Treatment of Reserves and Accumulated Profits in Accounting

The money that is left over after businesses pay their shareholders dividends is referred to as accumulated profit, also known as retained profits. The amount is included in a company's balance sheet; more precisely, it is included in the shareholder equity section. Losses that have been carried over from prior years and the sum reflected in the company's audited balance sheet are referred to as "accumulated losses."

Effect on Accumulated Profits and Losses at the Time of Reconstitution

At the time of reconstitution of the firm, any reserves which exist at the date of admission of the partner are transferred to the old partners in either the capital account or the current account, as the case may be in their old profit sharing ratio in order to give benefit to the old partners of their contribution towards the firm.

The accounting treatment of reserves, accumulated profits or losses is classified into two parts:

1. When reserves and accumulated profits/losses are transferred to capital accounts.

2. When reserves and accumulated profits/ losses are not to be transferred to capital accounts.

Accounting Treatment When Reserves and Accumulated Profits/Losses Are transferred to Capital Accounts

The following entries shall be passed when reserves and accumulated profits/losses are transferred to capital accounts:

1. For transfer of reserves and accumulated profits

2. For transfer of reserves and accumulated losses

Accounting Treatment When Reserves and Accumulated Profits/Losses Are Not to Be Transferred to Capital Accounts

Steps involved in passing a journal entry when reserves and accumulated profits/ losses are not to be transferred to the capital accounts:

Step 1: Compute the net effect of the reserves and accumulated profit or losses.

Step 2: Calculate sacrificing/gaining share.

Sacrificing/Gaining share= Old share - New share

Step 3: Compute the share of gain and loss in the net effect (computed in step 1) for each partner.

For gaining partner = Net Effect X Share Gained

For Sacrificing partner= Net Effect X Share Sacrificed

Step 4: Adjustment entry

Specific Line Item of Reserves and Accumulated Profits/Losses

1. Free reserves such as Reserve Fund, General Reserve, Capital Reserve, Retained Earnings, Undistributed Profits, Profit and Loss Account Credit Balance and contingency reserves will always be credited to the capital accounts of old partners in the old ratio.

2. Workmen compensation reserves are made in accordance with the provisions of the Workmen compensation act. Its treatment is dependent on the claim of workmen's compensation.

3. Investment fluctuation reserves are created out of profits in order to meet the fluctuation in the value of an investment in the markets. Its treatment varies as per the market value of the investment.

4. Profit and loss account debit balance, advertisement suspense account, preliminary expenses account, miscellaneous expenditure account, and deferred revenue expenditure account will always be debited to the capital account of old partners in the old ratio.

5. Few reserves, such as employees provident fund, taxation fund, employees saving fund, and machinery replacement fund, should never be distributed as they are neither profits nor free reserves.

Solved Questions

Q1. X, Y and Z are partners sharing the profits in the ratio of 4:3:2. From 1st April 2022, they decided to share the profits equally. On that date, their book showed a credit balance of Rs. 18000 in the profit and loss account and a balance of Rs 4500 in the general reserve. Record the necessary journal entries for the distribution of profit and general reserves.

Solution: Journal Entries

Q2. X, Y and Z are partners sharing the profits in the ratio of 4:3:2 .From 1st April 2022, they decided to share the profits in the ratio of 2:3:4. On that date balance sheet is as follows:

Balance sheet (An extract)

As at 31st March 2021

Show the accounting treatment if there is no other information.

Solution: Journal Entries

Journal Entries

Conclusion

At the time of reconstitution of the partnership firm, it becomes necessary to evaluate the assets and liabilities of the firm in order to have an equitable distribution of profit or loss among the partners of the firm. There must also be the treatment of reserves, accumulated profits or losses existing at the time of reconstitution of the partnership. The accounting treatment of reserves, accumulated profits or losses is classified into two parts: when reserves and accumulated profits/losses are transferred to capital accounts and when reserves and accumulated profits/ losses are not to be transferred to capital accounts.