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.