What Do You Mean by Treatment of Reserves?
The term reserves mean the profit amount, which is set aside with a purpose to utilise in need. In Accounting terms, this has been referred to as appropriation. Every reserve account carries a name which indicates its purpose or its use. Reserve account is a part of the net worth of the company. Thus, this can be said that reserve is an amount that is positioned on the liability side of the financial statement.
To sum up, a reserve is the part of the profit that is not distributed among the partners but retained in the business for further use. Treatment of the reserves is also done accordingly, which is the fundamental of this chapter.
What are the Reserves?
Retained earnings are known as the reserves. They are the portions of a business’s profits that have been set aside to strengthen the business's financial position and its work performance.
The reserves majorly used to purchase the fixed assets, to repay the debts, or to even expand the business, to pay bonuses and to repay dividends. This may be confusing for the students that the IFRS Standards call provisions a 'reserve', though they are not the same thing.
What are the Revenue Reserves?
Revenue reserves are the portions of profits that are earned by a company’s normal operations which are later set aside. Revenue reserves are divided into two types. These are:
General Reserves: These reserves, as suggested by their name, are not kept aside for any particular or destined purpose, they are for the general financial strengthening of the company.
Specific Reserves: While specific reserves are set aside for a specific purpose which cannot be used for any other reason. Specific reserves are also known as the special reserves. Take, for example, a bad debt reserve, which is an amount set aside in case a customer fails to pay and bad debt happens in the company.
Reserves in Accounting
In accounting, the reserves are recorded by debiting the retained earnings account and then crediting the same amount to the reserve account. After the activity which caused the reserve to be created has been completed, the entry is to be reversed by shifting the balance back to the retained earnings account.
For example, a business which wants to set aside the reserves to fund the purchase of a new office in another outlet. They need to credit the Office Reserve fund for Rs. 10,000 and debit the retained earnings account with the same amount. Once the sale is finalised, the original reserve entry is to be reversed with Rs. 10,000 debited into the Office Reserve fund and Rs.10,000 credited to the retained earnings account.
Reserve accounts are recorded as liabilities on the balance sheet under the heading ‘Reserves and Surplus’. While if a company makes losses, then no reserves are created as there will be no such need.
Need for Reserve in Business
If we credit the entire profits to the partner’s current account, then the partners become entitled to withdraw it, in cash or other kinds. This shows that all earnings by the firm are related to the partners. This situation can seriously affect the firm’s operations. One should understand that making a profit and having the surplus cash are two different things, which must be limited in the hands of the partner. This may lead to a situation where a firm may make a decent profit and may still not have the adequate cash to payout to the partner, as surplus being utilised beforehand.
A business re-invests its profits by acquiring the assets, which may be current assets like the stocks and receivables or any other fixed assets. Where a firm allows all the partners to withdraw the entire profit from the firm, there is no possibility of any growth prospect in the volume of business.
Therefore, this is very crucial not to distribute the entire amount of profit made in a year among the partners. The business needs to retain some part of the profit in the business for its growth and its continued successful existence in future.
FAQs on Treatment of Reserves: A Comprehensive Guide
1. What is the basic accounting treatment for reserves?
The basic accounting treatment for reserves involves setting aside a portion of the company's profits. Since reserves are an appropriation of profit and not a charge against it, they are created after calculating the net profit. The journal entry debits the Profit & Loss Appropriation Account and credits the specific Reserve Account (e.g., General Reserve). This transfer reduces the profits available for distribution to shareholders as dividends.
2. What is the difference between a reserve and a provision in accounting?
The primary difference lies in their nature and purpose. A provision is a charge against profit made to cover a known liability or a probable future loss, where the exact amount is uncertain (e.g., Provision for Doubtful Debts). In contrast, a reserve is an appropriation of profit, created to strengthen the company's financial position or meet future unforeseen contingencies, not for any known liability (e.g., General Reserve).
3. What is the journal entry for creating a General Reserve?
To create a General Reserve, a portion of the divisible profits is transferred. The accounting entry for this transaction is:
Profit & Loss Appropriation A/c ... Dr.
To General Reserve A/c ... Cr.
(Being amount transferred to General Reserve out of divisible profits to strengthen the financial position of the business)
4. Where is the General Reserve shown in a company's Balance Sheet?
As per Schedule III of the Companies Act, 2013, the General Reserve is presented on the Equity and Liabilities side of the Balance Sheet. It appears under the main heading of 'Shareholders' Funds' and the sub-heading of 'Reserves and Surplus'.
5. How is a Revaluation Reserve created and treated differently from other reserves?
A Revaluation Reserve is fundamentally different from reserves created out of operational profits. Here's how:
Creation: It is created when an asset is revalued upwards to its fair market value. This is an unrealised gain, not cash profit from business operations.
Nature: It is a type of Capital Reserve because it arises from a capital transaction, not from revenue-generating activities.
Usage: Unlike a General Reserve, a Revaluation Reserve cannot be used for distributing cash dividends to shareholders. Its primary purpose is to adjust the book value of the revalued asset.
6. Why is the transfer to reserves added back when preparing a Cash Flow Statement?
The transfer of profits to any reserve is a non-cash transaction. It is merely a book entry that moves funds from the Profit & Loss Appropriation Account to a Reserve account, both of which are part of equity. There is no actual inflow or outflow of cash. When preparing a Cash Flow Statement using the indirect method, we start with Net Profit and adjust for non-cash items. Therefore, the amount transferred to reserves is added back to the Net Profit to nullify its accounting effect and arrive at the true cash generated from operations.
7. In which common scenarios are accumulated reserves distributed among partners in a partnership firm?
Accumulated reserves and surpluses represent undistributed profits belonging to the partners. They are typically distributed upon the reconstitution of the firm to ensure that incoming partners do not get a share of past profits and outgoing partners receive their share. The key scenarios are:
Admission of a new partner: Reserves are distributed to old partners in their old profit-sharing ratio.
Retirement or Death of a partner: Reserves are credited to the capital accounts of all partners (including the retiring/deceased partner) in the old ratio.
Change in the profit-sharing ratio among existing partners.
8. Can a company use its Capital Reserve to pay dividends?
No, a company cannot use its Capital Reserve to pay cash dividends. Capital reserves are generated from capital profits, such as profit on the sale of fixed assets or profit on the re-issue of forfeited shares, not from the company's regular trading operations. According to company law, these reserves are not considered free for distribution and must be retained for specific purposes like writing off capital losses or issuing bonus shares, subject to the provisions in the company's Articles of Association.
