discount
from creditors. The discount provision is available in advance as a rate or as mentioned in the
agreement.
4. Provision for Taxation:
The Provision for taxation is created to meet expected income tax payable on the income of the
current year.
5. Provision for Depreciation:
The depreciation charged till date appears in the provision for depreciation account, which is

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shown either on the “liabilities side” of the balance sheet or by way of deduction from the
original cost of the asset concerned on the asset side of the balance sheet.

Accounting Treatment for Provisions

The accounting treatment of all types of provisions is almost similar. Therefore, the accounting
treatment is explained here taking up the case of provision for doubtful debts. As already stated
that when business transaction takes place on credit basis, debtors account is created and its
balance is shown on the asset-side of the balance sheet. These debtors may be of three types:
Good Debtors are those from where collection of debt is certain.

• Bad Debts are those debtors from where collection of money is not possible and the amount of
credit given is a certain loss.

• Doubtful Debts are those debtors who may pay but business firm is not sure about the
collection of full amount from them. In fact, as a matter of business experience, some percentage
of such debtors are not likely to pay, hence treated as doubtful debts. To consider this possible
loss on account of non-payment by some debtors, it is a common practice (and necessary also) to
make a suitable provision for doubtful debts at the time of ascertaining true profit or loss. The
provision for doubtful debts is usually calculated as a certain percentage of the total amount due
from sundry debtors after deducting/writing-off all known bad debts. Provision for doubtful
debts is also called „Provision for bad and doubtful debts‟. It is created by debiting the amount of
required provision to the profit and loss account and crediting it to provision for
doubtful debts account.

-Reserve
Reserve means an appropriation of profits or other surpluses to strengthen the liquid resources of
the business enterprise and not for meeting any liability, contingency or any commitment of the
business.
According to William Pickles, “Reserve means the amount set aside out of profit and other
surpluses, which are not earmarked in any way to meet any particular liability known to exist on
the date of Balance Sheet.”
Actually, in addition to the capital contributed by the proprietor, the amount set aside from the
profits or surpluses to reserves belongs to the proprietor, which will help the business during
difficult financial period. It is an appropriation of profits and not charged on the profits. This
means that in the case of loss, reserves cannot be created.. They are not created to meet any
liabilities, contingencies or commitments. It is important to mention here that the business cannot
create reserves in anticipation of some losses; however, in case of loss, reserves can be utilized.
When amount of reserve is invested in some outside securities it is known as „Reserve Fund‟.
Since reserves are appropriation and not charge against profits, they are shown in Profit and Loss
Appropriation Account instead of Profit and Loss Account.

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Importance of Reserves:
(i) Strengthening the Financial Position:
Reserves help in strengthening the financial position of the enterprise, since it can be used to
meet any unforeseen losses that may arise in future.
(ii) Source of Internal Financing:
By creating the reserves, profits are ploughed back into the business, which can be used as
source of finance.
(iii) Enhancing the Reputation of Enterprise:
In order to enhance the reputation or image of the company, regular dividends must be paid to
the shareholders in time. It is also necessary that the dividend should be equalized over the years.
This objective can be achieved, if the company maintains reserves because in the years of
inadequacy of profits, amount can be withdrawn from these reserves and paid to the
shareholders.
(iv) Keeping Working Capital Intact:
Reserve increases the working capital of the business enterprise. So in emergent and unforeseen
circumstances, business enterprise can use the amount kept in reserves and keep working capital
to the required level.
(v) Facilitating Heavy Amount when Needed:
Reserves can be created for some specific purpose, which can be used to meet that purpose only.
For the redemption of debentures, company has to pay huge amount to debenture [Link]
the debenture become due for payment, the company may face a financial difficulty, because a
large amount is generally required for redemption of debentures.
If, in a single go, such a large sum is to be paid out of the working capital, the operational
efficiency of the company may get affected adversely. Hence, it is always a prudent policy for a
company to retain some money out of its profits for redeeming the debentures. For this purpose
„Debenture Redemption Reserve‟ can be maintained by the company, in which a fixed amount of
profit is transferred. This will facilitate payment of such huge sum, when repayment to debenture
holders is due.
Types of Reserves:
Broadly, there are two types of reserves:
(i) Revenue reserves and
(ii) Capital Reserves
1. Revenue Reserves:
Revenue reserves are created out of profits, which have been earned in the normal course and
from the day to day activities of the business concern. Revenue reserves may further be classified
as:
(i) General Reserve
(ii) Specific Reserve and
(iii) Secret Reserve.
(A) General Reserve:

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General reserve is that amount of profits, which are set aside to meet some future contingencies
and not created for any specific purpose. These are generally retained for strengthening the
financial position of the business concern and to provide additional working capital for the
business when needed. Since this reserve can be utilised to meet any unknown purpose, so it is
also called „Contingency Reserve‟ or „Free Reserve‟.In any business enterprise, general reserve
is created for the following purposes:
(a) To strengthen the financial position of the business concern
(b) To make available additional working capital all the times
(c) To meet any liability or contingency, in case of unforeseen circumstances
(d) To equalize the rate of dividend over the years in case of inadequate profits
(B) Specific Reserve:
Specific reserves are created for some specific purposes. These reserves cannot be utilised for
any purpose other than the purpose for which they were created. However, if the article of
association permits then at the discretion of board of directors, specific reserves may be used for
a purpose other than the purpose of its creation.
Some examples of specific reserves are as under:
1. Dividend Equalization Reserve
2. Debenture Redemption Reserve
3. Investment Fluctuation Reserve
4. Workmen Compensation Fund
(i) Dividend Equalization Reserve:
Dividend equalization reserve is created to equalize the rate of dividend over the years. Usually,
in the year of large and adequate profits, a portion of profits is transferred in this account and in
the year of inadequate profits, the amount kept in this account can be used for paying the
dividend to the shareholders.
(ii) Debenture Redemption Reserve:
Debenture redemption reserve is created for the purpose of redemption of debentures at the end
of some specific period. In this connection, every year a specific sum out of the divisible profits
is set-aside in this reserve. The amount is to be invested in securities. The amount accumulated
with compound interest
produces the required amount, which has to be paid to debenture holders.
(iii) Investment Fluctuation Reserve:
Sometimes business enterprises invest their surplus funds outside their business in shares,
debentures or other securities. Also, the price of such investments keeps on changing, depending
on certain market conditions and/or government policies etc. To bear any loss in case of decrease
in value of such investments, business enterprises sets aside a part of profit in Investment
Fluctuation Reserve, so that any loss arising on account of decrease in value of such investment
can be met from this reserve.
(C) Secret Reserve:
Secret reserve is a reserve that does not appear in the balance sheet. It can be created in the years

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of higher profits and can be merged with the profits during the lean periods. Secret reserves can
be created as under:
(i) By undervaluing stock,
(ii) By making excessive provisions then the required,
(iii) By charging capital expenditure to revenue,
(iv) By showing contingent liabilities as actual liabilities of the enterprise.
Secret reserve is secret in the sense that the outsiders do not know it. It is suggested that keeping
in view the requirement of the case, secret reserve should be created within reasonable limits.
2. Capital Reserves:
Capital reserves are the reserves created out of capital profits.
Following are the examples of some items, which may form capital reserves:
1. Profit on Sale of Fixed Assets
2. Profit on Revaluation of Fixed Assets
3. Securities Premium received on Issue of Shares or Debentures.
4. Profit on Redemption of Debentures.
5. Profit prior to Incorporation
6. Profit on Re- issue of Forfeited Shares, etc.
Capital reserves can be utilized for writing off capital losses. However, in the case of joint stock
Company, capital reserves can also be utilized for issuing fully paid bonus shares to the
members. Generally, capital reserves are not available to shareholders for distribution of profits.
However, some capital reserves such as profit on sale of fixed assets can be utilized for
distribution as dividend, if the following conditions are satisfied:
(i) Articles of Association permit the company to do so,
(ii) The profits on sale of fixed asset must have been realized by the company in cash,
(iii) Such profits exist after revaluation of all assets and liabilities and not due to revaluation of
assets only.

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