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Treatment of Reserves and Accumulated Profits

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Last updated date: 27th Feb 2024
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An Introduction to Accumulated Profits and Losses

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

Reserves A/C Dr

Profit and Loss Account A/C Dr

To Partners Capital Account A/C

( in old profit sharing ratio)


2. For transfer of reserves and accumulated losses

Partners Capital Account A/C Dr

To Profit and Loss Account A/C

To Deferred Revenue Expenditure A/C

( in old profit sharing ratio)


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.


Accumulated Profits

XX

Add: Reserves

XX

Less: Accumulated Losses

XX

Net effect

XX


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


Journal entry in case of Profit

Gaining partners capital account Dr.

To Sacrificing Partner Capital account

Journal entry in case of Loss

Sacrificing Partner Capital account Dr.

To Gaining partners capital account


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

Date

Particulars

L.F

Dr

Cr

1 April

2022

Profit and Loss Account Dr

General Reserves Account Dr

To X Capital Account (4/9)

To Y Capital Account (3/9)

To Z Capital Account (2/9)

(Transfer of undistributed profit and general reserves on the change in profit sharing ratios)


18000

4500



10000

7500

5000


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

Liabilities

Amount

Assets

Amount

Workmen Compensation Reserve

45000

Investments (at cost)

400000

Investment Fluctuation Fund

36000




Show the accounting treatment if there is no other information.


Solution: Journal Entries

Date

Particulars

L.F

Dr

Cr

1 April

2022

Workmen Compensation Reserve Dr

To X Capital Account

To Y Capital Account

To Z Capital Account

(Transfer of workmen compensation Reserve on the change in profit sharing ratios)


45000

20000

15000

10000


Journal Entries

Date

Particulars

L.F

Dr

Cr

1 April

2022

Investment Fluctuation Fund Dr

To X Capital Account

To Y Capital Account

To Z Capital Account

(Transfer of Investment Fluctuation Fund on the change in profit sharing ratios)


36000

16000

12000

8000


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.

FAQs on Treatment of Reserves and Accumulated Profits

1. What is the workmen's compensation reserve? Explain its treatment at the time of reconstitution of the partnership firm.

Workmen's compensation reserves are made in accordance with the provisions of the Workmen Compensation Act. 

  1. When there is no claim, the reserve is distributed to old partners in the old ratio

  2. When the claim is lower, then the reserve amount is credited to the provision, and the balance is credited to the capital accounts of partners in the old ratio.

  3. When the claim is equal to the reserve amount, the entire reserve amount is transferred to the provision.

  4. When the claim is more than the reserve amount, the reserve and the excess amount is credited to the provision account, and the excess claim is debited to the revaluation account.

2. What are the possibilities when the market value of investments is less than the book value of the investments?

There are three cases when the market value of investments is less than the book value of the investments. First, when the fall in the value of the investment is less than the investment fluctuation reserve. Second, when the fall in the value of the investment is more than the investment fluctuation reserve, and last when the fall in the value of the investment is equal to the investment fluctuation reserve. So these are three cases when the market value of investments is less than the book value of the investments.

3. What are the basic adjustments of reserves and accumulated profits?

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. Profit and loss account debit balance, advertisement suspense account, miscellaneous expenditure account, and deferred revenue expenditure account will always be debited to the capital account of old partners in the old ratio. Few reserves, such as employees provident fund, taxation fund, employee saving fund, and machinery replacement fund, should ever be distributed as they are neither profits nor free reserves.